Avoiding liability for defective software

SAM Business Systems Ltd v Hedley & Co Ltd (2003)1 All ER Comm 34

It is more than two years since Watford Electronics Ltd v Sanderson Ltd [2001]1 All ER Comm 696), in which the Court of Appeal gave its leading judgment on exclusion of liability, limitation of liability and entire agreement clauses.

The case of SAM v Hedley, which took place earlier this year, has now afforded the Technology and Construction Court one of its first opportunities to address those issues.

Hedley is a firm of stockbrokers whose operations include the management of financial products.

Concerns in 1999 about Y2K risks prompted Hedley to replace ANTAR, the outmoded operating system that it had been using for its transactions.

Hedley replaced ANTAR with the InterSet system produced by SAM Business Systems.

It did so following SAM's representations about InterSet's impressive functionality.

SAM made those representations both in its marketing literature and through its sales representatives at meetings with Hedley's personnel.

Judge Bowsher found as fact that SAM had represented that InterSet was a highly automated product that would satisfy all of the transaction settlement requirements of a financial institution.

Those included the updating and reconciliation of client accounts, notification of trades to the securities industry's central settlement system, and the discharge of Hedley's Financial Services Authority (FSA) obligations.

SAM had also represented that anyone operating InterSet would not need any technical expertise.

SAM estimated the total cost of the project to replace ANTAR with InterSet would be at most 180,000.

On 18 October 1999, Hedley signed a licence agreement and a maintenance agreement for InterSet.

While the agreements did not provide for the total cost to Hedley, Judge Bowsher held that the common working assumption was that Hedley would pay 180,000.

Of that sum 116,000 would be for the licence fee and 19,000 for the requisite hardware for InterSet to run on.

Unfortunately, Hedley encountered extensive difficulties with InterSet almost as soon as the system went live in December 1999.

Hedley had to report the failures to the FSA.

Notwithstanding the continuing problems and SAM's unsuccessful efforts to fix them, Hedley continued to pay its instalments of the licence fee.

The problems continued and on 7 February SAM gave 30 days' notice to terminate the maintenance agreement.

On the next day Hedley informed SAM that it was discontinuing the implementation of InterSet.

By that stage Hedley had paid SAM 184,604.32.

Hedley then commissioned and installed replacement software.

In June 2001, SAM issued its claim form for 310,509.84 in respect of licence fee instalments and maintenance payments.

Hedley counterclaimed for 789,658.44, comprising items such as all the sums it had paid, its increased cost of working and loss of profits.

It based its counterclaim on breach of the licence agreement and on misrepresentation.

SAM denied breach of the licence agreement.

SAM also relied on five clauses in the agreements that purported to exclude some liabilities and to limit others.

In his judgment, Judge Bowsher provided an in-depth analysis of those clauses.

Clause 3.6 provided that the licence agreement contained the entire understanding of the parties, which understanding superseded all prior representations and negotiations ('the entire agreement clause').

Judge Bowsher noted the absence here of any further clause acknowledging that the parties had not relied on any representations when they entered into the contract.

He noted that the entire agreement clause that the Court of Appeal had considered in Watford v Sanderson had contained such an acknowledgement of non-reliance.

Judge Bowsher also found as fact that SAM had waived the entire agreement clause.

Clause 2.10 set out the mechanism for Hedley's acceptance testing of InterSet with the performance criteria listed in one of the schedules.

Clause 2.11 then provided that if InterSet did not pass its acceptance testing then Hedley would be entitled to terminate the licence agreement and receive a refund of all sums paid.

That return of funds would be Hedley's only remedy available if it did not accept InterSet.

At clause 3.2, SAM excluded any warranties in relation to InterSet.

At clause 3.3, it excluded liability for any direct damages and incidental or consequential losses that Hedley might sustain from using InterSet's, including loss of profits.

To the extent that any liability in damages remained, then that liability could not exceed the amount of the licence fee.

Judge Bowsher ruled that the sweeping nature of clause 3.3 could potentially exclude any damages flowing from SAM's misrepresentations of InterSet's functionality.

For that reason SAM retained the ability to exclude liability for its misrepresentations even though it had waived the entire agreement clause.

Whether it succeeded though would depend on the application of the Unfair Contract Terms Act 1977 (UCTA).

Judge Bowsher ruled that the entire agreement clause was a clause to which section 3 2(b) of UCTA applied.

He followed the guidance of the Court of Appeal in Watford and considered each of the relevant clauses in the context of the others to assess whether its terms were reasonable against the guidelines at schedule 2 to UCTA as SAM asserted.

He found that other software companies at the time had contracted using similar exclusion and limitation clauses.

Moreover, the parties were effectively of equal bargaining power.

He also ruled that Hedley had never sought to negotiate on the terms of any of the five clauses.

While SAM's potential exposure was enormous, Hedley could have been closed down by the regulator following the defects in the software.

Judge Bowsher assessed the issue of reasonableness by weighing the combined effect of the exclusion and limitation clauses in question.

Here SAM purported to exclude any possible liability, but at the same time Hedley could obtain a refund, provided it took the correct steps to test InterSet.

In light of the money-back guarantee and in the circumstances of the case, all of the five clauses were reasonable.

Accordingly, Hedley's counterclaim against SAM failed.

Judge Bowsher commented in obiter that without the money-back guarantee he would have struck down as unreasonable both the entire agreement clause and the exclusion of liability clauses.

However, he did consider that SAM's limitation of Hedley's recoverable losses to the licence fee paid would have been reasonable even without the money-back guarantee.

He also noted that in any event, Hedley could never have recovered both its entire expenditure on InterSet and damages flowing from InterSet's defects, as it had pleaded.

That was because Hedley had used InterSet for 17 months.

It could have obtained its money back if it had operated the money-back guarantee system.

It did not.

SAM's claim for 310,000 did not meet with much more success.

Judge Bowsher only allowed 9,000 of SAM's claim.

Software companies would be well advised to audit all claims about the efficacy of their packages in their marketing literature and check those made by their sales teams.

In the light of this decision, software supply contracts that provide an opportunity for customers to obtain their money back if the software fails at acceptance testing, appear to stand a better chance of surviving judicial scrutiny under UCTA than those that do not.

By Jonathan Cohen, Duane Morris, London