So Good It’s a Service: The Changing Legal Perspective on Computer Software

A cutting-edge legal issue prevalent across many contracts, both commercial and government, is the question of how to treat computer software: is it a service or good? This has substantial implications for the applicability of the Uniform Commercial Code (“UCC”) to a given contract, and on the Federal Acquisition Rules (“FAR”)’s applicability in government contracts. Traditionally, courts viewed all software as a good; after all, it usually came in a box or was housed in a floppy disk or CD-ROM; it seemed tangible. See Graham Packaging Co., LP v. Com., 882 A.2d 1076, 1087 (Pa. Commw. Ct. 2005) (comparing custom software to “canned” or “off-the-shelf” software). Modern developments in software have fractured this consensus, leaving courts struggling to place software along the goods/service spectrum.

Some courts still treat all software as a good. D.P. Tech. Corp. v. Sherwood Tool, Inc., 751 F. Supp. 1038 (D. Conn. 1990) (holding a contract for hardware, software, installation, and training was a contract for goods under the UCC, even when the computer system was “‘specifically’ designed for the plaintiff and not readily marketable”); see also Advent Sys. Ltd. v. Unisys Corp., 925 F.2d 670, 675-76 (3rd Cir. 1991). Others look to the predominate purpose of the contract. See Dealer Mgmt. Sys., Inc. v. Design Auto. Grp., Inc., 822 N.E.2d 556 (Ill. App. Ct. 2005); Design Data Corp. v. Maryland Cas. Co., 503 N.W.2d 552 (Neb. 1993). The most recent trend is for courts to find software is a “good” under the UCC when it is a generic product, and a “service” when it has been specially designed for a client. See Conwell v. Gray Loon Outdoor Marketing Group, Inc., 906 N.E.2d 805, 812 (Ind. 2009). Particularly, as the Third Judicial District in Utah recently determined in Questar Assessment, Inc., when the sale is for the design of specialized software to meet the buyer’s specific needs, the contract is one for service and the UCC does not apply. Questar Assessment, Inc. v. Utah State Board of Education, Case No. 2003276 (3rd Dist. Ct. Utah Feb. 26, 2021) (order dismissing Questar’s account stated claim and the USBE’s implied warranty claim).

Article 2 of the UCC applies only to transactions involving goods. UCC § 2-201. “Goods” are defined as “all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale.” UCC § 2-105(1). Being governed by the UCC can be advantageous because it provides implied warranties to the buyer, and because the sale of goods must conform with the rule of perfect tender. Beck Steel, Inc. v. Am. Stair Corp., 62 F.3d 396 (5th Cir. 1995). Under the rule of perfect tender, a seller’s goods must conform exactly to the specifications on the contract, including timing and method of delivery and quality of goods; a buyer may reject seller’s goods for failure to meet this standard of perfect tender. Midwest Mobile Diagnostic Imaging L.L.C. v. Dynamic Corp. of Am., 965 F. Supp. 1003, 1011 (W.D. Mich. 1997), aff’d sub nom. Midwest Mobile Diagnostic Imaging L.L.C. v. Dynamic Corp. of Am., 165 F.3d 27 (6th Cir 1998). Service contracts, by contrast, are governed by the common law of the state (or the FAR, if applicable), do not contain implied warranties, and require merely substantial performance of the contract. Substantial performance requires that all the essential elements of a contract be performed and that the defects in performance “do not prevent the parties from accomplishing the purpose of the contract.” Measday v. Kwik-Kopy Corp., 713 F.2d 118, 124 (5th Cir. 1983).

Because contract interpretation is so frequently a matter for state courts, the law in this realm is developing across 50 different jurisdictions. Despite this legal balkanization, recent court decisions provide clarity on the direction the courts are generally heading. Notwithstanding the “specially manufactured goods” language found in the UCC, (UCC § 2-105 (a)), courts are increasingly hesitant to find that the UCC applies when the software is custom designed. See Conopco, Inc. v. McCreadie, 826 F. Supp. 855, 858 (D.N.J. 1993), aff’d, 40 F.3d 1239 (3d Cir. 1994); Systems America, Inc. v. Rockwell Software, Inc., No. C-03-2232, 2007 WL 218242 (N.D. Cal. Jan 26, 2007); Page v. Hotchkiss, No. CV020067814, 2003 WL 22962151 (Conn. Super. Ct. Dec. 2, 2003). The same is true when the parties work together to create the software programing or when the software system is developed from scratch. See Multi-Tech Sys. v. Floreat, No. Civ-01-1302, 2002 WL 432016, at *3 (D. Minn. March 18, 2002); Pearl Investments, LLC v. Standard I/O, Inc., 257 F. Supp. 2d 326, 352-53 (D. Me. 2003).

Courts have also integrated the predominant purpose test—which requires the court to look to the entirety of the transaction to determine whether its predominant purpose is for the sale goods or services. Even a software contract that included five physical prototypes and may have appeared on its face to fall under the UCC was found in essence a contract for “knowledge, skill, and ability.” See TK Power, Inc. v. Textron, Inc., 433 F. Supp. 2d 1058, 1062 (N.D. Cal. 2006). As put by one early pioneering court, with software, the tangible end product is only “involved incidentally in the transaction,” it is the knowledge and skill of the programmer that is at the heart of the transaction. Wharton Mg’t Group v. Sigma Consultants, Inc., 1990 WL 18360, at *3 (Del. Super. Ct. Jan. 29, 1990). In another example, when a contract involved analysis, collection, storage, and reporting of data, that contract was for a service rather than a good. Liberty Financial Management Corp. v. Beneficial Data Processing Corp., 670 S.W.2d 40 (Mo. App. 1984). Some courts have found specially produced software more akin to a professor’s lecture than a professor’s book. See Sys. Am., Inc. v. Rockwell Software, Inc., 2007 WL 218242, at *5 (N.D. Cal. Jan. 26, 2007). This is particularly true, as the Utah Third District Court found, when the sale is for the design of specialized software to meet the buyer’s specific needs. Questar Assessment, Inc. v. Utah State Board of Education, Case No. 2003276; Simulados Software Ltd. v. Photon Infotech Private, Ltd., 40 F.Supp.3d 1191, 1199 (N.D. Cal. 2014).

Beyond the commercial realm, whether computer software is a good or service also impacts the applicability of regulations to government contractors under the FAR. For example, the Service Contract Act, 41 U.S.C. §§ 6701, et seq., imposes additional obligations on government service contractors, and several FAR provisions only apply if the contract at issue is a service contract. The Service Contract Act, 41 U.S.C. § 6703 outlines specially required contract terms such as minimum wage, fringe benefits, working conditions, and pay rates. See 41 U.S.C. § 6703(1)-(5). A violation of these terms can lead to actions against contractors including cancellation of the contract by the government, placing additional costs on the contractor, or withholding accrued payments due on the contract. See 41 U.S.C. § 6705. Violations may also lead to a three-year prohibition on a contractor’s ability to enter into a contract with the federal government. See 41 U.S.C. § 6706. Part 37 of the FAR thoroughly governs special provisions that apply to service contracts. See FAR Part 37, Service Contracting. Notably, under certain conditions, a contract for services must be awarded through sealed bidding, FAR Part 37.105(a); and the contract must include specific clauses, FAR Part 37.110.

In addition to the extra obligations from the FAR and the Service Contract Act, software service providers may miss out on special benefits provided to commercial item contractors. In order for services to be a commercial item under the FAR, they must be procured in support of a particular commercial item, they must be provided “contemporaneously to the general public under terms and conditions similar to those offered to the Federal Government,” or be services “of a type” that are “offered and sold competitively in substantial quantities in the commercial marketplace.” See FAR 2.101(5)-(6). Professional services are generally not commercial items under the FAR. See Envirocare of Utah, Inc. v. U.S., 44 Fed.Cl. 474, 484 (1999) (holding that radioactive waste disposal was not a commercial item because there was no established market or catalogue price). Thus, a software contract where the software is specially designed for the buyer may have difficulty meeting the test for a commercial item because it would be difficult to establish the market price.

Further, Contractors selling commercial items obtain certain benefits. They may request to have certain conditions for contracting such as warranties, termination, and risk of loss tailored pursuant to FAR 12.302(c)). Implementing statutes and executive orders is significantly more onerous for non-commercial items.  FAR 52.212-5. Commercial items are exempted from eight statutes including the Drug Free Workplace Act, Payment Protections for Subcontractors, and Limitations on Appropriated Funds, and enjoy limited or modified applicability from several more federal statutes. See FAR 12.503(a)-(b).

While there is active debate in the government contract realm as to whether computer software is a good or a service, it should be noted that the federal government always gets either (1) unlimited rights to the software; (2) restricted rights); or (3) government purpose rights. See FAR 52.227-14. Software developed exclusively at private expense (including off-the-shelf commercial items) will generally grant restricted rights to the government. FAR 12.11. Restricted rights allow the government to use the software on one computer at a time, transfer the software to a new computer, make a backup copy, modify the software, and allow third party contractors to use the software to make repairs or modifications. FAR 52.227-19. As should be apparent, “restricted rights” are still frequently more than a commercial customer would receive. Because a third-party contractor has to be allowed to modify or “repair” the software, these FAR provisions lend strong support to the idea that computer software is a good, rather than a service.

Whether software is considered to be a good or service has substantial implications for government contractors. Contractors selling or licensing software to the government should ask the contracting officer at the time of contracting whether the contract is for goods or services, while noting that the contracting officer’s word is not final and that courts will look to the nature of the contract.

As software design and development become more complicated, so to do software transactions. Building off the predominant purpose test, the modern trend is to recognize that simply because software is contained in a tangible medium, does not make that tangible medium the essence of the transaction. Conwell v. Gray Loon Outdoor Marketing Group, Inc., 906 N.E.2d at 812. Instead, there is a growing shift toward finding that specially produced software is service rather than a good. This development has significant implications; it determines whether courts should apply the UCC or common law principles to contract formation, breach, and damages. It may dictate the extent of implied warranties on the contract and can impute substantial contract obligations for federal government contractors subject to the Federal Acquisition Rules.

For additional information regarding whether your business is selling a good or service, or for assistance ensuring your business’ compliance with the FAR, please contact the experienced contract and government advising attorneys at Eckland & Blando LLP.