ON-LINE LICENSING STRUCTURES – CURRENT ISSUES
By
Lorin Brennan*
The Internet has now evolved into an accepted platform for commercial activity.
Several years ago, seminars like this were concerned whether it was even possible to make an
on-line contract. The courts have now put those issues to rest. Of course parties can contract
in an on-line environment. The main issues in on-line commerce now are centering on
traditional contract law issues of formalities, interpretation, enforcement and the like.
A large part of on-line contracting involves intellectual property interests. This has
led to a curious split in the cases. In general terms, when contract issues arise in an
infringement action, the courts tend to look first to the intellectual property laws and give
preference to their principles, often engaging in a preemption analysis. On the other hand,
when the contract issues arise in a traditional commercial law setting, such as a breach of
warranties, the courts tend to given preference to traditional commercial law rules, which are
traditionally grounded in state law. The result in many areas is two streams of decisions,
often reaching opposite results on similar facts depending on how the issue is framed. This
situation has placed on ever greater premium on clear contract drafting in order to give the
courts guidance on how an issue should be resolved.
This paper discusses a variety of contract issues that arise when licensing intellectual
property in an on-line environment. Primarily, this is a nuts-and-bolts approach, identifying
specific areas of conflict and suggesting practice pointers to head off disputes.1 The basic
idea is that it is better to take the time to craft the result you want up front in an agreement
than to wait for often unpredictable results in the courts.
A.
WHAT TYPE OF CONTRACT IS IT?
The first issue in drafting an on-line contract is to ask: what type of contract is it? As
on-line commerce has evolved, a variety of increasingly sophisticated types of contractual
structures have begun to emerge. These contracts in turn raise different structural and
business issues that often require a tailored approach. While many issues are common to all
of these contracts, there are often differences in emphasis and detail. This means that there is
no one-size contact that fits all cases. Instead, one must be sensitive to the different
commercial results the contracts are trying to attain. With this understanding in mind, we
might identify some types of on-line contacts commonly in use:
Upload Contract: This is a contract under which a transferor who owns or controls
information authorizes a transferee to make it available on its web site for further access or
use. A typical example is a licensing music or a motion picture to a web site, such as the
IFTA® Internet Rider, an industry standard form for licensing motion pictures over the
Internet.2 In the usual case, these contracts happen “off-line” in the sense that the contract is
negotiated and documented between the information provider and the web site operator
outside the web environment. However, some companies are developing on-line licenses in
* Manager, Gray Matter LLC, Newport Beach, California.
Gray Matter is a company that develops
intellectual property licensing and accounting software.
1 Many of the details in this paper are drawn from Lorin Brennan, Holly K. Towle & Joel Wolfson,
COMMERCIAL INFORMATION LAW, vol. 1, The Complete UCITA, (2005).
2
See Howard M. Frumes, Susan Cleary and Lorin Brennan, Developing and Internet and Wireless
License Agreement for Motion Pictures and Television Programming, 1 J. of International Media and
Entertainment Law 283 (2007).
which clients can conclude a contract directly over the Web and then deliver the content
electronically to the site. Thus, the term “upload” contract. An example is an agreement
between a writer and Amazon.com for marketing his books on its website.3
Download Contract: A “download” contract is the opposite side of the coin. It is a
contract under which a web site makes informational content available to the customer.
Access can be on a “streaming” or “downloading” basis (or sometimes a combination of
both). In streaming use, the customer can view the content in real time, but generally cannot
keep a copy other than the transient copy used to enable viewing. Sometimes this is called
“Internet Pay-Per-View.” In downloading use, the customer can keep a copy either on a
permanent basis, sometimes called “download to burn,” or temporary basis, sometimes called
“download to rent.” Downloading activities are often called “Internet Video on Demand.”
Access Contract: An access contract is an agreement that authorizes a customer to
access the site. This is different from a download contract, which authorizes access to
particular information content on the site. An access contact is often used in membership
sites, where a single periodic fee authorizes the customer to access individual items of content
without further charge. An example is an agreement to enter the Virtual World Second Life.4
Sometimes site owners believe that they do not need an access contract if they have a
download contract. This is not correct. An access contract determines terms for accessing
the site, as opposed to acquiring content from the site.
Financial Services: This is an agreement to provide ancillary services to a site to
facilitate e-commerce, such as payment or credit card processing. An example is an
agreement with a payment processor such as PayPal.5
E-commerce Contract: This is an agreement to sell traditional goods and services
over a web site. The contract may be an electronic contract made on-line, but it involves the
purchase and sale of traditional goods. An example is an on-line contract for the sale of
computers.6
Feed Contracts: This is a contract to provide content from one web site to another
web site. In some cases, the feed service also agrees to build the recipient web site. In such
contracts, one needs to obtain permission to access the content of the originating site in order
to make it available on the recipient site.7
Of course, a variety of other types of contract are possible. Yet several of these
contracts illustrate common themes now emerging in on-line contract disputes.
B.
DOES THE DEAL NEED TO BE SIGNED?
It is of course always good practice to make sure that an intellectual property contract
is duly authenticated – “signed” in the pre-electronic world – to comply with the Statute of
Frauds. If the contract involves a transfer of ownership, i.e., an assignment for patents and
trademarks, or an assignment or exclusive license for copyrights, then applicable federal
3
Hammer v. Amazon, 392 F.Supp.2d 423 (E.D. N.Y. 2005).
Bragg v. Linden Research, Inc. 487 F.Supp.2d 593 (E.D. Penn. 2007).
5
E.g. Combs v. PayPal, Inc. 218 F.Supp.2d 1165 (N.D. Cal. 2002).
6
E.g. Dell, Inc. v. Stenzel, 870 A.2d 133, 2005 ME 37 (2005).
7
E.g. SMC Promotions, Inc. v. Official Site Builders Corporation, 355 F.Supp.2d 1127 (C.D. Cal. 2005)
4
legislation requires an authenticated writing.8 However, what about a non-exclusive license?
Many on-line contracts are non-exclusive. Since federal law does not expressly require an
authenticated record for a non-exclusive license, does this mean that state law cannot require
one, or is a state Statute of Frauds nonetheless applicable to non-exclusive license?
1.
State Statute of Frauds and On-Line Contacts:
The issue of the applicability of a state law Statute of Frauds to an on-license contract
has been primarily litigated with respect to copyright licenses. Unfortunately, the courts are
divided on the proper result depending on whether the case arises in a commercial or an
infringement context.
Copyright Act § 204(a) requires a “signed writing” (now an “authenticated record”
due to E-Sign) for any “transfer of copyright ownership.”9 The definition of “transfer of
copyright ownership” excludes “non-exclusive licenses.”10 Thus, the federal courts are quite
clear that a non-exclusive copyright license does not require a “signed writing.”11 What they
are not clear about is whether Section 204(a) permits states to impose a writing requirement.
From a commercial law perspective, an argument can be made that since nonexclusive licenses are not mentioned in Section 204(a), Congress left the matter open for the
states to decide.12 This view is bolstered by decisions in the Second and Third Circuits, along
with several state courts, which have applied the local state statute of frauds to non-exclusive
software licenses.13 Unfortunately, none of these cases addresses the Copyright Act at all.
From the intellectual property law perspective, the counter argument is that Congress,
by saying nothing, intended that there be no writing requirement for non-exclusive licenses.14
Cases in the Fifth, Seventh, Ninth and Eleventh Circuits support this view by enforcing oral,
on-exclusive licenses.15 Unfortunately, these cases do not expressly hold that the Copyright
Act prohibits application of a state Statute of Frauds to a nonexclusive copyright license.
Rather, they simply avoid the issue.
8
Patents: 35 U.S.C. § 261; Copyrights, 17 U.S.C. § 203; Trademarks, 15 U.S.C. § 1060; see
generally COMMERCIAL INFORMATION LAW § 201[I] for further discussion
9
17 U.S.C. § 204(a).
10
17 U.S.C. § 101.
11
E.g. Lulirama, Ltd. v. Axcess Broadcast Services 128 F.3d 872, 879 (5th Cir. 1997); I.A.E., Inc.
v. Shaver, 74 F.3d 768, 775 (7th Cir. 1996).
12
See Paul Goldstein, COPYRIGHT § 4.5.1.b (2nd ed. 1999) (“It is not clear whether Congress’s
decision to omit non-exclusive licenses from §204(a)’s coverage preempts state statute of frauds
provisions requiring that non-exclusive licenses be in writing”).
13
Grappo v. Alitalia Linee Aeree Italiane, S.p.A. 56 F.3d 427 (2nd Cir. 1995); Advent Systems, Ltd.
v. Unisys Corp. 925 F.2d 670 (3rd Cir 1991); Triangle Underwriters, Inc. v. Honeywell, Inc. 604 F.2d
737 (2nd Cir. 1979); Systems Design and Management Information, Inc. v. Kansas City Post Office
Employees Credit Union, 14 Kan.App.2d 266, 788 P.2d 878 (1990) (applying Article 2 statute of
frauds to non-exclusive license under Kansas law); Myers v. Waverly Fabrics, 101 A.D.2d 777, 475
N.Y.S.2d 860 (N.Y.A.D. 1984) aff’d 65 N.Y.2d 75 (1985) (New York law); Freedman v. Select
Information Systems, Inc., 221 USPQ 848, 851 (N.D. Cal. 1983) (California’s general contract law)
14
E.g. Melville D. Nimmer & David Nimmer, NIMMER ON COPYRIGHT § 10.03[A][7] (arguing by
“negative implication” that a non-exclusive license does not require a writing) and § 10.03[A][8]
(“…contract rules established under state law can not invalidate any aspect of federal copyright law.
Given that the statute of frauds at issue in Grappo subjected non-exclusive licenses – which may be
oral under federal law regardless of value – to a selective writing requirement under state law, it would
appear suspect.”) (2002 ed.). See also Lulirama, Ltd. v. Axcess Broadcast Services 128 F.3d 872, 879
(5th Cir. 1997) (citing NIMMER for this result).
15
Lulirama, Ltd. v. Axcess Broadcast Services 128 F.3d 872, 879 (5th Cir. 1997); Jacob Maxwell,
Inc. v. Veek, 110 F.3d 749, 752 (11th Cir. 1997); I.A.E., Inc. v. Shaver, 74 F.3d 768, 775 (7th Cir. 1996);
Effects Associates, Inc. v. Cohen, 908 F.2d 555 (9th Cir. 1990), cert. denied 498 U.S. 1103 (1991).
The classic example of this latter situation is Effects Associates v. Cohen16 Larry
Cohen, a movie producer, declined to pay full freight for special effects of alien ooze
disguised as frozen yogurt, even though he used the effects in a movie. The effects house,
arguing that non-payment vitiated the license, sued to enjoin distribution of the movie as
copyright infringement. The Ninth Circuit saw this as really a dispute about payment. Not
wishing to deprive an eager public of The Stuff, it decided that, although there was no
exclusive license because no writing was signed, there was a non-exclusive license, thus
avoiding the infringement claim. The Court, which was only thinking copyright, called it a
day by noting that under Section 204(a) there is no writing requirement for non-exclusive
licenses. Had it gone the next step, it would probably have concluded that is a state statute of
frauds did apply to the implied non-exclusive license or that Cohen’s part performance
satisfied the statute under the usual exception.
An unreported decision by a New York District Court, Holtzbrinck Publishing v.
Vyne17 is one of the few cases to address the conflict head on. Holtzbrinck, the publisher of
Scientific American, hired Vyne under an oral contract to produce its Web site. When the
relationship soured, Vyne sued for copyright infringement. The court found Vyne had
granted Holtzbrinck an implied, perpetual, non-exclusive license to continue using the
programs created for the Web site. To this Vyne interposed a statute of limitations defense
based on New York state law. Holtzbrinck countered that the Copyright Act does not require
a writing for a non-exclusive license, and this would preempt state law. Although the issue
was fairly presented, the court elected to dodge the issue. It said that, since the license
involved both services and a grant of rights, and since the services could be, and were,
performed within one year, the state Statute of Frauds was satisfied in any case.18
2.
Practice Pointer:
The practice pointer here is the same one lawyers have been giving for centuries.
When in doubt, get it in writing – or some suitable electronic form.
C.
CAN RIGHTS OR OBLIGATIONS UNDER THE DEAL BE TRANSFERRED?
The on-line business started by simply making content available for access on a web
site. But it did not stay there. The business continues to evolve innovative methods to make
content available in new forms and uses. This “repurposing” can involve alteration of either
the web site or the content in a manner that makes it available to customers through new
sources. It can also involve authorizing third parties to access the content in new ways. An
issue that commonly arises in such cases is whether this new conduct is authorized by the online license agreement. In simplistic legal terms, the question is whether the “repurposing”
constitutes an assignment or a sublicense. But the answers are not so simple. Unfortunately,
this is another area where the law is still far behind practice, and confusion continues between
commercial and information law approaches.19
16
17
Effects Associates, Inc. v. Cohen, 908 F.2d 555 (9th Cir. 1990), cert. denied 498 U.S. 1103 (1991)
Holtzbrinck Publishing Holdings, L.P. v. Vyne Communications, Inc., 2000 WL 502860
(S.D.N.Y. 2000).
18
Holtzbrinck, 2000 WL 502860. The court also noted that the non-exclusive license was implied
in law and hence not subject to the statute to begin with.
19
See Larry A. DiMatteo, Depersonalization of Personal Service Contracts: The Search for a
Modern Approach to Assignability, 27 AKRON L. REV. 407 (1994) (“A comparison of the fact patterns
among the cases has shown no consistent underlying jurisprudence that a practicing lawyer can look to
in preparing his arguments on assignability. Once can find many examples of conflicting decisions in
cases involving almost identical fact patterns, justified by the same personal services rationales.”)
1.
Some Basics About Transfers:
Before looking at some of the recent cases in this area, it helps to review some basic
principles when dealing with transfers of information contracts.20
Early law looked to the characteristics of the services to be performed in addressing
issues of transferability. Services involving workmanlike efforts were presumed transferable,
but those of a personal nature were per se non-transferable.21 As Justice Holmes put it:22
“Service is like a marriage . . . [I]t may be repeated, but substitution is unknown.” Later
courts began to look not to the nature of the services but rather to their impact on the other
party, finding that a transfer that does not deprive the other party of the substantial benefits of
the contract was allowed.23 UCC Article 2-210 tried to codify the rules in language that was
open ended enough for courts to find it embraced both tests.24
Given the confusion, many contracts contain express language limiting assignment.
Unfortunately, there are significant differences in attitude and approach between the
commercial law and the information law cases when considering “anti-assignment” clauses.
As a general matter, the commercial law cases tend to favor transferability of rights and
obligations, and thus have developed a array of tricky rules to find that contract terms which
purport to prohibit “assignment” are in reality ineffective to do so. On the other hand, the
intellectual property cases continue to apply the workmanlike/personal services distinction in
order to find that information contracts, especially non-exclusive licenses, are nontransferable unless authorized by express language. Unfortunately, the courts are increasing
mixing these approaches, so that cases dealing with transfers of contractual interests are
applied to transfers of informational rights, and vice versa, often with bizarre results.
Let’s summarize what the differing rules should be, with the understanding that these
rules are not often followed in practice.
Starting with the information approach, one must recall that there are two general
types of transfers. One is a transfer of an ownership interest, traditionally accomplished by
an assignment. In modern practice, the Copyright Act treats an exclusive license as a type of
ownership transfer, akin to a partial assignment.25 The other is a grant of a use privilege,
typically by a non-exclusive license. With this distinction in mind, the rules are – or should
be – straightforward. An ownership transfer allows the transferee to make further transfers
(e.g. assignments and licenses) unless otherwise restricted in the contract. A use privilege
20
This discussion is drawn from COMMERCIAL INFORMATION LAW §§ 503[A] et seq.
E.g. Taylor v. Palmer, 31 Cal. 240, 247-248 (1866) (“All painters do not paint portraits like Sir
Joshua Reynolds, nor landscapes like Claude Lorraine, nor do all writers write dramas like
Shakespeare or fiction like Dickens. Rare genius and extra-ordinary skill are not transferable, and
contracts for their employment are therefore personal, and cannot be assigned. But rare genius and
extraordinary skill are not indispensable to the workmanlike digging down of a sand hill or the filling
up of a depression to a given level, or the construction of brick sewers with manholes and covers, and
contracts for such work are not personal, and may be assigned.”)
22
American Colortype Co. v. Continental Colortype Co., 188 U.S. 104, 107, 23 S. Ct. 265, 47
L.Ed. 404 1903) (assignment of employment contracts that threatened to disclose trade secrets).
23
E.g. Arnold Productions, Inc. v. Favorite Films Corp., 298 F.2d. 540 (2nd Cir. 1962).
24
Compare Sally Beauty Co., Inc. v. Nexxus Products Co., Inc., 801 F.2d 1001 (7th Cir. 1986)
(supplier of trademarked hair care products could terminate exclusive distribution contract for transfer
to direct competitor, since contract for personal services per se non-transferable) with Baxter
Healthcare Corp. v. O.R. Concepts, Inc., 869 F. Supp. 606 (N.D.Ill. 1994), aff’d 69 F.3d 785 (7th Cir.
1995) (anti-assignment provision not breached by acquisition of stock of buyer, distinguishing Sally
Beauty because the case involved a nonexclusive license to supply products, not to sell them).
25
See COMMERCIAL INFORMATION LAW § 501[D] for further discussion. Note that for patents and
trademarks, some exclusive licenses can be treated as “assignments” where they include all of the
hallmarks of an assignment.
21
does not allow the transferee to make further transfers (e.g. sublicenses) unless otherwise
authorized in the contract.
Turning to the commercial law approach, the rules are more complex. In principle,
the courts will enforce a contractual restriction on a transfer of rights or obligations.
However, in practice courts are generally disposed to find contractual obligations
transferable, and thus they have developed numerous distinctions that require an increasing
array of precise language to make a restriction stick. These include:
 Assignment vs. delegation: An assignment of rights is treated as different from a
delegation of duties. Thus, a prohibition of any “assignment” of a contract does not
prevent a delegation of duties. To avoid this result the contract must expressly
restrict “any assignment of rights or delegation of duties.”
 Right vs. power: Many courts say a restriction on the right to assign or delegate does
not restrict the power to do so. That is, an unauthorized transfer is considered a
breach of the anti-assignment clause which nonetheless does not deprive the
breaching party the power to vest rights in the transferee. The aggrieved party can
sue still sue for breach, but courts applying this approach often find the breach
immaterial. To avoid this result that contract must also expressly provide than an
unauthorized transfer is “void and of no effect.”
 Discretion v. Good Faith: Other courts add that exercise of any power to object to an
assignment is subject to the obligation of good faith and fair dealing, so that a party
cannot object to an assignment either in bad faith, or, in some cases, on unreasonable
grounds. To avoid this result the contract must expressly state that a party has the
right to consent or object to any proposed assignment “in its sole discretion.”
 Change of Form vs. Transfer: Other courts find that a change of form of the party is
not an “assignment” within the meaning of an anti-assignment clause. Thus, a
transfer of corporate stock is not necessarily a transfer of a contract made by the
corporation. To avoid this result the contract must provide that an unauthorized
transfer also includes a change in form, i.e. “a transfer includes any transfer of a
controlling interest in stock or other equity ownership of a party, or in membership
interests or other evidence of control, or substantially all the assets of a party.”
 Outright Prohibition: Revised Article 9-408 now says point blank that any contract
term or rule of law that purports to prohibit the assignment of a “general intangible”
is “ineffective.” When the section was originally approved by NCCUSL in 1999, the
section was limited to terms that prevented creation, attachment or perfection of a
security interest, but technical amendments in the final version, which was then
adopted by most states, extends it to any provision restricting transfer that “might
give rise to a termination, right of termination, defense, or remedy.”
Thus, when the issue involves whether an information contract is transferable, which
typically arises in an infringement case, the rule should be simple. Simply look to whether
the transfer involves an ownership interest, i.e. assignment for patents and trademarks, or
assignment or exclusive license in copyright cases, or a non-exclusive license. Then
determine whether express contract language authorizes or prohibits a further transfer. In
commercial law cases, however, the test is more complex. One must parse the nature of the
obligations and the impact of a transfer on the complaining party. Then one needs to review
any anti-assignment clause with a fine tooth comb.
Unfortunately, it does not always work out this way.
2.
Some Unusual Cases on Transfers:
A recent on-line case, SMC Promotions, Inc. v. Official Site Builders Corporation26,
illustrates some of issues. For years SMC has been in the business of providing specialty
products to independent distributors known as “members.” SMC (through an affiliate) builds
web sites for its members to sell its products over the Internet. Each such website contains
links to SMC’s primary website, SMCorp.com, and comes preloaded with specialty pictures
and narratives from SMC’s copyrighted “World of Products.”
OSB Corp. is a competitor that also builds websites for SMC members containing
links to the SMC catalog. OSB claimed that the SMC Membership Rules expressly permits
each SMC member to “copy or use designated SMC product descriptions, product
photographs and .jpg files on [the member’s] website to advertise products [the member has]
purchased from SMC for sale to [the member’s] customers.” OSB further claimed that its
agreement created “an agency relationship” that authorized OSB to use SMC’s copyrighted
material on behalf of its member-clients. SMC, however, said that under its Membership
Rules, although a member can copy SMC’s material, the member “may not delegate or
authorize any other person to do so.” This was enough for the court. Citing cases that
included Gardner v. Nike,27 it decided that OSB’s conduct exceed the scope of the license and
was infringing, thus justifying a preliminary injunction.
While this result may ultimately be correct, the reasoning used to get there is strange,
as it mixes commercial and infringement concepts. The members clearly appointed OSB as
their agent to exercise their rights under the Membership Agreement. Other courts have held
that appointment of an agent is not a transfer of a license and hence does not violate an “antiassignment” clause.28 Moreover, although the Membership Agreement prohibited a
delegation of duties, under the right/power distinction it could be argued that the appointment
of OSB may have been a breach of this provision, but did not deprive the Members of the
power to do so, meaning that SMC could sue for breach, but was not entitled to an injunction.
The point is that the court applied concepts from the infringement cases to conduct that would
have been better analyzed under the commercial cases.
In support of its conclusion, the SMC court cited Gardner v. Nike, the premier
example of total confusion in this area. In Gardner, the Ninth Circuit came to the astonishing
conclusion that an exclusive copyright license was not assignable absent contractual
authorization.29 It did so by utterly confusing the commercial law and infringement cases.
According to the decision, “Nike transferred the exclusive, perpetual, worldwide right to
Sony to use [its character] MC Teach” and Sony then “assigned all its rights in [this transfer]
to Gardner, on a quitclaim basis.” The parties stipulated that the original transfer to Sony was
an “exclusive license.” The issue was whether Sony’s “assignment” to Gardner was valid.
The court looked to Copyright Act, 17 U.S.C. § 201(d)(1), which says that “ownership of a
copyright may be transferred in whole or in part by any means of conveyance,” and
concluded that since this section did not expressly make exclusive licenses assignable without
consent, they are not so. That is, Gardner reasoned an exclusive license is still a “license,”
and hence not “assignable” without the licensor’s consent, even though Section 201(d)(1)
now treats copyright exclusive licenses as akin to partial assignments.
26
27
SMC Promotions, Inc. v. Official Site Builders Corporation, 355 F.Supp.2d 1127 (C.D. Cal. 2005)
Gardner v. Nike, 279 F.3d 774 (9th Cir. 2002).
28
E.g. E.g. Arnold Productions, Inc. v. Favorite Films Corp., 298 F.2d. 540 (2nd Cir. 1962)
(hiring an agent to perform marketing and distribution services under motion picture license not an
unauthorized assignment); Taco Corporation v. Hudson, 231 S.C. 553, 99 S.E.2d 419 (1957)
(appointment of an exclusive agent to find sublicensees not itself a sublicense).
29
See Melville D. Nimmer & David Nimmer, NIMMER ON COPYRIGHT § 10.02[B][4] (2002 ed.)
(“debunking” the result in Gardner).
Like OSB, Gardner applied concepts from the infringement cases to what would have
been better analyzed under the commercial cases. In each case, the transfer might have been
an “assignment” (state law meaning) of contractual rights or a delegation of contractual
duties, rather than an transfer of an information interest. Indeed, neither court really paid
much attention at all to just what the transfer involved. At various points the District Court
and the Ninth Circuit in Gardner Sony-Gardner agreement an “assignment,” a “quitclaim,”
an “agency,” an “exclusive license,” and a “sublicense.” Yet each of these is different. One
wonders what would have been the result if Gardner called the transfer a “partial
assignment.” The proper classification of just what is being transferred - contractual
obligations or informational rights - and how its is accomplished - assignment or license,
assignment of rights or delegation of duties or appointment of an agent - can put one into an
entirely different set of rules often with different results.
Gardner has been severely criticized. Courts in other circuits have found the
reasoning wrong and point blank refused to follow it.30 Indeed, in Leicester v. Warner
Bros.31, the Ninth Circuit had held that an exclusive copyright license included the right to
grant sublicenses where the license was silent, a result hard to reconcile with Gardner.
Finally, an interesting decision in this area, albeit not in an on-line contract, is Banc
of America Strategic Solutions, Inc. v. Cooker Restaurant Corporation32 It held that, despite
Revised 9-408 a security interest does not attach to an Ohio liquor license. The court noted
that, in Ohio, a liquor license is a privilege, not a property right. Under Revised 9-203(b), a
security interest only attaches to the extent of a debtor’s “rights in collateral.” Since under
Ohio law a debtor does not have transferable “rights in collateral,” a security interest cannot
attached despite Revised 9-408. It will be interesting to see if courts apply this reasoning to a
non-exclusive intellectual property license (as they should).
3.
Practice Pointers:
As the on-line business evolves, new and innovative methods have also evolved to
repurpose content for customer access. These include:
 Site reformatting: Reformatting a web site to allow access from other platforms,
such as creating a mirror version in Wap format for access on mobile devices.
 Copy reformatting: Reformatting the content to make it available over different
players, such as Windows Media® or Real Player.®
 Encoding: Creating encoded or encrypted copies using different digital rights
management systems.
 White labeling: Making content from one web site available for access to another
site but without the banners and labeling. The idea is that the content looks as if it is
directly available on the host site. In this case the “white labeled” site often conducts
the customer billing for its content.
 Feeds: Providing feeds from one site to another. This is sometimes called “licensing
links” instead of “licensing content.” The idea is that the hosting site makes secure
links available allowing customers on the initiating site to directly access content on
the hosting site, while allowing the initiating site to continue customer billing.
30 E.g Traicoff v. Digital Media, Inc. 439 F.Supp.2d 872, 877 (S.D. Ind. 2006) (“This court also finds the
reasoning in Gardner to be unpersuasive. A natural reading of the Act's language leads to the conclusion that
exclusive licensees, as copyright owners of their exclusive rights, are free under the Act to transfer those rights to
third parties.”); In re Golden Books Family Entertainment, 117 F. Supp.2d 99,101 (D. Mass. 2000) (declining to
follow Gardner); also Rodrigue v. Rodrigue, 218 F.3d 432, 436-437(5th Cir 2000) (copyright ownership includes
right to transfer and encumber).
31 Leicester v. Warner Bros., 232 F.3d 1212, 120 (9th Cir. 2000).
32 Banc of America Strategic Solutions, Inc. v. Cooker Restaurant Corporation 2006 WL 2535734 (Ohio
App. 2006)

IPTV: This allows television programs to be available over the internet.
Each one of these developments involves “repurposing” – to use a generic term – of the
content or the site. Not all of these fit easily into the traditional categories of “assignment” or
“sublicense” or “delegation.” For example, is creating a Wap site a sublicense, or just an
allowed use? Does creating feeds constitute a license to the host site, or merely a delegation
of the duty to collect payments? Given the confusion in the courts, it is necessary to define
precisely the type of uses that are allowed or disapproved. Moreover, given the difference in
attitude between the commercial law and intellectual property law cases, one should look
carefully at language that attempts to limit transferability.
D.
WHAT IS THE DURATION OF THE DEAL?
A crucial provision in many on-line contracts is the duration or “term” of the deal. A
great many issues become less serious if the term of the deal is short, or, comparably, the
parties have a flexible right to terminate. Licensors often prefer shorter terms so that they can
end a deal that becomes undesirable. Licensees, on the hand, often prefer longer terms,
especially if they are investing considerable sums in advertising or marketing. This means
that duration provisions need to be carefully drafted. What happens, however, if the parties
fail to specify the duration adequately? Is the contract then perpetual or terminable at will?
The answer is again split between the infringement and commercial perspectives.
1.
License Contacts of Indefinite Duration:
Initially, one should note that the rules on contact duration differ depending on the
type of intellectual property involved, and whether the transfer is an assignment or a license.
For patents, assignments and licenses are generally considered to run for the life of the patent
if no duration is specified.33 For trademarks, assignments of unspecified duration are also
considered perpetual, but licenses without a specified duration are considered terminable at
will absent estoppel or the like.34
The main litigation in this area has been with copyright transfers. There are some
structural differences between copyrights and patents or trademarks. First, for copyrights,
exclusive licenses are treated as a “transfer of ownership” akin to a partial assignment. 35
Second, the Copyright Act contains a termination right allowing various parties to terminate a
grant within a 5 year window starting 35 years from the making of the grant, a provision
added to compensate for the elimination of the former dual term.36 These differences have
led to a somewhat different approach for copyright transfers.
Starting with the infringement perspective, in the early case of Manners v. Morosco37
the Supreme Court decided that an exclusive copyright license of unspecified duration would
be “perpetual,” where “perpetual” is a term of art meaning “for the duration of the copyright.”
Later, the Ninth Circuit, in Rano v. Sipa Press, Inc.38 held that a non-exclusive copyright
license of unspecified duration “ran for at least 35 years,” i.e. it was “perpetual” unless earlier
terminated as allowed in the Copyright Act39, and this result preempted state law.
33
34
See COMMERCIAL INFORMATION LAW § 308[B][2][a] for further discussion.
See COMMERCIAL INFORMATION LAW § 308[B][2][c] for further discussion.
17 USC § 101 (definition of “transfer of copyright ownership”).
17 USC § 101; see COMMERCIAL INFORMATION LAW § 308[B][2][b] for further discussion.
37
Manners v. Morosco, 252 U.S. 317, 40 S.Ct. 335, 64 L.Ed. 590 (1919).
35
36
38
39
Rano v. Sipa Press, Inc. 987 F.2d. 580 (9th Cir. 1993).
17 U.S.C. § 206(b)(6).
Cases starting from a commercial perspective, however, take a different view. In
Wathal v. Rusk,40 the Seventh Circuit said that a non-exclusive copyright license of indefinite
duration was terminable at will under applicable state law rules, and the Copyright Act did
not pre-empt this result. The Eleventh Circuit, in Korman v. HBC Florida, Inc.,41 agreed.
Looking to the termination language in Copyright Act § 203(b)(6) that “a grant, if it does not
provide otherwise, continues in effect for the term of copyright provided by this title,” the
Eleventh Circuit held a state termination “at will” rule would “otherwise provide.”42
The problem with Wathal and Korman is that they really do not answer the question.
They merely kick the can into state law. Under state law, a bilateral contract of indefinite
duration with on-going performance obligations on both sides is of course terminable at will.
However, a non-exclusive license is also treated as waiver of the right to sue, and as such is
irrevocable if supported by consideration or detrimental reliance, as both the Seventh and
Eleventh Circuits have themselves held.43 So in practical effect, this would apparently lead
back to what Rano said: a non-exclusive copyright license of indefinite duration, as a waiver
of a right to sue, is generally irrevocable unless terminated under the Copyright Act.
In two recent cases the Seventh Circuit has substantially undercut Wathal. The first
was Baldwin Piano.44 Baldwin Piano granted Deutsche Wurlitzer a trademark license for the
famous “Wurlitzer” name. Eighteen years later, it decided that the license was “of indefinite
duration” and hence cancellable at will. The relevant contract language said: “[T]his
Agreement shall continue in force without limit of period but may be cancelled by the
Licensor for material breach.” The court noted that under Illinois law, a non-exclusive list of
reasons for termination makes the term indefinite allowing termination at will, whereas an
exclusive list permits termination only for the reasons stated.45 The court decided that the
language allowing “cancellation for breach” was an exclusive list and hence the contract was
not terminable at will.
Last year, in Automated by Design46 the Seventh Circuit again declined to follow
Wathal in a case involving a non-exclusive copyright license. Automated granted Raybestos
a license to use its copyrighted designs for a clutch plate. Raybestos contended the license
allowed it to let other parties use the designs. Automated disagreed, but in any case
contended that the license was terminable at will and duly revoked. Here, the contract
language was even dicier, since it allowed Raybestor to terminate for default or at its
convenience.47 Nonetheless, the Seventh Circuit again held that this was an “exclusive”
provision so that the contract was not of indefinite duration and hence not terminable at will.
Both Baldwin Piano and Automated by Design certainly seem to raise hair-splitting
to a fine art. The real reason for each decision, however, is more likely the analysis by Judge
40
Wathal v. Rusk, 172 F.3d 481 (7th Cir. 1999).
Korman v. HBC Florida, Inc., 182 F.3d 1291 (11th Cir. 1999)
42
Korman at 182 F.3d 1297.
43
I.A.E., Inc. v. Shaver, 74 F.3d 768, fn. 10, (7th Cir. 1996); Jacob Maxwell, Inc. v. Veek, 110 F.3d
749 (11th Cir. 1997). Korman deferred to Florida law, and Thomas N. Carlton Estate v. Keller, 52
So.2d 131, 133 (Fla. 1951) held “[w]hen a party waives a right under a contract he cannot, without
consent of his adversary, reclaim it.”
41
Baldwin Piano, Inc.v. Deutsche Wurlitzer GmbH, 392 F.3d 881 (7th Cir. 2004).
Baldwin Piano at 392 F.3d 884.
46
Automated by Design, Inc. v. Raybestos Products Company, 463 F.3d 749 (2006).
44
45
Automated by Design, at 463 F.3d fn.6 (“(a) Default. Purchaser may terminate this order or any
part thereof by written notice if Seller fails to make deliveries or complete performance of services
within the time specified or in accordance with agreed schedules . . . (b) Purchaser’s convenience.
Purchaser may terminate this order for its convenience in whole or in part by written notice to Seller.”)
47
Easterbrook in Baldwin Piano of the economic difference between a hard goods distribution
agreement and an intellectual property license. It is worth quoting in detail48:
This trademark license differs from a distribution contract. These parties are not
locked together in a form of partial integration by contract—as, for example, when a
distribution partner serves as a substitute for vertical integration into warehousing
and sales. The 1985 contract was designed to partition the Wurlitzer music empire,
giving Deutsche Wurlitzer a line of business that would henceforth operate
independently of its former parent. Baldwin Piano and Deutsche Wurlitzer do not
need to coordinate their activities in order to produce or deliver a product; all they
need do is manage their businesses so as not to injure the other (as, for example, by
diluting the trademark’s value by attaching it to inferior goods). There is no need to
facilitate renegotiation. Nor were the stakes reciprocal, as in distribution contracts.
Baldwin Piano yanked Deutsche Wurlitzer’s license with no loss to itself, and with a
potential for gain if it then went into the jukebox business or licensed another firm to
use the trademark.
We might say that Judge Easterbrook looked at the economic differences between the
infringement approach and the commercial approach, and found the infringement approach,
with its grounding in the economics of intellectual property practice, determinative.
Another case worth noting is Armstrong Business Services Inc. v. H & R Block,49
which concerned franchise agreements with a 5-year term that automatically renewed for
subsequent 5 years terms absent an agreement not to renew. The court held that these were
not contracts of indefinite duration, but ones with fixed terms.50
2.
Practice Pointers:
In intellectual property on-line contracts, the best practice is to state an express
duration (“term”), e.g. this agreement continues for X years. If additional length is required,
state a fixed term and allow periodic renewal options.
If negotiations do not allow a definite duration, then if possible make it explicit
whether the contract is terminable at will or only for specified reasons. That is, indicate
whether the causes for termination are exclusive (definite) or non-exclusive (indefinite). A
contract provision that says the contract continues “unless and until cancelled for breach,”
may be considered exclusive, but then one is leaving the ultimate resolution to the courts.
E.
ESTABLISHING PAYMENT RIGHTS
An important part of an on-line contract is the payment rights. Licensors certainly
desire to ensure that royalties are paid on time, and that they have a right to cancel the
contract in case of material default in payment. Conversely, licensees also have an interest in
recovering advance royalties or up front payments in case the licensor later defaults. One
might think a simple contract term requiring payment, and allowing cancellation for nonpayment, is enough. Not always. There have been some recent cases that raise the stakes in
this regard that require careful handling in precise contract language.
There are two aspects to the payment issue: determining when payments are due; and
ensuring how to collect them. This section starts with the first issue and the related
accounting considerations. The next section deals with the second issue.
48
Baldwin Piano at 392 F.2d 885-886.
Armstrong Business Services Inc. v. H & R Block, 96 S.W.3d 867 (Mo.App 2002).
50
Armstrong at 96 S.W.3d 878.
49
1.
Accounting Issues In Establishing Payments:
The first issue is determining what royalty payments are based on and when they are
due. This involves the accounting questions of revenue realization and recognition. Just
because a licensee receives cash does not mean any royalty payments are due. Two examples
involving on-line contracts may illustrate the issues.
Here is language from a recent on-line hosting agreement the author was asked to
review (with discussion areas highlighted):
Total Gross Revenue means the sum of each gross revenue amount gathered
from each client’s Service, calculated by determining the proportionate share of
bandwidth used through the leased feed of this Agreement within that Service of the
total amount of bandwidth used for that same Service. The resulting percentage will
be calculated against the amount paid by the client for the Service to determine which
gross revenue amount is relevant to the Service under this Agreement. Gross revenue
will only be added to Total Gross Revenue and calculated upon receipt of client
payment.
This may be usefully compared with language from the sample IFTA® Internet Rider
defining “Internet Revenue” (gross receipts) on which royalties are due for movies licensed to
a web service:
Internet Revenue - Defined. “Internet Revenue” means the sum on a
continuous basis of all of the following amounts derived from or attributable to each
Internet Licensed Right and Authorized Internet Use:
(1) All monies and other consideration of any kind, received by, used by or
credited to Distributor, any Distributor Affiliate, or any approved subdistributors or
agents, attributable to any accessing, streaming, downloading or using of the Picture
in the exercise of each Internet Licensed Right and Authorized Internet Use,
including amounts under security deposits;
(2) All such monies and other consideration derived from credit cards, debit
cards, cash, checks or otherwise, from consumers or end users from any accessing,
streaming or downloading of the Picture less only chargebacks, credits and refunds
actually paid;
(3) All such monies and other consideration derived in the exercise of any
Authorized Internet Use from: (i) including allowed trailers, commercials or other
advertising before, after, or within the continuity of the Picture; or (ii) including
banners, logos, icons, text, hyper-text, meta-tags, symbols or other identifying
information of a product or service or their provider on the same web page as the
Picture, or any of its elements or identifying information; and
(4) Where in the exercise of any Authorized Internet Use the Picture is exploited
with another Motion Picture, product or service, a fair and reasonable allocation of all
monies, subscription fees, ad revenue and other consideration derived from so doing
to the Picture on a non-discriminatory basis uniformly applied, such as per byte
streamed or downloaded.
The first sample raises a number of issues about the source of the gross revenue and
how it is reported for royalty purposes that are better covered in the second sample:
 The first sample speaks of “each gross revenue amount” but does not identify
what those sources may be. The second sample extensively catalogues revenue areas to
direct a later audit to what activities are covered.
 The first sample speaks of income “gathered.” This term has no meaning in
accounting practice. The second sample speaks of income “received by, used by or credited
to” which conforms to standard usage.
 The first sample has awkward language about apportioning gross receipts among
multiple sources, does not indicate the exact formula used, and does not deal with formula
changes. The last paragraph of the second sample deals with the allocation issue by setting
auditable standards while allowing the licensee flexibility to operate.
 The first sample only calculates gross on “amounts paid by client.” This is the
revenue realization standard. The problem here is that it only pays royalties on cash, not
other consideration. For example, assume the licensee did a “barter” deal with Google which
gave the licensee advertising in exchange for providing content. In the first sample, arguably
the value of the advertising would not be included in the licensor’s royalty, as there are no
“amounts paid.” The second sample uses a more expanded definition covering monies and
“other consideration of any kind.”
 The first sample only calculates gross “upon receipt of client payment.” This is
the revenue recognition standard. What if the licensee asks the client to hold cash due and
apply it against other debts of licensee? As no cash was received, can the licensee avoid
income recognition? That is why the second sample refers to income “received by, used by
or credited to.”
These issues are of course important in effective contract drafting. But with the
passage of Sarbanes-Oxley, they are acquiring a larger context. There have been several
recent cases against intellectual property licensors alleging securities violations for reporting
revenue in a manner that does not conform to Generally Accepted Accounting Principles
(GAAP). The GAAP principles look at specific terms in the relevant licenses that impact
revenue recognition. Thus, proper license language determining when revenue is realized
and recognized for royalty purposes may in turn impact how those licenses are handled in the
accounting department for financial reporting purposes, which in turn can impact liability of
senior company officers who have to certify the results under Sarbanes-Oxley. In other
words, the royalty accounting language right in a license can have effects all the way up the
corporate ladder. Two recent cases illustrate the concerns.
The first case is a class action, Barrie v. Invoice-Brite, Inc.51 Invoice-Brite published
voice recognition software. The plaintiffs alleged securities fraud due to improper revenue
recognition in licensing transactions, including a license of the software to a cellular service
interested in expanding its pre-paid wireless system.
The court began by noting that the GAAP principles for revenue recognition for
software licenses were contained in American Institute of Certified Public Accountants
(“AICPA”) Statement of Position 97-2 (“SOP 97-2”). These principles required satisfaction
of four conditions before revenue can be recognized for a “sale” [note: unfortunate term] of
software: (1) persuasive evidence of a contractual arrangement must exist; (2) delivery must
have occurred; (3) the vendor’s fee must be fixed or determinable; and (4) collectability is
probable. At this point, one should note that the first three of these principles will
immediately implicate legal issues surrounding contract formation and drafting. The
requirement that a contractual arrangement exist does not necessarily mandate a final
executed, authenticated agreement, but if the failure of execution or authentication could give
a defense to enforcement, it can impact recognition issues. Similarly, a royalty based on a
licensee’s income will rarely be “fixed or determinable” on signature.
51 Barrie v. Invoice-Brite, Inc., 397 F.3d 249 (5th Cir. 2005) mod. and reh’g. denied 409 F.3d 653 (5th
Cir.2005).
The basic problem in Barrie, however, was the second prong, dealing with “when
deliver has occurred.” In explaining this concept, SOP 97-2 stated that even “[a]fter delivery,
if uncertainty exists about customer acceptance of the software, license revenue should not be
recognized until acceptance occurs.”52 The SEC staff had issued a further advisory which
said “when contractual customer acceptance provisions exist, the staff generally believes that
the seller should not recognize revenue until customer acceptance occurs or the acceptance
provisions lapse.”53 In other words, a central tenet of revenue recognition – delivery – turns
on the contractual provisions for customer acceptance. In Barrie, the plaintiffs alleged
securities fraud because Invoice-Brite recognized revenue, and hence reported substantial
earnings, when the software was shipped [note: another unfortunate term] to the licensee,
rather than waiting until it was installed, tested and formally accepted under the contract.
The issue of when delivery occurs under a license is a thorny one. In movie licenses,
for example, there is often reluctance to make delivery of any materials prior to payment due
to the piracy risk. Thus, “payment on delivery” terms are usually heavily negotiated. In
some cases, “delivery” is defined as a licensee’s receipt of a “notice of delivery” that the
licensor is prepared to ship materials (a “tender of delivery”), and at that point payment is
due. In other cases, delivery occurs, and payment is due, upon a licensee’s receipt of a bill of
lading (e.g. and air waybill) showing materials have be given to a carrier. In other cases,
“delivery” does not occur until after receipt and a period of formal inspection and approval.
These provisions in turn impact revenue recognition issues. In an on-line environment, where
“delivery” can consist of an electronic transmission one the Web, defining what constitutes
“delivery” and when it is deemed to have “occurred” requires careful handling.
Another case raising similar issues, although unreported, is SEC v. Yuen.54 Yuen was
the Chief financial officer of Gemstar, an entertainment services company. Gemstar was in
the business of licensing an interactive program guide for television (“IPG”) that allowed
viewers to sort, select, and schedule television programming for viewing. The program was
activated through a device that was installed cable and digital set top boxes and transmitted
via the cable systems. The case again alleged securities fraud doe to improper revenue
recognition under licenses.
The court began by noting the difference, under GAAP principles, between
realization and recognition. “Revenues are realized when goods and services are exchanged
for cash or claims to cash, whereas revenues are realizable when assets received or held are
readily convertible to known amounts of cash or claims to cash. Revenues are earned
[recognized] when an entity has substantially accomplished what it must to be entitled to the
benefits represented by the revenues.”55 The court again noted the four factors stated in
Barrie needed for revenue recognition from SOP 97-2.
The court then chronicled a litany of examples that read like a text book on what not
to do for proper revenue recognition. For example, in two cases Gemstar recognized revenue
based on terms of an expired license, telling their outside auditors a new deal was pending
except for minor technicalities when in fact in one case the parties were in bitter litigation and
in another intense negotiation. Gemstar also recognized revenue for licensed advertising
based on a purported oral modification despite the fact that the amount was disputed (i.e.
payment was uncertain) and valuation of advertising was problematic (i.e. amounts were not
fixed or determinable). Gemstar recognized revenue on deals to acquire an e-book licensing
and fantasy sports licensing business while failing to disclose that it had made a companion
deal to pay an equal amount in expenses (i.e. collectability not probable).
52
53
Barrie, at 397 F.3d 256.
Barrie, at 397 F.3d 257, quoting SEC Staff Accounting Bulletin No. 101 (Dec. 3, 1999).
54
SEC v. Yuen, 2006 WL 1390828 (C.D.Cal. 2006)
55
Yuen, at para. 55.
2.
Practice Pointers:
The point of this discussion is not to turn lawyers into accountants. Instead, the
purpose is illustrate that license terms defining the sources of revenue and when they are
recognized for royalty payment purposes can have a profound impact on required financial
disclosures with respect to the license.
On the one hand, parties typically like to delay payment of upstream royalties until
income is both realized and recognized, since although cash may be received (income
realized), it may nonetheless not be earned (recognized) due to a contingency that requires
repayment to the vendor. On the other hand, parties often like to recognize downstream
income as soon as possible for financial reporting purposes in order to shore up the company
balance sheet. The Yuen case contains several examples where the company recognized
contingent income precisely for this purpose, illustrating the tensions involved.
As a drafting matter, parties involved in preparing licenses agreements, especially for
public companies, should discuss contract terms with the accounting department to ensure
that contract provisions match the company expectations for financial reporting.
F.
SECURING PAYMENT RIGHTS
Although a party may have a contractual right to payment under an on-line contract,
that alone is not enough to ensure payment, especially if other creditors intervene. This is
because Revised Article 9 has now classified royalties due under a license as “accounts.”56
This means for a party to ensure its right to collect payment, especially in case of an
intervening bankruptcy, one may need to “perfect” the rights under Revised 9. This is
another area where there is a substantial split in the cases.
1.
Securing Royalties:
Whether royalties under intellectual property licenses should be perfected by filing in
the federal filing offices or under in the local Secretary of State is a matter of considerable
controversy. The courts are again split, with those that approach the issue from an
infringement perspective inclining to the federal offices, while those who look at it from a
commercial point of view, primarily the bankruptcy courts, lean towards the state system.
Revised 9 has further confounded the issue by apparently deferring to the federal system, but
in language that is opaque at best. Until this issue is definitely resolved, a careful
practicioner will comply with both. Let’s give two illustrations of the practical consequences.
The first case is a recent on-line transaction involving AOL, In re EBC I, Inc.57. EBC
entered into an agreement with AOL for on-line advertising services. EBC pre-paid an $8.25
million license fee, but only received $2.3 million in ad services when it announced it was
insolvent and preparing to file for bankruptcy. Upon receipt of the notice, AOL invoked an
ipso facto clause and terminated the contract. EBC’s bankruptcy trustee then sued AOL to
recover the value of the unprovided services (i.e. $8.25 M - $2.3M = $6.95M) as a fraudulent
conveyance under 11 U.S.C. § 548. AOL defended on the grounds that the contract made the
advance payment non-refundable and that it was validly terminated. AOL lost on all counts.
The next case is a sobering decision from the music business, In re Valley Media.58
Valley Media was a record rack jobber that entered into distribution agreements with a
variety of record companies who provided CDs and DVDs to Valley on a “consignment”
basis. When Valley went belly-up, the trustee attempted to dispose of the unsold inventory of
records while, naturally, treating any resulting royalties due the record companies as
56
57
See UCC Revised Article 9-102(a)(1) (definition of “account).
In re EBC I, Inc., 356 B.R. 631 (Bktcy. D. Del. 2006).
58 In re Valley Media, 279 B.R. 105 (Bktcy. D. Del. 2002).
unsecured debts of the estate. The trustee argued a pure commercial law perspective: the
record companies delivered physical goods – CDs and DVDs – to the debtor and did not
properly file a UCC-1 financing statement disclosing the “consignment sale;” hence their
rights were avoidable by the trustee. The court agreed.59
The record companies, however, countered with a copyright preemption argument.
They said that providing the records did not constitute a “first sale” under the Copyright Act,
and hence further sale of the records would violate their copyrights. This is one of the first
cases in which intellectual property rights were asserted as superseding the commercial law
rules in Revised 9. It doubtless will not be the last. Forced to look at the case from an
intellectual property perspective, the court agreed that the Copyright Act would preempt the
trustee’s right to dispose of the goods under Revised 9 unless a “first sale” had occurred.
Here the case started to go sideways, at least from an intellectual property perspective. The
court decided two distribution licenses were validly terminated before the commencement of
the case, and as such the trustee could not resell those records. But it held that other
distribution licenses which had not been terminated pre-petition authorized the estate to resell
the records, thus satisfying the “first sale” test, even though the estate did not assume them. 60
The idea that a trustee may exercise rights under an unassumed license is quite strange.
What both EBC and Valley Media make clear is that merely relying on contract
terms, including payment and termination rights, may not be enough to ensure payment when
intervening creditors intervene, especially a bankruptcy trustee. As a practical matter, one
should note that the bankruptcy courts are steeped in state commercial law, especially
Revised Article 9, and often show little understanding of, or sympathy to, intellectual
property issues. One can expect a tough ride indeed in a bankruptcy courtroom, as Valley
Media demonstrated all too well.
2.
Practice Pointers:
The proper way to perfect a security interest in intellectual property royalties is an
issue of enormous complexity and controversy.61 Until the matter is resolved, the best thing
for a practitioner to do is to comply with both Revised 9 and federal intellectual property law.
For Revised Article 9, that means filing a UCC-1 financing statement indicating that
the licensor has reserved a right to royalties, or that the licensee has a right to recoup advance
payments. The financing statement must be filed where the debtor is “located” as determined
under Revised 9-307. For technical reasons, one should also file in the District of Columbia,
especially where international rights are involved. Revised 9-505 allows filing a financing
statement by a “licensor” or “licensee.” Revised 9-509(b) says that by “authenticating a
security agreement” a debtor automatically authorizes filing a financing statement; otherwise
the debtor must consent to the filing in an authenticated record. Thus, the license agreement
should include a provision authorizing either party “to file any financing statement or other
document which the party reasonably believes is necessary or convenient to enforce, secure
or perfect any of it rights under this agreement.”
For intellectual property law, filing must be done in the appropriate federal filing
offices. The Copyright Act does allow filing of non-exclusive licenses as well as ownership
transfers. As to patents and trademarks, one should also file evidence of transfer that reserves
a royalty or payment right in the PTO. While licenses are not technically recordable in the
PTO, this may change, so in significant deals one may try to record licenses as well.
59
In re Valley Media, 279 B.R. 122-124.
In re Valley Media, 279 B.R. 137-138.
61
See generally Lorin Brennan, Financing Intellectual Property Under Federal Law, 23 Hastings Comm/Ent
195 (2001) and Financing Intellectual Property Under Revised Article 9, 23 Hastings Comm/Ent 309 (2001)
60
This will be an area for future litigation. As such, filing everywhere you can is cheap
insurance, especially in major deals. Filing in both the state and federal systems does not
ensure that you will win, but it is can prevent an immediate loss for “failure to file”.
G.
ARE THERE WARRANTIES AND INDEMNITIES?
Every on-line contract should contain representations and warranties along with
indemnities for their breach. Representations and warranties often fall into three broad
categories: those regarding capacity of the parties; those pertaining to information content,
such as validity and non-infringement; and those involving performance, usually functionality
measures in the case of software. Warranties can be express or implied. Indemnities fall into
two categories: indemnities against liability, and indemnity against claims. The difference is
that an indemnity against claims includes a duty of defense, while one against liability only
does not. These indemnities may also be express or implied.
There has been increasing litigation over the existence, scope and interpretation of
warranties and indemnities in information contracts. Unfortunately, this is another area
where the case law is quite muddled, with a split again appearing between the infringement
cases and the commercial cases. While this short paper cannot address all of the nuances, the
following are issues that have raised considerable concern.
1.
Warranties Regarding Infringement
One area where there has been a good deal of litigation is the scope of warranties
against infringement. A good example is a recent decision by a California Court of Appeal
that involved both express and implied warranties, Linear Technology Corp. v. Applied
Materials, Inc.62.
Linear purchased semiconductor processing equipment from Applied. The Purchase
Order said Applied would indemnify Linear against “all claims … and liabilities of every
kind and nature … arising out of [Applied’s] warranty that [Linear’s] ‘purchase, installation
and/or use of the goods covered hereby will not result in any claim of infringement ... of any
patent ...’”63 When Linear was sued for patent infringement, it cross-complained against
Applied for express and implied indemnity. Applied demurred.
First, Applied argued it did not breach any express warranty because the patent
owner did not claim that Allied’s equipment or use of the equipment had infringed its patents.
Instead, it sued Linear for infringing a process involved in manufacturing semiconductors.
This illustrates the distinction that a utility patent can cover a product or a process. In effect,
Applied argued that it had only warranted against infringement of product patents, not
process patents. This approach had been successful in other cases.64 The Linear court,
however, said that the allegations of breach of warranty in Linear’s complaint were sufficient
to survive a demurrer, but to establish liability Linear would ultimately have to prove that the
alleged patent infringement in fact did fall within the scope of the warranty.
Second, Linear sued Allied for breach of the implied warranty against noninfringement in UCC Article 2-312(c). That section says:
(c) Unless otherwise agreed a seller who is a merchant regularly dealing in
goods of the kind warrants that the goods shall be delivered free of the
rightful claim of any third person by way of infringement or the like but a
buyer who furnishes specifications to the seller must hold the seller harmless
against any such claim which arises out of compliance with the
specifications.
62
63
Linear Technology Corp. v. Applied Materials, Inc., 152 Cal.App.4th 115, 61 Cal.Rptr.3d 221 (2007)
Linear, at 152 Cal.App.4th 125-126.
64
E.g. Motorola, Inc. v. Varo, Inc., 656 F.Supp. 716 (N.D. Tex. 1986)
An initial issue, of course, is whether any provision of UCC Article 2 properly applies to
information contracts.65 Unfortunately, the courts have typically ignored this threshold
question, particularly when goods embodying information are involved, and instead have
turned to whether Article 2-312 is preempted by federal law. The answer is split along the
usual infringement/commercial law fault line.
Following the commercial law line, the Linear court looked to the decision of the
Federal Circuit in Cover v. Hydramatic Packing66 Cover said once the buyer of an infringing
product settled with the patent owner, the Patent Act was “out of the picture,” allowing the
buyer to recover in the state law implied indemnity action. However, Cover dealt with the
second phrase in the statute, the “seller hold harmless provision” not the first phrase
involving a “rightful claim.” On this basis, a district court, in 84 Lumber Company v. MRK
Technologies, Ltd.,67 declined to follow Cover, stating that under the Patent Act only the
federal courts have jurisdiction to determine a “rightful claim” of patent infringement. The
Linear court disagreed, and held the implied indemnity claim was not preempted.
Unfortunately, there is another line of cases that both Cover and Linear ignored. In
Northwest Airlines, Inc. v. Transport Workers Union of America,68 the Supreme Court held
that federal courts, as courts of limited jurisdiction, do not have authority to allow
contribution among joint tortfeasors who violate a federal statute unless the statute
specifically authorizes it. This rule has been extended to indemnity claims.69 Following
Northwest Airlines, numerous courts, primarily in infringement actions, have held that since
neither the Patent Act, Copyright Act nor Lanham Act create a right of contribution among
joint infringers, the federal courts cannot imply such rights, and state law provisions, in
particular UCC 2-312, that have the same effect, are preempted.70
The bottom line is that implied warranties against infringement, at least for claims
arising under the federal intellectual property statutes, may be preempted by federal law.
Thus, the prudent contract drafter will include an appropriate warranty against infringement,
and ensure that it has sufficient scope to cover all infringement claims.
Turning to express warranties, many intellectual property statutes allow elevated
damages for willful infringement, and the issue is whether an express indemnity covers such
damages. In many states it is against public policy to indemnify against willful, intentional or
criminal misconduct.71 However, the adoption of comparative fault principles in other states
65
For discussion of the controversy, see, e.g. Raymond T. Nimmer, Images and Contract
Law - What Law Applies to Transactions in Information, 36 HOUSTON L. REV. 1 (1999); Lorin
Brennan, Why Article 2 Cannot Apply to Software Transactions, 38 DUQUESNE L. REV. 459 (2000)
66
Cover v. Hydramatic Packing Co., Inc., 83 F.3d 1390 (Fed. Cir. 1996), cert. denied 519 U.S. 869 (1996).
84 Lumber Company v. MRK Technologies, Ltd., 145 F.Supp.2d 675 (W.D. Pa. 2001
68 Northwest Airlines, Inc. v. Transport Workers Union of America, 451 U.S. 77, 101 S.Ct. 1571, 67 L.Ed.2d
750 (1981)
69 E.g. Levit v. Ingersoll Rand Financial Corp. 874 F.2d 1186, 1191 (7th Cir. 1989) (“Rights of contribution
and indemnity are no different in principle from other implied rights of action.”)
70 Patents: McNeilab, Inc. v. Scandipharm, Inc., 1993 WL 212424 (E.D.Pa. 1993), aff’d in part, rev’d in part
95 F.3d 1164 (Fed.Cir. 1996) (Northwest Airlines prohibit claims for contribution or indemnity among joint patent
infringers); Motorola, Inc. v. Varo, Inc., 656 F.Supp. 716 (N.D. Tex. 1986); Copyrights: Johnson v. Smith, 1997
U.S. Dist. LEXIS 20167, 43 U.S.P.Q.2d 1538 (N.D.Ga. 1997); Trademarks: Getty Petroleum Corp. v. Island
Transport Corp., 862 F.2d 10 (2nd Cir. 1988), cert. denied 490 U.S. 1006 (1989). For further discussion see
COMMERCIAL INFORMATION LAW § 401[G]; also David Hricik, Remedies Of The Infringer: The Use By The
Infringer Of Implied And Common Law Federal Rights, State Law Claims, And Contract To Shift Liability For
Infringement Of Patents, Copyrights, And Trademarks 28 TEX. TECH L. REV. 1027 (1997)
71 Foley v. Luster, 249 F.3d 1281 (11th Cir. 2001) (under Florida law, indemnity not available to a direct
copyright infringer, but is available to vicarious infringer who is only “passively liable”); Globus v. Law Research
Service, Inc., 418 F.2d 1276, 1288 (2nd Cir. 1969), cert. denied 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970)
(“one cannot insure himself against his own reckless, wilful or criminal misconduct”); Equitex, Inc. v. Ungar, 60
P.3d 746 (Colo.App. 2002) (public policy in Colorado prohibits contribution or indemnity for intentional
misconduct); Pease & Elliman, Inc. v. Stewart, 50 Misc. 2d 330, 270 N.Y.S.2d 324 (1965), aff’d 50 Misc.2d 332,
67
allows some contribution even among intentional tortfeasors.72 The point is that even an
express indemnity must be parsed carefully to determine what conduct it covers and the
extent to which it is enforceable.
2.
Practice Pointers:
Warranties and indemnities are another area where careful drafting pays off. With
regard to warranties, it is important to describe precisely the scope of what is covered and
what is excluded. When crafting an indemnity, one must make sure to cover all claims of
infringement. In many cases, parties drafting an indemnity provide for any indemnity against
any “breach of any representation, warranty or covenant.” An indemnity against breaches of
a covenant is a nullity, because one is already primarily liable for breach of a covenant, and
as such an indemnity adds nothing. However, if the indemnity also includes attorneys fees,
then such an indemnity against a breach of a covenant is in reality a hidden “attorneys’ fees”
clause. One should take care to ensure this was intended.
H.
HOW IS THE DEAL ENFORCED?
The “standard terms” in an on-line contract often contain some of the most important
provisions: those dealing with enforcement of the contract in case of default. These
enforcement provisions often include three provisions: arbitration; choice of forum; and
choice of law. As more and more business occurs on-line, these provisions in on-line
contracts are increasingly becomes sources of litigation.
1.
Arbitration Clauses:
The use of arbitration clauses in on-line contracts could be the subject of an entire
conference. From the point of view of an on-line site, arbitration can be a simple and cost
effective way to resolve what are often low-dollar disputes. Also, arbitration usually does not
allow class actions. Of course, these are some of the very results that make arbitration
unattractive to consumers.
When it comes to arbitration one can notice another emerging split in the cases. On
the one hand, the Supreme Court remains a huge fan of arbitration, and seems determined to
push more and more cases before arbitrators. On the other hand, state courts, and several
lower federal courts, have shown growing concern that arbitration has become a vehicle to
impair consumer substantive rights, and so have been increasingly willing to invalidate
arbitration clauses under a variety of guises, the most popular being unconscionability. Some
recent decisions indicate the extent of the split.
The first case is an astounding decision by the Supreme Court late last year in
Buckeye Check Cashing, Inc. v. Cardegna.73 Plaintiffs entered into a loan contract with
Buckeye. They later filed a class action claiming that the contracts were void ad initio under
Florida law for charging usurious interest, and hence not subject to arbitration. The Florida
Supreme Court agreed. It noted that in Prima Paint74 the Court had held that questions
whether the contract was unenforceable, e.g. as against the Statute of Frauds, or voidable, e.g.
due to fraud in the inducement, were for the arbitrator to decide. However, it was widely
assumed that whether a contract was void was to be decided by the court. In Buckeye Check
270 N.Y.S.2d 327 (1966) (no indemnity for deliberate or willful misconduct under New York law). An indemnity
agreement, in the face of suspicion of wrongful activity, can be evidence of the willfulness of the activity, leading
to increased damages. H.B. Fuller Co. v. National Starch and Chemical Corp., 689 F.Supp. 923, 952-953
(D.Minn. 1988) (patent infringement).
72 See COMMERCIAL INFORMATION LAW § 401[G].
73
Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440, 126 S.Ct. 1204, 163 L.Ed.2d 1038 (2006).
74 Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395, 87 S.Ct. 1801, 18 L.Ed.2d 1270 (1967).
Cashing the Supreme Court, per Justice Scalia, said “no.” Even allegations that the contract
was void were to be determined by the arbitrator. As the Supreme Court of Florida pointed
out, such a result could lead a court to enforce contracts for criminal activity. The Supreme
Court, however, was not swayed.
This pro-arbitration stance, however, is to be contrasted with the approach in the
lower courts. A good example is Combs v. PayPal, Inc75. Combs filed a class action against
PayPal in a California federal district court alleging mishandling of customer complaints.
PayPal moved to compel arbitration under its on-line, clickwrap User Agreement. Although
there was some skirmishing about whether the class representatives had indeed consented to
the click wrap, for purpose of the motion the court assumed that an agreement was made and
that California law applied. It then proceeded to find the arbitration clause unconscionable.
The court noted that California law requires a showing of both procedural and substantive
unconscionability. First, it found the agreement to be an “adhesion contract,” which met the
procedural unconscionability test. Second, it found the arbitration clause to be substantively
unconscionable on the following grounds: (i) the agreement lacked mutuality of obligation in
that it allowed PayPal in its discretion to withhold funds in dispute, restrict or close accounts,
and investigate a customer’s finances; (ii) the agreement allowed PayPal to amend its terms
without prior notice or negotiation, and PayPal made now showing of any “business realities”
justifying such one-sided action; (iii) the agreement prohibited consolidation of claims in
arbitration, e.g. “arbitration class actions”; and (iv) the agreement elected AAA commercial,
not consumer, arbitration, the costs of which would likely exceed any individual claim.
Combs was followed this Spring in Bragg v. Linden Research, Inc.76 a case involving
a property dispute in the Virtual World. Linden maintains a Virtual World known as Second
Life where it allows users to buy property using virtual money than can be exchanged for real
money. Bragg acquired a parcel of virtual land named “Taessot.” When Linden found out, it
claimed the purchase was improper, took away Taessot, and froze Bragg’s accounts. When
Bragg sued, Linden moved to compel arbitration under its Terms of Service (TOS). Both
parties agreed that California law applied. Following Combs, the Pennsylvania District Court
in Bragg found the procedural unconscionability test was met because the TOS was an
adhesion contract and the arbitration clause was hidden in a “General Conditions” paragraph.
It also found the clause substantively unconscionable because: (i) the provision lacked
mutuality in that it gave Linden a range of one-sided pre-arbitration remedies while denying
similar remedies to customers, including the ability “at any time for any reason or no reason
to suspend or terminate your Account, terminate this Agreement, or refuse any and all current
or future use of the Service without notice or liability to you,” and to amend the TOS “at any
time in [Linden’s] sole discretion”; (ii) the costs of arbitration, which required using ICC
rules and three arbitrators, were excessive, requiring an estimated deposit of $2,625 just to
initiate a claim; and (iii) the choice of an exclusive forum in San Francisco; and (iv) the
requirement of confidentiality, which gave Linden “a far superior legal posture by ensuring
that none of its potential opponents have access to precedent while, at the same time, the
company accumulates a wealth of knowledge on how to negotiate the terms of its own
unilaterally crafted contract.”
What is noteworthy in this decision is the extent to which the lower courts are willing
to expand or resuscitate older contract doctrines to challenge arbitration clauses. In Buckeye
Check Cashing, the Supreme Court continued to push challenges to the contract as whole into
arbitration, limiting challenges solely to the arbitration clause itself as reviewable by the
court. In response, the lower courts are increasing applying doctrines that really apply to the
contract as a whole specifically to the arbitration clause. For example, a lack of mutuality is
75
76
Combs v. PayPal, Inc. 218 F.Supp.2d 1165 (N.D. Cal. 2002).
Bragg v. Linden Research, Inc. 487 F.Supp.2d 593 (E.D. Penn. 2007).
an older doctrine that usually goes to consideration for the contract as a whole, but both
Combs and Bragg found the lack of mutuality of remedy in the arbitration clause indicated
substantive unconscionability. Similarly, unconscionability in terms outside the arbitration
clause proper, such as self-help remedies, the ability to amend terms of use, or choice of
forum or law provisions, are nonetheless used to invalidate the referral to arbitration.
2.
Choice of Forum Clauses:
Choice of forum is an increasing source of conflict in an on-line contract.
Potentially, a web site can be dealing with customers anywhere in the world. In case of a
dispute, the prospect of filing suit, or being sued, anywhere in the world, or even anywhere in
the United States, can be daunting. Thus, web sites often want to include choice of forum
clauses that require suits to be brought in their home state. From a consumer’s point of view,
however, the prospect of going to a remote location to sue for what is often a small amount
can be a serious disincentive. This can be particularly true where the remedies in the selected
state are more limited, such as a lack of class actions.
The Supreme Court has considered forum selection clauses in several cases. In M/S
Bremen v. Zapata Off-Shore Co,77 the Court held a forum selection was presumptively valid,
and the party challenging the clause had to “clearly show that enforcement would be
unreasonable and unjust, or that the clause was invalid for such reasons as fraud or
overreaching …. [or] enforcement would contravene a strong public policy of the forum.”
Bremen involved commercial parties. In Carnival Cruise Lines v. Shute,78 the Supreme Court
considered a forum selection clause contained in a consumer contract – a preprinted ticket
form for a cruise line that provided all disputes were to be resolved in Florida, the home state
of the cruise line. The ticket form was not seen by a Washington couple until the tickets
arrived in Seattle. The wife was injured while the ship was in the Gulf of Mexico, and
brought suit in Seattle. The Ninth Circuit held the forum selection clause unenforceable
under M/S Bremen. The Supreme Court reversed, stating:79
[It would] be entirely unreasonable to assume that a cruise passenger would
or could negotiate the terms of a forum clause in a routine commercial cruise
ticket form. Nevertheless, including a reasonable forum clause in such a form
well may be permissible for several reasons. Because it is not unlikely that a
mishap in a cruise could subject a cruise line to litigation in several different
fora, the line has a special interest in limiting such fora. Moreover, a clause
establishing [the forum] has the salutary effect of dispelling confusion as to
where suits may be brought…. Furthermore, it is likely that passengers
purchasing tickets containing a forum clause … benefit in the form of
reduced fares reflecting the savings that the cruise line enjoys….
Based M/S Bremem and Carnival Cruise Lines, there was a strong belief that forum
selection clauses in on-line contracts would generally be enforceable. In particular, a large
on-line provider, AOL, routinely included forum selection clauses in its contracts requiring
disputes to be resolved in the courts in Virginia, where AOL is headquartered.
That belief was put to the test in a decision handed down last month by the
Washington Supreme Court in Dix v. ICT Group, Inc.80, ___ Wash.2d ___, 161 P.3d 1016
(2007). The court generally endorsed the approach in M/S Bremem and Carnival Cruise
Lines. However, it found that the lack of class actions in Virginia raised serious issues. The
case before it was brought as a class action under the Washington Consumer Protection Act.
77
78
M/S Bremen v. Zapata Off-Shore Co.., 407 U.S. 1, 92 S.Ct. 1907, 32 L.Ed.2d 513 (1972).
Carnival Cruise Lines, Inc. v. Shute, 499 U.S. 585, 111 S. Ct. 1522, 113 L.Ed. 2d 622 (1991).
79 Carnival Cruise Lines, at 499 U.S. 593-594.
80 Dix v. ICT Group, Inc., ___ Wash.2d ___, 161 P.3d 1016 (2007).
The court noted a split of authority whether the lack of class actions in the chosen forum
invalidated the forum selection clause under the public policy exception in M/S Bremen.
Finding that the CPA evidenced a strong public policy in Washington towards protecting
Washington consumers, the court invalidated the clause in AOL’s contract. It concluded81:
If a forum selection clause precludes class actions and thereby
significantly impairs Washington citizens' ability to seek relief under the
CPA for small-value claims, the clause violates the public policy underlying
the CPA's dual enforcement scheme expressed in the attorney general and
private rights of action under the act. Because AOL’s forum selection clause
precludes class actions for small-value CPA claims and there is no feasible
alternative avenue for seeking relief on such claims, the forum selection
clause is invalid and unenforceable and dismissal was an abuse of discretion.
3.
Choice of Law Clauses:
The close relationship between choice of forum and choice of law clauses is
illustrated by a recent decision of the Second Circuit in Phillips v. Audio Active Ltd.82.
Phillips, known professionally as Pete Rock, entered into a music recording contract with
Audio Active. The contract contained a choice of law clause that required its validity and
construction to be interpreted under English law, and that required all legal proceedings that
might arise out of the contract to be brought in England. In other words, a combined choice
of forum and choice of law clause selecting English law. Phillips brought suit for both breach
of contract and copyright infringement in New York. Audio Active sought to dismiss citing
the choice of forum clause. The issue for the court was what law should be used to interpret
the choice of forum clause, English law under the contractual choice of law provision, or
New York law, including applicable federal law, as the law of the forum? The Second
Circuit, while noting the sparse authority on the subject, stated that in the usual case the law
chosen in the contract should be used to interpret the choice of forum clause. In particular,
was the choice of forum mandatory or permissive, and, if mandatory, would it be
unenforceable on public policy or other grounds? Finding that the parties did not brief the
issue, and believing that there was no substantive difference between New York law and
English law, the court applied New York law to find the choice of forum enforceable.
This decision raises a potentially significant issue for on-line contracts. As will be
discussed in the next section, in several on-line contracts courts do pay attention to choice of
law clauses in interpreting both arbitration and choice of forum issues. Often, the parties
merely agree to the rules where the court is situated, but this need not be the case.
In addition, many contracts contain choice of law provisions that choose the
substantive law of a jurisdiction “other than its choice of law rules.” The goal of these
provisions is often to avoid a renvoi. However, in light of Phillips, it may make sense to
rethink these provisions where one seeks to invoke specific choice of law rules to interpret a
choice of forum clause. In the alternative, it may be prudent to specify in a contract precisely
which laws should be used to interpret a choice of forum clause.
4.
An Example of All Three Interacting:
A series of cases involving various on-line contracts used by Dell show how these
provisions are interacting.
81
Dix at 161 P.3d 1024-1025.
82
Phillips v. Audio Active Ltd., __ F.3d ___ 2007 WL 2090202 (2nd Cir 2007).
The starting point is a 2004 case, Defontes v. Dell Computer Corp.,83 an unreported
decision from Rhode Island that has nonetheless generated a good deal of commentary.
Defontes commenced a class action against Dell for alleged overcharging of sales tax. Dell
moved to compel arbitration under its Terms and Conditions. The Terms and Conditions
were available from a hyperlink on Dell’s website, sent to the customer with the order
confirmation, and included with the computer when it was shipped. The opening paragraph
said: “By accepting delivery of the computer systems, related products, and/or services and
support, and/or other products described on that invoice. [sic] You (“Customer”) agrees [sic]
to be bound by and accepts [sic] these terms and conditions....” The second paragraph said in
all caps that the contract was governed by Texas law. And a later paragraph said in all caps
that all disputes were subject to arbitration. The court, however, found the arbitration clause
unenforceable.
The court began by asking which law governed interpretation of the arbitration
clause, Texas law under the contractual choice of law provision, or Rhode Island law as the
law of the forum? Finding that Texas law was a reasonable choice, and that application of
Texas law would not violate a fundamental public policy of Rhone Island, the court decided
that Texas law applied.
Turning to the arbitration agreement, the court decided that the plaintiffs had not
really consented to the arbitration clause because they had not consented to the entire
agreement. The court found that the inclusion of the Terms and Conditions on Dell’s
website, which the court categorized as a browsewrap contact, was insufficient because,
supposedly, there was no indication on the website that these terms were part of the contract.
The court also found the inclusion of the Terms and Conditions with the computers
themselves insufficient because the court believed that they did not sufficiently disclose that
rejection of the computers also rejected the arbitration terms.
In any case, the Defontes court also decided to test whether the arbitration clause was
enforceable due to unconscionability. The court found that the contract was a contract of
adhesion and thus procedurally unconscionable. It decided that, although Texas did not allow
class actions for the dispute in question, this did not make the substantively unconscionable.
Moreover, the arbitration clause bound the consumer to arbitration, but Dell was free to
choose arbitration or litigation. Noting that the law requires “mutuality of obligation” not
“equivalency of obligation,” the court found this unobjectionable. However, the decisive
provision was the phrase that “These terms and conditions are subject to change without prior
written notice at any time, in Dell's sole discretion.” Although this phrase did not apply
specifically to the arbitration provision, the court decided that Prima Paint nonetheless
allowed the court to look at the “contract as a whole” to determine the impact of this
provision. The court decided that this phrase made the entire contract illusory, thus making
the arbitration clause unconscionable and hence enforceable.
Defontes appears do what Prima Paint expressly said courts are not to do. That is,
the court looked at provisions that would invalidate the contract as a whole and applied them
to the arbitration clause, when the proper approach is to look only at specific challenges to the
arbitration clause itself. Prima Paint noted the FAA only requires that the arbitration clause
be in writing, that the arbitration clause is severable, and thus challenges to arbitration must
go to the clause itself. The supposed defects in formation went to invalidity of the contract as
a whole, which, especially under Buckeye Checking, should have been refereed to the
arbitrator. The illusory contract reasoning literally turns Prima Paint on its head. The
illusory claim goes to the contract as a whole. But the Defontes court seems to say that,
because Prima Paint makes arbitration clauses severable, one can apply a mutuality analysis
solely to the arbitration provision, when in fact it should apply to the contract as a whole.
83
Defontes v. Dell Computer Corp. 2004 WL 253560 (R.I.Super.), 52 UCC Rep.Serv.2d 795 (2004).
A year later, in 2005, an Illinois appellate court considered the identical contact in
Hubbert v. Dell Corp.,84 with completely different results. Plaintiffs sued Dell for false and
deceptive advertising, and Dell moved to compel arbitration. The contract was the same
Terms and Conditions considered in Defontes, which was available on-line through a hyperlink on Dell’s web site, printed on the back of the original invoice, and included with the
computers when shipped. The court again began by applying the choice of Texas law in the
Terms and Conditions. Contrary to Defontes, however, the Hubbert court found that the
Terms and Conditions on Dell’s web site, which included the arbitration clause, were part of
the contract since the hyperlink was conspicuously displayed and the web pages on which
parties completed their purchase said “All sales are subject to Dell’s Term[s] and Conditions
of Sale.” The trial court had also found the arbitration clause procedurally unconscionable
because it was not “conspicuous.” The Hubbert court reversed, finding that Texas law did
not require arbitration clauses to be conspicuous, but in any case the clause met the test
because it was in all caps. The Hubbert court also rejected several substantive
unconscionability challenges, finding that the arbitration rules did not necessarily impose a
“loser pays attorney’s fees rule,” would not deprive plaintiffs of a claim for punitive
damages, and was not invalid merely because it disallowed class actions.
The Supreme Judicial Court of Maine followed suit later in Dell, Inc. v. Stenzel.85
Once again, plaintiffs filed a class action against Dell for alleged overcharging of sales tax,
and Dell moved to compel arbitration under its Terms and Conditions. The court began by
deciding, but not holding, that Texas law applied, since the plaintiffs could not show a
substantive difference between Maine and Texas law in deciding on the validity of an
arbitration clause. The Stenzel court then read the same language as had the court in
Defontes: “By accepting delivery of the computer systems, related products, and/or services
and support, and/or other products described on that invoice[, the customer] agrees to be
bound by and accepts these terms and conditions.” However, contrary to Defontes, the
Stenzel court found this language quite sufficient to place the plaintiffs on notice that return
of the computers would also constitute a rejection of the Terms and Conditions, including the
arbitration clause. Turning to the arbitration clause, the plaintiffs contended that it was
illusory because of the provision that “These terms and conditions are subject to change
without prior written notice at any time, in Dell’s sole discretion.” The court began by
notice, quite correctly, that this challenge appeared to go to the contract as a whole which,
under Prima Paint, had to be referred to the arbitrator. The plaintiffs countered that the
clause allowed Dell to change the terms applicable to the arbitration. The court, however,
reading this clause along with the integration clause, found that it merely allowed Dell to
change the terms and conditions applicable to future sales. The court also rejected the claim
that the arbitration clause was unconscionable because it allowed Dell to elect arbitration or
litigation, denied class actions, or that the costs were excessive.
Finally, the Oklahoma Supreme Court threw its hat in the ring in Rogers v. Dell
Computer Corp.86 Again, consumers started a class action against Dell regarding overpaid
sales tax and Dell moved to compel arbitration. The court looked at both Defontes and
Stenzel and found them wanting. The court said that the case needed to be decided under the
UCC. The issue then was whether the Terms and Conditions were properly made a part of
the contact under UCC 2-2061, or whether they were additional terms under UCC 2-207.
While the court said it believed that Defontes was probably the better result, it found that
there had been insufficient evidence presented on the exact mechanics of how the contract
84
Hubbert v. Dell Corp., 359 Ill.App.3d 976, 835 N.E.2d 113 (2005).
Dell, Inc. v. Stenzel, 870 A.2d 133, 2005 ME 37 (2005).
86 Rogers v. Dell Computer Corp., 138 P.3d 826, 2005 OK 51 (2005).
85
was formed, and therefore remanded for further findings on whether the Terms and
Conditions, which included the arbitration clause, became part of the contract.
What can one say about these cases? They all involve the same Terms and
Conditions and similar claims, yet four different courts are split on what law applies to the
contract formation, whether a contract was formed, how to apply Prima Paint to interpret an
arbitration clause, whether a test of mutuality/illusory contract applies just to the arbitration
provision or the contract as a whole, and what factors show procedural and substantive
unconscionability.
5.
Practice Pointers:
It is hard to say exactly what one can glean from these cases except that enforcement
provisions are very carefully scrutinized and hence must be drafted with great care. Some
points do seem to emerge:
 Avoid omnibus provisions that allow a party to change any terms and conditions
in the party’s discretion. For example, under UCITA § 304 a provision
modifying terms only applies to future performances, requires notice to the other
party and, in mass market licenses, a right to terminate if unaccepted.87 In any
case, make clear the phrase does not apply to arbitration clauses.
 Specify what law applies to interpreting the choice of forum clause. Be very
careful about routinely choosing only a states substantive law without its choice
of law rules.
 Think carefully about selecting a forum that does not allow class actions.
Consider how selecting such a forum interacts with an arbitration clause.
 In arbitration clauses, be careful about allowing pre-arbitration remedies in one
party’s “sole discretion.” If only one party is bound to mandatory arbitration,
make sure that there are good, credible business reasons for so doing. Make the
arbitration clause conspicuous.
 Select arbitration procedures that a reason, fair and relatively inexpensive.
I.
CONCLUSION
The early disputes in on-line commerce revolved around whether it was even
possible to make an effective contract on-line. Then they turned to questions of jurisdiction
regarding when and whether an on-line service provider could be sued. Now the issues are
turning more to standard contract enforcement issues. This is an area new to the courts, and
there is still considerable confusion and conflicting decisions. Now more than ever this
situation places a premium on careful drafting for on-line contracts.
87
See COMMERCIAL INFORMATION LAW § 304[C].