Technology & Litigation

There is a new Seventh Circuit Court of Appeals opinion that is likely to have a significant impact on SaaS providers.  In Digitech Computers, Inc. v. Trans-Care, Inc. (link here), the 7^th Circuit focuses on a SaaS agreement for Digitech to provide certain management software licensing components for Trans-Care (an ambulance and medical transportation service).  The Court ultimately upheld a breach of contract claim in favor of Digitech, significantly reduced Digitech’s damages award, and reduced Digitech’s award of attorneys’ fees.  I am certain that it was a Pyrrhic victory for Digitech (to say the least).  The interesting points from the opinion for the technology legal counsel are the lessons to be learned.      

The pertinent facts for the opinion are that Digitech sent an initial proposal on February 3, 2006, which included a proposed 90-day satisfaction guarantee.  The parties then negotiated for two and ½ months until they reached a SaaS agreement they both accepted.  The final agreement did not include this 90-day provision.  It also lacked a final integration clause.  It did have an attorneys’ fees provision but only unilaterally directed toward collection of unpaid charges.  The software went live on January 1, 2007.  On March 1, 2007, Trans-Care tried to walk away from the deal citing that the software didn’t work properly.  They also didn’t pay for anything, which peeved Digitech, who locked the software on April 3, 2007.  It goes without saying that litigation ensued. 

Digitech sued Trans-Care for breach of contract.  Trans-Care counterclaimed for constructive fraud.  The parties proceeded before the magistrate judge who (1) dismissed the fraud claim; (2) found in favor of Digitech on the breach of contract claim; (3) awarded Digitech damages of 33 months of payments of the software license; and (4) awarded Digitech attorneys’ fees.  Both parties appealed.

The Court’s opinion can be broken down into three main areas:  (1) the breach of contract claim for Digitech [which also encompasses the constructive fraud counterclaim by Trans-Care]; (2) Digitech’s damages; and (3) the award of attorneys’ fees.  There are lessons to be learned from each area.

I.                     Breach of Contract analysis

The valuable lesson to be learned here is that a company, particularly a SaaS company, must be diligent in their contract drafting.  We don’t get to see the contract at issue here, but we do know that it did not include an integration clause.  This means that there was nothing in the contract advising the parties that this was the final and full embodiment of the agreement.  This, then, opened up the case to the admission of parol evidence (prior written and oral discussions) and opened the doors to all kinds of potentially problematic items.  In my opinion, the only reason the Court did not enforce the 90-day guarantee referenced in the initial offering was the sophistication of the parties and the time-lapse between the last reference of it and the final agreement.  This could just have easily been  the result of lack of evidence before the Court as it was an actual delay.  A finding that the 90-day guarantee was integrated would have been troubling for Digitech, and was easily avoided by a carefully drafted agreement.  And I can attest that these types of issues arise often in litigation (both SaaS litigation and other commercial litigation).  The representations of the initial offer don’t necessarily match the final deal and when it all goes south, the party who would get more out of the initial proposal wants it included.  The lack of careful drafting cost these parties a good chunk of time and money that could have been avoided with an integration clause.

II.                     Damages Provision analysis

This part of the opinion is, in my opinion, more significant to the SaaS business than the contract claim part.   As I indicated above, you can negotiate around the contract claim issues that arose by being diligent in your drafting.  The Court’s analysis on the damages provision is more troubling.  The Court, reasoning that a party should not recover twice for the same breach, reasoned that Digitech should not recover its full licensing fee damages, but rather only the time from when they went live with the service until they turned it off, minus 90 days.  Since they turned it off one month after the running of the 90 days, the Court concluded that the damage award had to be reduced from 33 months to 1 month.  And the Court’s reasoning behind this is that, although Digitech had an elections of remedies provision, Digitech terminated the agreement rather than suspending it.  This can put the SaaS provider in a pickle (and is, again, something that we often see litigated).

As is often the case, the easiest answer here is to address this issue in the contract.  Digitech could have easily provided in the contract for a situation where they are providing services and not getting paid, and what would happen then (including what the applicable penalties would be).  Another option would have been to suspend with proper notice and force Trans-Care to terminate.  One point the Court focused on was the fact that Digitech provided no notice.  Particularly where the out-of-pocket costs to the SaaS provider are upfront costs, the injured SaaS provider can either (a) leave the water running and sue for the amounts owed or (b) turn off the water, but let the person know how to turn it back on and when they fail, sue for the amounts owed.  Either way, the company is in a better argument position than Digitech when they have to sue to collect the monies owed.      

III.                Attorneys’ Fees analysis

The final important aspect of this opinion is the reduction of attorneys’ fees.  The Court reasoned that because the language at issue in the contract was limited to unilateral collection efforts, Digitech was not entitled to recovery on its defense of the fraud counterclaim.  The Court urged, instead, to draft a more open and broadly applicable attorneys’ fees provision.  However, as the SaaS guru Mr. Castor so astutely pointed to me, this has the risk of exposing a smaller, start-up SaaS provider to the whims and whimsy of a much larger contracting party.  If the Court’s options to the entrepreneur are either (1) limit your fees to only collection and you get nothing for defense or (2) make a broad provision, then it is really almost a distinction without a difference.  I don’t mind going on record as saying that I disagree with this part of the Court’s opinion.  When a counterclaim is brought in response to a suit, it is part of that suit.  The efforts of the attorney in defending the counterclaim are interwoven with the costs of prosecuting the action, particularly when, as in this case, the counterclaim is an argument for getting out of the obligation.  Digitech could not sit idly by and not defend the counterclaim (at least not while still hoping to win their claim).  Thus, those fees are part of the collection.  But that is the opinion of just one humble technology litigator. 

                Overall, this opinion is likely to have some lasting effects.  The key lesson for the SaaS provider, or any other company, is to ensure that your contracts are fully developed and that you’ve considered your options when the deal blows up.