Federal Preemption and Contract Invalidation of Quasi-Open-Source Software Development Agreements
Term Paper for Legal Issues of the 21st Century, Spring 2001
Professor David D. Friedman
Santa Clara University School of Law
Brian S. Boyer
May 5, 2001
Table of Contents
Summary.............................................................................................................................. 3
Introduction......................................................................................................................... 4
The International Scope of Internet Transactions in Intellectual Property Rights............. 5
Contract Principles, UCITA and the Problem of Technological Protection....................... 8
Dichotomy between Intellectual Property Law and Contract Law and the Relation to Preemption Principles....................................................................................................... 15
Patent
Law......................................................................................................... 17
Copyright
Law.................................................................................................. 19
Trade
Secret Law............................................................................................... 24
Police Power Over the Contract........................................................................................ 27
Police
Power over the Contract under UCITA................................................. 29
Contract Preemption by Federal Law and Invalidation by Public Policy under UCITA. 31
Analyses............................................................................................................................ 34
Application
of Preemption Principles............................................................... 34
Statutory Preemption.................................................................................... 34
Conflict Preemption...................................................................................... 38
Application
of Contract Invalidation Principles............................................... 39
Invalid for Unfairness.................................................................................... 39
Invalid for Unconscionability........................................................................ 42
Invalid for Public Policy................................................................................ 43
Open-Source Software Development Contracts............................................................... 45
Applications
to Possible Provisions in Software Development Contracts....... 47
Broadly Define Material Breach: Maximize Property Control.................... 48
Prohibit Reverse Engineering: Prevent Fair Use........................................... 50
Requiring Covenant-Not-To-Compete: Restrain Competition.................... 51
Require Transfer of Ownership: Retain Ensuing Rights.............................. 52
Require All Works to be Joint Works: At Least Share in Profits................. 55
Conclusion......................................................................................................................... 57
The open-source software development concept has proven to be a monumental improvement over old methods of ÒclosedÓ or in-house software development. The power of the internet to share information is combined with its ability to facilitate transactions to produce a truly a world-wide multi-party development effort. As a result, a copyrighted software program can be stressed in ways that traditional development could never accomplish. The result is a highly developed piece of work that was accomplished at breakneck speed. Financial gains have been proven to the extent that large organizations have felt the impact and have been experimenting with the concept. As a result, Òopen-sourceÓ agreements can be mutated into agreements that merely give the information provider the advantages while taking away user rights that are inherent in copyright and contract policy. This paper sets the landscape by discussing the international need for contract limitations. Both federal preemption and contract invalidation principles are then presented to provide a basic understanding of the metes and bounds of the freedom to contract within the realm of the highly developed intellectual property regime. Private software development contracts should be limited to the confines of the federal purpose of intellectual property law in order to increase predictability in internet transactions, increase harmony in transactions made between citizens of different states and nations, and protect intellectual property rights of parties in weaker bargaining positions. A contract that exceeds the scope of intellectual property law can be preempted by federal law or invalidated through general contract principles and public policy.
The thesis of this paper is that private software development contracts should be limited to the confines of the federal purpose of intellectual property law in order to increase predictability in internet transactions, increase harmony in transactions made between citizens of different states and nations, and protect intellectual property rights of parties in weaker bargaining positions. A contract that exceeds the scope of intellectual property law can be preempted by federal law or invalidated through general contract principles and public policy.
Limiting contract provisions in the United States to the confines of intellectual property law will create interstate uniformity and promote harmony in international transactions over the internet. In the United States, an individualÕs freedom to act is limited by both state and federal law, and interpretation of the US Constitution by Congress and the US Supreme Court establishes these limits. The US Supreme Court has determined that the state can control its own economic policy, which includes the power to regulate contractual freedom. Intellectual property rights are provided by the US Constitution, legislated by Congress, and interpreted and enforced by the courts. The State purpose in controlling contract law is to strengthen and protect the economic well-being of its citizens, whereas the federal purpose of intellectual property protection is two-fold: to provide an economic incentive to create while maximizing public access to that creativity to promote a competitive marketplace. The primary issue in this paper is whether state or federal law should control the balance between intellectual property and commerce objectives in contract agreements. Federal preemption power of the Copyright Act, and federal preemption power in general, are examined in light of the relative purposes of each legal regime.
The first section of this paper looks at the international scope of internet transactions. The second section reviews contract principles, the design of the Uniform Commercial Code (UCC) and its relation to the Uniform Computer Information Transactions Act (UCITA), and the problems of electronic self-help. The third section examines the dichotomy between intellectual property and commerce as it relates to preemption principles. The fourth section analyzes preemption and contract principles in general as applied to intellectual property contracts and then applies those tools to the open-source software concept. The paper concludes by reexamining arguments in light of the goals and analyses presented in the context of provisions that may exist in software development agreements.
The internet allows parties at opposite ends of the world to form contracts in the time it takes to click ÒI Agree,Ó but the tension between intellectual property and commerce varies between nations and creates different contract expectations. Both the United States (US) and the European Union (EU) have recognized the tension, but the EU has a system to direct state economic policy. Each US state retains control over its own economic policy limited only by federal preemption. Thus, although the US cannot dictate economic policy, it can preempt state power to avoid frustration of intellectual property law.
The internet is not only a place where private individuals can exchange expression freely, but it is also a place where private businesses can transact in valuable information. Unfortunately for the intellectual property owner, the internet is a medium where this information can easily be infringed, misappropriated, or passed off as the work of another by anyone with a home personal computer. Contract law has been used as a tool to maintain control over transactions involving intellectual property rights over the internet. Protective legislation may be insufficient in protecting property rights violated over the internet, since tortfeasors often cannot be identified, are not subject to jurisdiction, or even if subject to jurisdiction, cannot be served. As a result, electronic self-help protection has been combined with contracts to more effectively control property without relying on enforcement of legislation.
The internet simplifies entering contractual agreements with parties anywhere in the world, and the parties to such contracts often pay little attention to the terms. Contracts involving intellectual property encompass potential issues of infringement and breach. As a result, such contracts involve both the law of Òthe place where the contract was madeÓ and the law of Òthe place where the act occurred.Ó Commonality in law between states and nations becomes essential to understanding contractual expectations, such as what Ògood faith and fair dealingÓ means in a particular circumstance, what constitutes a material breach, and the contemplated cost of breach. Intellectual property protection carries with it a very strong notion of territoriality. As such, there may always be differences in the protection that nations give intellectual property, but the importance of geographical boundaries between nations should decrease as the understanding of transactional expectations regarding intellectual property increases. Limiting US contract provisions to the confines of intellectual property policy should facilitate this harmony by providing harmony between the states. The Preface in the most recent UCITA states it well: ÒThe need for a coherent, uniform body of law has never been greater. Revolutions in telecommunications and computer technology have made geography increasingly irrelevant to modern commerceÉThe liberating promise of technology cannot be fully realized unless there is predictability in the legal rules that govern such transactions.Ó[1]
The European Union (EU) has developed a tripartite structure, similar to the US in order to enact and harmonize commercial regulations governing and protecting the 15 member states of the Union.[2] The EU enacts Regulations that serve as the supreme law directly applicable to the states. Directives are enacted to harmonize law between the states through guidelines that the states are free to frame however they choose. In particular, Europe has formed a Directive to harmonize expectations in software rights and contract limitations are a part of that plan.[3] In a similar pursuit for harmony, the US joined the Berne convention in an effort to make copyright practice uniform between members of the convention. The US has preemption principles, rather than directives. Preemption principles are better than directives in that they are enforceable against the parties, whereas directives are only enforceable against the state that did not enact the national law as directed.[4] Thus, US transactions involving copyrighted material can be better defined on a national basis by keeping contract provisions within the confines of copyright policy through federal preemption. First, such transactions within the US could not usurp fair use reserved to the public.[5] Second, such transactions between US citizens would be better defined. The supporting argument is that since state law cannot frustrate the purpose of federal law, private parties cannot use contracts to defeat the purposes and design of federal intellectual property law.
UCITA is modeled on the UCC, which is driven by the need for uniformity between jurisdictions. States control contract law and UCITA appears to allow electronic restraint and electronic self-help, which through freedom to define material breach, arguably frustrate the purpose of federal intellectual property law. Electronic restraint appears to be free of any regulation, and if a breach is material, electronic self-help can be used anywhere, except mass-market contracts. The evolution of such legal and technological power to define and enforce your own contracts creates the need for well-defined limits of contract enforcement.
Private parties to a contract, the state, and the federal government all have different interests in controlling transactions. Contracts are promises that can be remedied by law if breached and must be based on mutual assent and consideration, where such consideration must be based on a bargain for exchange, and valuable.[6] Contracts must not only be based on good faith and fair dealing[7], but regulations governing transactions should be uniform between jurisdictions to harmonize contract expectations and protect parties in a weaker bargaining position from unconscionable terms.[8] Private parties want freedom from government intervention and have argued for freedom of contract in light of due process considerations of liberty and property.[9] In Lochner,[10] the number of hours that could be worked in a bakery was limited by a statute that was struck down. The statute was a product of politics in which labor unions had organizational power to control consumer prices and the bargaining power of workers that would be willing to work longer for less money.[11] The State wants to control economic policy to protect citizens from such arrangements by creating legislation and exercising police power.[12] The Federal government wants to harmonize law and prevent forum shopping while preserving the purposes of federal law.[13] Current law has identified the problems of the Lochner era and says that there is not a fundamental right to contract, but rather that the state has sovereign authority to legislate economic policy.[14]
Uniformity was a main purpose of enacting the Uniform Commercial Code (UCC). The goal was to create a uniform body of sales law, and in particular, uniform regulation of the sale of goods.[15] The emphasis on uniformity among jurisdictions is expressly stated as one of the three purposes and policies of the code.[16] Parties are allowed to contract out of the UCC with the sole exception that the obligations of good faith, diligence, reasonableness and care cannot be waived.[17] The UCC is essentially stand alone where enacted, except where general principles of law and equity can supplement,[18] and applies to the State where enacted if there is an Òappropriate relationÓ to the transaction, unless the parties choose the law of another State or nation with a Òreasonable relationÓ to the transaction.[19] Remedies for breach are limited to restore the aggrieved party to the position he would have been in if the contract were fully performed, but no punitives or consequential damages are allowed.[20] Important to the scope of this discussion, the UCC recognizes differences in expertise that relate to relative bargaining power between merchants and buyers.[21] The seller is obligated to transfer and deliver and the buyer is obligated to accept and pay as agreed in the contract, but the court has discretion to invalidate all or part of a contract for unconscionable or illegal terms.[22]
New law has been proposed to handle digital transfer of information. Article 2 of the UCC handles sales of goods, whereas services are handled by the Restatement (Second) of Contracts. Both statutes are based on general contract principles of mutual assent, bargain for exchange, valuable consideration, and breach. However, our economy has developed a market for information, which is an intangible good and doesnÕt fit well within either scheme. This lack of fit led to the development of Article 2B, which began through multiple revisions as an outgrowth of the UCC. UCC2B lost the support of ALI as a result of too much information provider bias in seeking regulatory control through contract provisions that threatened the rights of information users. The withdrawal of ALI prevented adoption of the code into the UCC, but the NCCUSL continued revisions under the new title, Uniform Computer Information Transactions Act (UCITA). UCITA has addressed many of the concerns over information provide bias regarding the right of possession, prevention of use, and self-help repossession.[23]
Parties are not limited to just designing their own contracts, but they can also enforce those terms electronically. Self-help allows contracting parties to create and enforce their own contractual boundaries without judicial intervention. Electronic self-help is a unique means of enforcing contracts involving software. Such technology provides the means for a licensor to remotely repossess software, program software to terminate upon specified conditions, or program software to activate a digital lock upon breach. To avoid abuse of electronic self-help, UCITA requires the following: mutual assent to the self-help provision, at least 15 days notice before exercising self-help, and limiting self-help to cases of material breach.[24] Further, UCITA does not allow electronic self-help in mass-market contracts, situations where information is inseparably commingled with the licensorÕs information, and cases where the public could suffer harm from such enforcement.[25] Abuse of self-help must be controlled, so UCITA provides the licensee with recourse for wrongful use of such electronic self-help technology.[26]
Allowing parties the freedom to define a Òmaterial breachÓ leaves much room for software contracts to frustrate IP law, despite limitations under UCITA.[27] UCITA appears to remove all limitations on electronic self-help if done without a breach of peace and done outside of mass-market contracts.[28] Further, UCITA does not limit use of electronic restraint to prevent a licensee from breaching terms.[29] Thus, although UCITA has not been widely adopted,[30] the debates and revisions surrounding UCITA nonetheless reflect the main interests and concerns regarding information transactions and provide a very strong framework for state legislation. Particular to this discussion, it should be noted that UCITA does recognize the potential for conflict between Copyright law and electronic self-help.[31]
Federal intellectual property law balances public policy goals of developing an incentive to create by giving property rights to creators, while maximizing public access to creations in order to promote a competitive marketplace.[32] States have the freedom to regulate intellectual property within the confines of the purpose of federal intellectual property law.[33] The objective of contract law over the sale of goods is three-fold: 1) simply, clarify, and modernize commercial transactions law; 2) permit expansion of commercial practice through custom, usage, and party agreement; and 3) make law uniform among jurisdictions.[34] The US Supreme Court has addressed the intellectual property balance by leaving unprotected ideas in the public domain to copy and compete. As such, the state can regulate unprotected material without threat of preemption.[35] Parties to a contract may seek relief under both contract and intellectual property laws if there is no double remedy.[36]
Until 1978, state law controlled unauthorized copying, sale, and performance of unpublished works through common-law copyright protection.[37] Now, federal protection attaches as soon as the work is fixed in a tangible medium of expression.[38] The general principle of preemption is that federal law is supreme over state law under the Supremacy Clause.[39] There are generally two forms of federal preemption: field and conflict. Field preemption occurs when federal law consumes an entire field without room for state regulation. Conflict preemption occurs when added state protection conflicts with the purposes of federal law. An example of conflict preemption would be a state law that attempts to prohibit public access to unprotected subject matter.[40] Another form of preemption is provided by statute. For example, the Copyright Act expressly preempts state law if two elements are met: the state provides rights equivalent to those enumerated in the Act, and the subject matter of concern is copyrightable.[41] A comparison and synthesis of patent, copyright, and trademark law provides general policy principles that should be followed in federal preemption analysis, as well as any attempt to invalidate a contract by public policy.
The purpose of patent law is to provide an incentive to create by granting economic rights while maximizing public access to creativity to stimulate competition. Courts balance this purpose with the purpose of contract law when determining contract rights. For example, the incentive to create can be obtained by allowing contracts over unprotected subject matter, but the subject matter must not be removed from the public domain. Parties to the contract can limit themselves from accessing material in the public domain, since others can still copy and compete, as long as the subject matter was not in the public domain prior to the contract. Thus, the issue is whether the contract terms are generally preempted by the public policy of patent law.
Patent protection is provided for inventions that meet requirements of subject matter, novelty, and nonobviousness.[42] Patented inventions are protected for a term of 20 years from the time of filing to allow time for return on investment prior to giving the invention to the public. Patent owners often recoup and profit by charging royalties through license agreements. Further, licenses can defeat the first-sale doctrine by avoiding complete transfer of ownership.[43] Thus, allowing parties to design their own contracts concerning their intellectual property is also incentive to create. Problems occur when licenses are either misused to get patent-like protection over unprotectible property[44], or to give patent rights greater than those awarded by Congress[45].
The incentive to create can be obtained by allowing contracts over unprotected subject matter, but the subject matter must not be removed from the public domain. Parties to the contract can limit themselves from accessing material in the public domain, since others can still copy and compete, as long as the subject matter was not in the public domain prior to the contract. In Sears[46], the defendant copied an unprotected lamp, so the plaintiff tried to claim damages through state unfair competition law. The US Supreme Court held that the balance in public interest between the incentive to create and free competition requires that unprotected ideas remain in the public domain to copy. In Kewanee[47], the US Supreme Court held that where Congress has Òdrawn no balanceÓ to unprotected subject matter, the state should be free to regulate. In Aronson[48], the US Supreme Court looked to the Kewanee 3-fold purpose test to uphold a contract despite lack of patent protection: CongressÕ purpose in passing patent laws are (1) incentive to invent; (2) promote disclosure of inventions; and (3) ensure unprotected material stays in public domain. The US Supreme Court held that by enforcing a contract regarding an unprotected key ring, the inventor had the incentive of gaining royalties, sales under the contract discloses the idea to the public, and parties not privy to the contract could still copy the idea. Further, the key ring idea was not taken from the public, since the key ring had not yet been offered for sale. In Bonito[49], the US Supreme Court held that a state statute that protected a plug mold process that was not kept secret was preempted, since such protection would frustrate CongressÕ purpose of keeping unprotected ideas in public domain.
The purpose of copyright law is to provide an incentive to create by granting economic rights while maximizing distribution of that creativity to the public. Reverse engineering of copyrighted software programs is fair use, stimulates competition and expands the market by allowing access to unprotected functional elements. Contracts that control copyrightable subject matter and create rights equivalent to the enumerated federal copyrights are preempted under ¤301. Even if the contract rights are not equivalent to those enumerated in ¤301, the contract can still be preempted for frustrating the purpose of the Copyright Act. Thus, the issues become whether the contract terms are statutorily preempted or generally preempted by the public policy of copyright law.
Copyright law protects the ownerÕs right of reproduction, preparation of derivative works, distribution, public performance, and public display, but the fair use exception leaves a portion of those rights in the public domain.[50] In all cases, the court must look to four factors to determine whether there is fair use of the protected expression: (1) purpose and character of the use; (2) nature and character of the protected work; (3) amount and substantiality of portion used; and (4) effect of use on the potential market or value of the work.[51] In computer programs, the unprotected elements are hidden in object code, and the law allows reverse engineering of software programs in order to obtain those elements and prevent software developers from gaining a monopoly over public domain material. In Altai,[52] the court held that reverse engineering of a computer program is essential to separate expression from idea so that the public can gain access to elements of the software program that must remain public domain, such as elements that provide function, efficiency, and external factors such as compatibility. The method of abstraction-filtration-comparison is described to illustrate how the protected portion of a program is obtained and compared to the alleged infringing program. In Sega,[53] the court held it is fair use for a competing software manufacturer to copy protected object code to reverse engineer if there is a legitimate reason, and reverse engineering is the only way to access the unprotected ideas. The purpose and character of the use was commercial, and thus presumptively unfair, but the use was only intermediate copying to acquire unprotected elements, and the defendantÕs work was independent. The nature of the protected work demanded less protection, since computer programs are functional in character, despite their creative element. The amount and substantiality taken is irrelevant if the ultimate use is limited to fair use, and the effect on the potential market was to increase competition through use of public domain material, but also to expand material available to consumers.
Copyright law expressly preempts state law that provides rights equivalent to those enumerated in the Copyright Act while allowing states to provide additional protection by adding extra elements to those rights[54]. However, the state must not frustrate CongressÕ purposes and objectives.[55] Congress intended to make copyright law uniform through ¤301 of the Copyright Act by abolishing any state created rights equivalent to copyright over subject matter that falls within the scope of copyright law.[56] For ¤301 to preempt state law, the subject matter the state is trying to protect must first fall within the Copyright Act,[57] and second, the state law must protect rights equivalent to those enumerated in the Copyright Act.[58] Thus, an otherwise valid contract will prevail over federal intellectual property policy if neither ¤301 nor conflict preemption is present.
The first question in ¤301 preemption analysis is whether unprotected material is copyrightable subject matter, and the mere fact that subject matter failed to meet the standards of copyright law does not necessarily make it fall outside of the Copyright Act.[59] Unprotected subject matter within a copyrighted expression has been held to be copyrightable subject matter,[60] such that state law protecting such subject matter within the protected expression may be preempted by ¤301. In NBA[61], the court held that unprotected subject matter within a copyrighted expression is part of that expression, so that a state claim for misappropriation of uncopyrightable facts within copyrightable expression is preempted by ¤301. In Board of Trustees of the University of Alabama,[62] the court held that ideas and methods in a doctoral dissertation were copyrightable subject matter, although unprotected, and thus preempted by ¤301. The major argument to these holdings is that once material within a copyrightable expression is not protected, it is no longer copyrightable subject matter and state law concerning such matter should control.[63] However, even if this major argument were to preclude preemption under the Copyright Act, conventional preemption analysis may still prevail. The Sears[64] conflict preemption argument that unprotected material is public domain by act of Congress may still provide a means of preempting state law over such subject matter.
The second question is whether the state law protects rights equivalent to those in ¤106. The extra-elements test is one way of making that determination. If there is an extra element that makes the state cause of action qualitatively different than the copyright action, then ¤301 does not preempt. In Baltimore Orioles[65], the court held there was not preemption where extra elements in a state law publicity claim did not make the claim qualitatively different from copyright, since the ÒpurposeÓ of both claims is to promote performances that appeal to the public. In Harper & Row[66], the court held there was not preemption even though the state claim for tortious interference with contract requires extra elements of awareness and intent in copying the material, since these elements only broadened the ÒscopeÓ of the right and did not change the ÒnatureÓ of the claim that the copyright law was meant to protect. However, in Del Madera[67], the court held that an implied promise not to copy a map was enough to preempt a state claim of unjust enrichment, since the implied promise not to use or copy materials within the subject matter of copyright is the ÒessenceÓ of copyright protection.
The purpose of trade secret law is to provide an incentive to create by granting economic rights while preserving commercial morality, which is a narrower policy goal than copyright. Trade secret adds the element of police protection over commercial behavior and seems to protect contracts controlling trade secrets from federal preemption. However, since trade secret protection is cumulative to other forms of protection, loss of trade secret status can revive copyright protection and thus preemption. Thus, the issues become whether the material is in fact a trade secret, and if not, whether statutory or general preemption apply.
Trade secret is state law and protects valuable information, so that parties can maintain a competitive advantage in production or sale of goods or services whether or not the information is capable of any other form of protection.[68] The goals of trade secret law are to (1) provide an incentive to create know-how that may ultimately benefit the public while (2) discouraging improper conduct by competitors.[69] Trade secret violations occur when the secret was acquired, disclosed, or used either through improper means or misappropriation.[70] Copyright preemption through ¤301 will only occur when the extra elements of trade secret law, which are proof that the trade secret was acquired or used through improper means or misappropriation, serve different purposes than copyright infringement. The purpose of both copyright and trade secret are to protect the owner from unauthorized use by another. The difference is that trade secret protection is narrowed to violations that include an element of knowledge of the misappropriation or improper means, whereas copyright infringement does not require such knowledge. Thus, the argument against federal preemption of trade secret law would be that the state is providing extra protection to the public by policing commercial morality.[71] In Kewanee[72], the court formulates a three-fold purpose test defining the federal purpose of patent law to hold that there is no preemption of trade secret law in general, because trade secrets provide an incentive to create, do not take material from the public domain, and although trade secrets do frustrate public disclosure of ideas, the state interest in policing commercial behavior outweighs the slight chance that parties would choose trade secret protection where patent protection is available.[73]
Trade secret law requires continuous use of the know-how to deserve protection, in addition to consideration of 6 other factors: (1) whether the know-how is widely known outside of claimantÕs business; (2) who knows of the know-how within claimants business; (3) the methods used to keep the know-how secret; (4) the value of the know-how to claimant and competitors; (5) the amount spent in developing the know-how; and (6) the difficulty for others to properly acquire or develop the know-how.[74] As a result, information may not meet the requirements of trade secret protection even though the owner would like to claim such protection.
If reasonable efforts are not taken to maintain secrecy, the information will lose trade secret status. In Rockwell,[75] the plaintiff distributes trade secret Òpiece-partÓ diagrams to subcontractors through confidentiality agreements. The defendant argued the diagrams were not trade secret because thousands were distributed, copied, and distributed to others without permission, all of which were outside plaintiffÕs business. The plaintiff argued that disclosure is often necessary for efficient exploitation of a trade secret. The issue became whether distribution of a large volume of trade secret material to outsiders without restriction on copying or requiring return removes trade secret status. The court held that the volume distributed is not as important as whether distribution was limited to suit a purpose, and whether the trade secret owner made reasonable efforts under the circumstances to maintain the secret. The court reasoned that requiring little maintenance of the secret would provide ÒwindfallÓ protection over information with little value to the owner, whereas requiring too much protection would reduce commercial efficiency. Thus, the level of effort required to maintain a trade secret must be limited to what is reasonable.
An aggrieved party can not only seek relief through federal preemption, but can also seek relief through invalidation of the contract using general invalidation principles or through public policy.
Regardless of whether the contract is preempted by federal law, the contract will not be enforceable unless it is valid. A legally enforceable contract requires mutual assent to a valuable consideration that was bargained-for and involves a legal detriment to both parties.[76] Both parties must have the capacity to enter a contract, which excludes infants and the mentally ill.[77] Contracts can be invalid for unfairness,[78] unconscionability,[79] or on grounds of public policy.[80] Contracts can be unfair for misunderstanding,[81] mistake,[82] or overreaching by misrepresentation,[83] as well as illegality.[84] A contract is unconscionable where, in light of the commercial background and needs of the particular trade or case, the provisions are so one-sided as to be unconscionable under the circumstances existing at the time of assent.[85] Contracts can be invalid on grounds of public policy where legislation says that such provision is unenforceable, where enforcing the provision is clearly outweighed by public policy under the circumstances,[86] or where there is an unreasonable restraint of trade.[87]
Breach of contract affords remedies for both material and non-material breach, but there is no duty of return performance if the breach is material.[88] In determining whether a breach is material, the court looks to five factors: 1) the extent to which the injured party will be deprived of the benefit he or she reasonably expected; 2) the extent to which the injured party can be adequately compensated for the benefit of which the party will be deprived; 3) the extent to which the party failing to perform or to offer to perform will suffer forfeiture; 4) the likelihood that the party failing to perform or to offer to perform will cure the failure, taking into account all the circumstances, including any reasonable assurances; and 5) the extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.[89] This means that if a breach is material, it may be possible to get damages for the entire expected performance under the contract, rather than damages for only the affected provisions.
UCITA follows the same basic contract validity principles as the UCC and Restatement but appears to have a stronger sense of enforcing the contract, allowing parties to define what is material for purposes of breach, and making sure parties can obtain the benefit of the bargain.
UCITA and Article 2 are based upon the principle of freedom of contract, such that the terms and effect of a contract can be varied by agreement with some exception. Both statutes provide default rules that apply only if the parties do not specify some other rule. Parties want flexibility, but legal rights in contracts are unclear without certain default rules. Formation of contracts and invalidation for unfairness and unconscionability generally follow existing state law, but may be supplemented or displaced by UCITA.[90] For example UCITA agrees that assent to the contract binds the parties, even if they did not read the contract, understand, or separately assent to each term. Enforceability of terms is affected by unconscionability, public policy, good faith, etc. However, UCITA does not agree with the Restatement (Second) of Contracts that says where a party believes the other party would not have assented if he knew about a particular term, the term is not part of the agreement.[91] Absent unconscionability, fraud or similar conduct, parties are bound by the terms to which they assent after having had an opportunity to review. UCITA follows the unconscionability standard of Article 2 but exceeds Article 2 in authorizing courts to strike down over-reaching language that frustrates fundamental public policy.[92]
The concept of breach as defined by UCITA is based on the principle that parties are entitled to the performance for which they bargain.[93] Any breach entitles the other party to damages, but UCITA adopts the rule in common law and international law that some breaches are so immaterial that they do not justify cancellation of the contract. In such cases, it is better to preserve a contract with minor problems than allow cancellation and cause loss of value to one party or unfair opportunism to the other. Materiality depends on the agreement, and the agreement can either define what is material or simply say cancellation is agreed upon for any type of breach. If breach is not defined in the contract, then the court has to weigh the circumstances, the aggrieved partyÕs perspective in light of the nature of the bargain, and the expected benefits. UCITA provides three ways to identify what is material: contract terms defining materiality, a substantial failure to perform an essential term, and a breach causing substantial harm to the aggrieved party or a denial of a reasonably expected significant benefit.[94] Thus, UCITA appears to allow the parties free reign over defining a material breach, and this freedom appears to be absent under the Restatement (Second) of Contracts and the UCC.
Contracts can be preempted partially or entirely by federal law that directly regulates specific terms, but there is no general federal preemption power over contracts. Public policy can outweigh and invalidate contracts, and such policy is strongest when legislated and not purely local. Policy supporting innovation, competition, and fair use are most likely to invalidate contract provisions, but this likelihood is reduced by free negotiation of risk allocation and benefit in the market. UCITA provides for invalidation through public policy interests, but appears to favor contract enforcement over preemption or invalidation by public policy.
The concept of federal preemption, violation of public policy, and consumer protection are combined in a single section of UCITA.[95] Essentially, UCITA recognizes the conflict between the goals of federal intellectual property and contract law. The ReporterÕs Notes in ¤105 focus on state interest in contract enforcement, the First Amendment interest in public access to information, and free competition. In essence, ¤105 of UCITA recognizes that federal law preempts any conflicting provision of UCITA, and that any term violating fundamental public policy may nullify the entire contract, be severed from the contract, or be limited by the court to avoid the conflict. UCITA does not recognize a general preemption power over contract by patent or copyright law, but does recognize that such federal rules may directly regulate specific contract terms. However, UCITA does not define to what extent this may occur.[96] This paper addresses some particular provisions that may exercise this principle.
Broader public policy interests can invalidate a term even where federal law does not specifically preempt, or the term is not unconscionable.[97] This power to enforce public policy over freedom of contract is also recognized in the Restatement (Second) of Contracts.[98] Courts should try to override contract terms only where such policy is stated by legislature and should consider the following: (1) the extent to which enforcement or invalidation of the term will adversely affect the interests of each party to the transaction or the public, (2) the interest in protecting expectations arising from the contract, (3) the purpose of the challenged term, (4) the extent to which enforcement or invalidation will adversely affect other fundamental public interests, (5) the strength and consistency of judicial decisions applying similar policies in similar contexts, (6) the nature of any express legislative or regulatory policies, and (7) the values of certainty of enforcement and uniformity in interpreting contractual provisions.[99] Invalidating on the basis of public policy must also consider the national and international nature of transactions. As such, courts should hesitate when invalidating terms based on purely local policies. Where parties have negotiated for terms in their agreement, courts should be even more reluctant to set aside terms of the agreement.
The public policies UCITA recognizes as the most likely to invalidate transactions are innovation, competition, and fair use, but UCITA feels that contract law will usually not frustrate these policies, since contract allocates risks and benefits in ways that are market dependent. This is particularly true when the information is trade secret, since this information is restricted to the contracting parties and is not in the public domain where ÒpublicÓ policy weighs heaviest.[100] In fact, UCITA suggests looking to patent and copyright law for guidance on public policy limits, and further discusses how the Digital Millenium Copyright Act (DMCA) has expressly handled the policy conflict between separating expression from idea in order to reverse engineer copyrighted expressions for interoperability in programs that are digitally locked.[101] For example, courts now must allow breach of digital locks in order to obtain interoperability computer programs through reverse engineering.[102]
The previous discussion indicates that an aggrieved party can seek resolve through preemption or invalidation of the contract. Preemption analysis involves looking at ¤301 and general preemption principles. Invalidation looks at basic contract principles and public policy. This section attempts to consolidate and apply the above principles in a generic manner to understand the limits of their use.
Recall that copyright law preempts contract law through either express statutory preemption or general conflict preemption.
Even though the material is copyrightable subject matter and the right is equivalent that provided by the Copyright Act, some courts hold that contracts affecting unprotected copyrightable subject matter are not preempted, since they simply uphold agreements between parties to the contract and do not remove unprotected material from the public domain. The reasoning is that federal preemption should only apply to conflicting state law, not to private contracts, since copyrights are held out against the world, whereas contracts only apply to the parties.
The issue of whether state contract law is preempted by ¤301 looks at two questions: first, whether the contract provision under scrutiny affects copyrightable subject matter, and second, whether the rights affected by the provision are equivalent those enumerated in ¤106. The court must look at any extra elements in the contract claim that are not present in a copyright infringement claim to determine if there is equivalence between the contract right and the copyright. The only extra element in a contract claim is bargain-for-exchange.[103] If the extra element does not provide a qualitative difference between the state law claim and copyright, ¤301 preempts. Thus, the issue regarding ¤301 will be whether bargain-for-exchange element has a different purpose, nature, or essence than the copyright protection.
The purpose and nature of copyright is to stimulate creation and dissemination of expressive works by granting authors economic rights. Using the Baltimore Orioles ÒpurposeÓ rule, one could argue that the purpose of a bargain-for-exchange is to ensure that the holder of the economic right receives valuable consideration for that right, or if the consideration for the contract is the copyright itself, that the copyright is valid. In one sense, both the element of unauthorized use of the copyright and the element of bargain-for-exchange have the purpose of protecting the economic right of the copyright owner, and thus are not qualitatively different. In another sense, it could be argued that bargain-for-exchange protects both parties, not just the copyright owner. Thus, statutory preemption may or may not apply to contracts controlling copyrighted material. It is at this juncture that a judge must decide whether national uniformity is a more important purpose than preserving state freedom to control contracts.
The 7th Circuit has held that contracts affecting unprotected intellectual property are enforceable, since they only uphold agreements between parties to the contract and do not remove unprotected material from the public domain. The reasoning is that federal preemption should only apply to conflicting state law, not to private contracts. In ProCD[104], the court held that a shrinkwrap contract restricting use of public domain telephone directory data is valid, since those not parties to the contract are free to collect and compile all 3000 phone directories if they choose. Only parties to the contract are affected. The defendant argued copyright preemption, since telephone directory compilations are generally not protectible by copyright.[105] In the preemption analysis, the court pointed out one function of ¤301(a): to prevent states from giving special protection to works that Congress decided should be in the public domain. The court found database material to be copyrightable subject matter under ¤301, but questioned whether contract rights could be equivalent to copyrights. The court said they are not, since copyrights are enforceable against the world, whereas contracts are enforceable only against the parties to the contract. Further, a purpose of contracts is to promote private ordering essential to an efficient market, whereas a purpose of federal preemption law is to prevent states from regulating in areas reserved to the federal government.[106] Therefore, the argument is that there should only be preemption where there is threat of state regulations that conflict with federal purpose, not where private parties contract for market efficiency. The court in ProCD cited examples where courts have upheld or may uphold trade secret contracts for unpatentable material,[107] rental contracts for copyrighted videotapes,[108] and contracts involving unpatentable material not yet in public domain.[109]
General federal preemption determines whether state law conflicts with federal purpose, but courts can vary in their interpretation of the purpose.
General federal preemption simply looks at whether the contract provision conflicts with the purposes of federal law rather than whether the state law is qualitatively different.[110] Conflict preemption is not always clear on its face, since courts may vary in their interpretation of the purpose of a particular copyright law. For example, in Rano,[111] the court held that an oral agreement with no specified duration would be terminable at-will by state contract law, but federal copyright law requires the agreement to specify the term, or the term is not terminable until 35 years have passed from the start of the license. On the contrary, the court in Walthal[112] held that the 35 year limit is the maximum rather than the minimum term, allowing contracts without a specified term to terminate at-will. Thus, the court has discretion to determine the purpose of the federal law and then rule on whether the state law frustrates that purpose.
Recall that contracts can be invalid for unfairness, unconscionability, or public policy. In general, UCITA follows traditional contract law with respect to general principles and adds an emphasis on the ability to invalidate contracts for public policy conflicts while also stressing the importance of enforcing the contract to ensure each party gets the benefit of the bargain. Thus, there seems to be tension between the UCC and UCITA in that UCITA adds protection through greater recognition of public policy, but UCITA also stresses enforcement of the contract above all else.
A contract would be unfair if assent or consideration is based on misunderstanding, mistake, or overreaching by misrepresentation.
Misunderstanding[113] negates assent in that either one or both of the parties did not agree to the same thing, but thought they did, and the difference is material.[114] The court will uphold the contract in the aggrieved partyÕs favor if one of the parties knows of both meanings and the aggrieved party does not, but will void the agreement if neither knew or had reason to know of a material difference in meaning or both knew and had reason to know of the difference. Thus, a licensee that Òagrees to give up his programÓ may not actually be agreeing to giving up the copyright. More importantly, the licensor may know or have reason to know that the licensee misunderstood.[115] In this case, the licensee should be able to maintain the agreement while keeping his copyright. Mistake[116] in contract formation is a risk that can be allocated by contract such that an otherwise voidable contract will stand.[117] An aggrieved party can void a contract for a material mutual mistake, but can only void for unilateral mistake where enforcement would be unconscionable, or the other party knew, had reason to know, or caused the mistake.[118]
A mistake becomes elevated to a misrepresentation[119] in four ways: a party knows that disclosing a fact (1) is necessary to prevent a previous assertion from becoming a misrepresentation, fraudulent, or material;