DRAFT

FOR DISCUSSION ONLY

NATIONAL CONFERENCE OF COMMISSIONERS

ON UNIFORM STATE LAWS

AUGUST 1, 1998

Copyright ã 1998

By

THE AMERICAN LAW INSTITUTE

and the

NATIONAL CONFERENCE OF COMMISSIONERS

ON UNIFORM STATE LAWS

JOHN A. CHANIN, 1020 Aoloa Place, Suite 206B, Kailua, HI 96734

STEPHEN Y. CHOW, One Beacon Street, 30th Floor, Boston, MA 02108

THOMAS T. GRIMSHAW, Suite 3800, 1700 Lincoln Street, Denver, CO 80203

LEON M. MCCORKLE, JR., P.O. Box 1008, 52 E. Gay Street, Columbus, OH 43216-1008

THOMAS J. MCCRACKEN, JR., Room 600, 134 N. LaSalle Street, Chicago, IL 60602

LEWIS B. STONE, 52^nd Floor, 200 Park Avenue, New York, NY 10166

Copies of this Act may be obtained from:

NATIONAL CONFERENCE OF COMMISSIONERS

ON UNIFORM STATE LAWS

211 E. Ontario Street, Suite 1300

Chicago, Illinois 60611

312/915-0195

Article 2B concerns transactions that largely have never been covered by the U.C.C. The industries and transactions affected by Article 2B involve subject matter unlike the traditional U.C.C. focus on goods. In Article 2B transactions, the value lies in the intangibles: the information and rights to use information.

Article 2B provides a framework for contractual relationships at the center of the information era. This proposal is in effect a cyberspace contract statute. The measure of the project lies in its ability to accommodate diverse practices in a new information era. Evaluating the balance hinges on one's perspective, yet, as the following indicates, Article 2B distributes benefits among the various parties.

The 1990's witnessed a shift in the source of value and value production in the economy. The service sector now dominates. The information industry exceeds most manufacturing sectors in size. The entertainment industry was the first post war international industry in the United States. The on-line industry is the most recent. The software industry, which provides the basis for the information age, did not exist in the 1950's. Today, its products dominate the economy and challenge traditional law in many areas.

Contracts in information are not equivalent to transactions in goods. The contracts emphasize different issues and bring into play a different policy structure concerning to what extent liability risk ought to be created for the author, provider or distributor of the informational subject matter.

Nature of a License.

The paradigmatic transaction is a license of information, rather than a sale of goods. The transaction is characterized by 1) the conditional nature of the rights or privileges conveyed to use the information, and 2) the focus on information, rather than goods for the value conveyed. A license is unlike a sale or lease of goods in many ways, including what the transferee received by the contract. The Federal Circuit Court of Appeals, for example, has stated: "[A] patent license agreement is in essence nothing more than a promise by the licensor not to sue the licensee [even] if couched in terms of "[L]icensee is given the right to make, use, or sell X""

Licenses are commercial transactions. Licensing is a primary means of commerce in digital information; it is important in all information industries. In licensing, contract terms play an important role in defining the product conveyed that transcends sale of goods terms dealing with warranties, time of delivery, and the like. The terms of a license also typically provide for express grants of rights (or permission) to use information and express limitations on use. The grant and restrictions are product and are often buttressed by the licensor's property right to control various uses of the information under patent, copyright or similar law. A license for computer software is a much different commercial value if it grants a right to commercially reproduce 100,000 copies than if it grants the right to personal use of a single copy. Yet, the information and perhaps the particular copy may be identical in both cases

Typically, license use restrictions are enforceable unless a particular term in a particular context conflicts with general doctrines against intellectual property misuse or similar constraints. Courts have enforced license restrictions precluding commercial use of a digital database, limiting a right to access, barring the making of a copy of software, limiting use to a specific computer, limiting use to internal operations of the licensee, controlling redistribution to a particular package of software and hardware, precluding modifications, and various other contract limitations. Article 2B does not create contract law here - it merely provides a more coherent base for contracting.

Many commercial licenses deal with rights in intellectual property, but in many other cases the license is not based on intellectual property rights. For example, numerous licenses in Internet or for on-line services grant one party permission to enter the and obtain information from the computer of the other. That form of licensing is increasingly important in the digital world. Article 2B describes this framework as an "access contract". Where the relationship extends over time, it creates various ongoing obligations (e.g., the obligation to pay, the obligation to maintain accessibility) not present in other licenses.

Commercial Context.

As in commerce in goods, licensing spans a wide range of commercial practices and also occurs in the mass market. Article 2B focuses on many commercially important transactions, but does not apply to all information licensing. It excludes, for example, most forms of patent and trademark licenses.

There are a wide range of companies. Many are large entities, but to an extent far greater than in the fields of selling goods or leasing them, the vast majority of information providers are small companies, reflecting the often small overhead of software and other information enterprise and the role of the software and other information industries as a focus for modern entrepreneurs. The average size of a software company in California, for example, is less than ten employees. The average in the state of Washington is twelve employees.

Similarly, while many people have their primary contact with licensing in reference to mass market transactions, in practice, the most significant forms of licensing and the center of major economic aspects of this field of commerce lie outside the mass market.

At every level of commerce, information providers that may be perceived as primarily licensors are in fact intimately and comprehensively both licensors and licensees with respect to most of their commercial practice. This is true because, for most information products, the product source involves combinations of information from numerous sources, obtained through licenses or similar transactions.

Transactional Context.

There are many different types of licensing, reflecting a diversity as great as that in fields of commerce associated with the production and sale of goods.

One way of distinguishing among the various types of licenses in modern commerce differentiates between licenses that relate to information in copies physically transferred to a licensee, as contrasted to licenses that enable a licensee to access a computer in which information is located. Within transactions in which copies are made available on diskette or otherwise to a licensee subject to license conditions, a variety of transactional formats exist. In some, a licensor deals directly with the end user. In others, a chain of distribution intervenes; the publisher does not deal directly with the end user. In each case, the basis of the license resides in either the existence of intellectual property rights in the information or, more simply, the fact that the licensor has control over a source of the information that the licensee desires to utilize.

The distribution options are affected by the property rights involved. In areas covered by Article 2B, copyright law is a dominant (but not sole) source of intellectual property rights. Copyright law gives the copyright owner the exclusive right to make copies of its work, to distribute copies, to make derivative works, to publicly display or perform the work, and other rights. These rights are not relinquished by selling or transferring a copy of the information. Thus, a basic choice for a copyright owner is whether to license some or all of these rights or to sell copies of the work. A sale relinquishes some rights with respect to the copy. A license tailors what rights are granted. In text publishing, current practice in the non-electronic mass market involves a sale of copies, while transactions for distribution or acquisition of works use many different formats. In motion pictures, licensing is used to provide content to theaters, while in the consumer market, copies are either sold or rented under terms that preclude public performance. Computer programs are typically licensed, although computer game distribution frequently involves sales of copies.

Direct Licenses. Many licenses are face-to-face contracts between the copyright owner and the licensee. In most cases, direct licenses (often standard form agreements) transfer a copy to the licensee subject to express contractual use restrictions. Increasingly, copies are moved to the licensee's site electronically. An additional format involves no delivery of a copy, but licensed access to the information for brief periods as needed.

In direct licensing, common terms include limiting use to a designated system, for specific purposes (e.g., internal use only), subject to confidentiality conditions, transferability limits, and similar restrictions. In software licensing, a central factor of distribution recognizes that loading software into a computer and, even, moving it automatically from one part of memory to another part, constitutes making a copy that falls within the copyright owner's exclusive rights.

Direct licensing also occurs in the many contractual relationships in which information (software, text, movies) is developed for the licensee. Here, it is very common for small companies or individuals to be licensors. This illustrates an important point in the overall contract issues. While large providers are important factors, small company licensors are more numerous and are economically important.

Indirect Distribution Licensing. Commercial licensing also occurs in context of broader distribution chains. These are not analogous to distribution methods used in the sale of goods because of the intangible subject matter and the overlay of intellectual property rights which include the exclusive right to distribute copies. While it over-simplifies the matter, it is useful to discuss two distinct frameworks.

The first involves use of a master copy and is common in the movie industry and in software contracts. A "distributor" receives access to a single master copy of the work and a license to make and distribute additional copies or to make and publicly perform a copy. For example, Correl Software licenses a distributor to load its software into the distributor's computers. Correl limits the distributor to no more than 1,000 copies which can only be distributed in the computers and subject to an end user license. If the distributor does not perform within the limits of this license, since both making and distribution of copies are within the owner's copyright, the unauthorized acts would be infringements as well as contractual breaches.

An alternative uses tangible copies of the software. For example, Quicken may license a distributor to distribute its up to 1,000 copies of its accounting software in packages provided by Quicken. While in some industries, the publisher will sell 1,000 copies to the distributor to achieve this result, a license is used in the software industry. In the license, the distributor is allowed to distribute copies to retailers, provided that conditions are met, such as terms of payment, use of the original packaging, and making the end user distribution subject to an end user license. The distribution right is an exclusive copyright right; distributions outside the license infringe the copyright.

In both formats, the information product eventually reaches an end user. If it does so in an ordinary chain complying with the distribution license, the end user is in rightful possession of a copy. If the authorized distribution involved sales of copies, no more is required to give the end user the very limited rights of the owner of a copy spelled out in copyright law (e.g., to transfer it, make a back-up if it is software, make some changes essential to use if it is software). If, however, the copyright owner elected a licensing framework, the end user's right to "use" (e.g., copy) the software depends on the end user license. Typically, this is in a license from the publisher to the end user. It creates a direct contractual relationship that would not otherwise exist. The contract leaps the chain of distribution and creates a direct link to the publisher by the end user. It is the only contract that enables the end user to make copies of the software.

Article 2B supports contractual choice and commercial expansion in information contracting. In addition, an important theme involves the need to create and preserve as broad as possible a field for expression and communication of ideas, images, and facts; material that this Article refers to as "informational content."

The convergence of technology and the evolution of the information age reflects a fundamental shift in our society and in how people interact, trade and establish commercial relationships. "Informational content," which consists of sights, sounds, text, and images that are communicated to people, has become important commercially. That importance does not diminish its political or social role. The technology does change how informational content is distributed and enhances the importance of direct contracts in that distribution.

As contract rules evolve, basic First Amendment and related policies must remain central. Even as informational content becomes a significant commercial commodity, we must not forget that informational content and its communication in a marketplace of ideas remains equally relevant to political and social norms in this country. What law does here affects not only the commercialization of information, but also the social values its distribution has always had in society.

Informational content does not become something entirely different if the provider or author distributes it commercially can hardly be a premise. Commercialization is not inconsistent with the role of information in political, social and other venues of modern culture. If it were, newspapers, books, television, motion pictures, video games, and other sources of informational content could not exist. How contract law in Article 2B creates (or precludes) liability risk, allows (or precludes) authors to control distribution of their works, or allows (or denies) the right to contract for licenses of information has a significant impact on new, and in older, systems of distribution.

These underlying values argue strongly for an approach to contract law in this field that does not encumber, but supports incentives for distribution of information and its distribution. That theme permeates this Article 2B.

The UCC is a commercial statute whose basic philosophy builds on two assumptions about commercial contract law. The first commercial law theme assumes that contract law should preserve freedom of contract. This permeates the UCC as noted in Article 2A comments: "This article was greatly influenced by the fundamental tenet of the common law as it has developed with respect to leases of goods: freedom of the parties to contract... These principles include the ability of the parties to vary the effect of the provisions of Article 2A, subject to certain limitations including those that relate to the obligations of good faith, diligence, reasonableness and care."

The idea that parties are free to choose terms can be justified in a number of ways. It leads to a preference for laws that provide background rules, playing a default or gap-filling function in a contract relationship. A default rule applies only if the parties do not agree to the contrary. Default rules should mesh with expected or conventional practice in a manner that projects a favorable impact on contracting and that can be varied by the contracting parties. This is in contrast with rules that dictate terms and regulate behavior. As a matter of practice, default rules are common in commercial contexts, while consumer law contains many regulatory rules.

A White Paper Report on global commerce in information strongly indorsed the non-regulatory and contract freedom approach taken in U.S. law and in Article 2B for allocating rights and risks in the information economy.

The second commercial law premise defines codification as a means to facilitate commercial practice. Grant Gilmore expressed this in the following terms:

To be accurate and not original refers to commercial practice as an appropriate standard for gauging appropriate contract law unless a clear countervailing policy indicates to the contrary or the contractual arrangement threatens injury to third-party interests which social policy desires to protect. Uniform contract laws do not regulate practice. They support and facilitate it. The benefits of codification lie in defining principles consistent with commercial practice which can be relied on and are readily discernible and understandable to commercial parties.

Article 2B embraces this philosophy. In context, the best source of substantive default rules lies not in a theoretical model, but in a reference to commercial and trade practice. This is not simple faith in empirical sources for commercial law. It stems from the reality that, even though we may not know how law interacts with contract practice, decisions about contract law will continue to be made. In those decisions, we should refer for guidance to the accumulation of practical choices made in actual transactions. The goal is a congruence between legal premise and commercial practice so that transactions commercial parties achieve commercially intended results.

Yet, the transactions range from a casual deal between two individuals at a garage sale to transactions between sophisticated businesses employing multiple lawyers and affecting billions of dollars of business. The approach is not to draft rules that an individual party would negotiate tailored to each case, but to select an intermediate or ordinary framework whose contours are appropriate, but whose terms will be altered in the more sophisticated environments.

Article 2B reflects an effort to balance and develop appropriate contract law themes reflecting several other major social policy questions. One involves the relationship between contract law and intellectual property law.

The interaction has existed for generations. Article 2B does not create contract law in this field. For many years, owners of intellectual property have contracted for selective distribution of their property and limited contracted-for use. Law enforces the contract options, subject to specific restrictions in federal property law, antitrust or misuse doctrine, and some directly preemptive federal rules.

In most cases, patent and copyright law coexist with state contract law. As stated in the Copyright Act, federal law preempts any state law that creates rights equivalent to property rights created under copyright. But as both a practical and a conceptual matter, copyright (or patent) do not generally preempt contract law. Indeed, contracts are essential to use the property. A contract defines rights between parties to the agreement, while a property right creates rights against all the world. They are not equivalent.

Yet, there are socially important issues here. Digital technology and the distribution systems it allows are changing the contours of how information is placed in commercial settings and what rights or protections are appropriate as a matter of property law for the new methods of distribution. These changes have led to a wide-ranging property law debate that ultimately goes to very fundamental social policy issues about the use and distribution of information. It has been argued in international treaty negotiations and in Congress. The issues that these debates present cannot and should not be resolved as a matter of state contract law.

Article 2B adopts a neutral position with respect to what, ultimately, are issues of federal and international information rights policy. The disputed issues must be resolved by courts and Congress, rather than through state legislation. Article 2B takes no position on these policy questions, but merely provides a generic contract law framework to bring to modern form the existing complex network of common law, code and general industry practice.

The basics of the neutrality policy are in Section 2B-105, which specifically recognizes federal preemption and that Article 2B does not displace state trade secret law. A proposed new provision of this section further emphasizes the neutrality principle by expressly recognizing the ability of courts in common law to apply fundamental public policy principles to the limited extent to which those principles clearly over-ride the policies that sustain enforcement of contracts. Article 2B does not change the law on the enforceability of any restrictive clause that entails copyright misuse or that offends fundamnetal First Amendment concerns. We expect that, as they do today, courts will continue to reject abusive clauses when they encounter them by applying existing doctrines that preserve the role of information in society.

Some have argued that Article 2B should take a proactive position. Thus, they argue that Article 2B should prohibits contract clauses regarded as improper from the perspective of persons holding to one view of this property rights policy debate. The Drafting Committee and the Conference as a whole, and the ALI membership when presented with the issue a second time, rejected the demand to take one or the other side of this debate.

Federal intellectual property law also places some specific and recognized limits on contract. These include restrictions on transferability, some recording requirements, a statute of frauds, and a rule that enforces property rights against good faith purchasers. A state law cannot ignore these rules. While state law themes might prefer a rule that a secured creditor can create and enforce a creditor's interest in a licensee's rights, federal law precludes any transfer of a licensee's rights in a non-exclusive license without the licensor's consent. A default rule that ignores this preemptive provision creates true traps for the unwary. In Article 2B, state contract law is made parallel to such specific preemptive rules, although in several situations, provisions push against explicit federal rules insofar as reasonably possible.

This interaction of state law and specific federal yields default rules that, in some cases, do not correspond to the treatment of analogous issues in other parts of the UCC. These provisions reflect a policy of correspondence of rules in addition to simple recognition that federal law preempts contrary state law.

Because of the concentration of observers from technology fields, Article 2B has become the context for development within the UCC of rules regarding electronic commerce. These rules have been developed in coordination with the NCCUSL project on an Electronic Transactions Act. It is anticipated that the electronic commerce rules here will be adapted to Article 2 and Article 2A, or placed in Article 1 ultimately applicable throughout the UCC.

The electronic commerce rules are contained in Sections 2B-105 through 2B-120, in addition to some definitions (e.g., Section 2B-102, conspicuous) and various contract formation rules (e.g., Section 2B-204). This group of sections reflects several policies.

1. The parties must be able to use electronic authentication (Section 2B-102(3): authentication encompasses the idea of signature) and electronic records, rather than just signed papers, and to engage in transactions all or part of which will be established by automated systems ("electronic agents" as defined in 2B-102).
2. There must be fair allocation of risk reflecting that licensors and licensees of information will vary in terms of their sophistication and economic power. Thus, while Article 2B creates an important new consumer protection in 2B-118, there are no stated dollar limits limiting risk and favoring one or the other party. The "deep pocket" here may be either the licensor or the licensee. The risk allocation is, in part, in Section 2B-116 and 2B-115.
3. The legal protections for electronic commerce must be technologically neutral. This is reflected in the rules on what is the effect of an agreement to follow a procedure to identify a party (described as an "attribution procedure") or to detect errors in electronic records (Section 2B-118).

In the political process that surrounds any new law, many public statements have been made about the effect of Article 2B on consumer protection. Most are political efforts to mislead.

The truth is simple. Article 2B retains current UCC consumer protections, preserves existing non-UCC consumer laws, and creates new protections for the digital environment. When contrasted to existing law in the fields covered, Article 2B expands or retains consumer protection in virtually all states.

Nevertheless, Article 2B is a commercial statute and its primary focus is not on the creation of a uniform consumer protection code. It does not aggressively regulate contracts as many consumer advocates would prefer. It does create new protections in some cases such as Section 2B-118 and 2B-208. It does not take away protections created under existing UCC law.

The following chart compares Article 2B consumer rules that exist in the UCC or common law.

Access contracts do not depend on intellectual property rights. The owner of a computer system has a fundamental right recognized in criminal law and property law to exclude others from access to its system and to condition the terms on which it permits access to occur. Access contracts may distribute rights on the basis of informational rights, but they also reflect the right to control use and access. This does not mean that identical information cannot be obtained elsewhere, but merely that obtaining the information from the access provider can be conditioned on assent to its own terms of access. The access provider can contract for its data and establish contractual terms of access that bind the other contracting party even though the licensee could, if it chose, obtain identical information from other sources or its own research.

An access provider may, or may not, be in a position to give contractual rights in the information accessed by the licensee. In some cases, the information is controlled by the access provider, while in others there is a three-party framework. In the three-party relationship, one party provides access, while another (the content provider) licenses use of the information. This latter transaction involves two and, in some cases, three separate contracts. The first is between the content provider and the access provider. This may be an ordinary license or an access contract that gives the access provider a right provide a gateway to access information contained in a system controlled by the content provider. The second is between the access provider and the end user. This is the access contract. The third arises if the content provider contracts directly with the end user. The various contracts are independent of each other.

2. "Attribution procedure." This term is new. It deals with electronic commerce and refers to agreed on, adopted, or otherwise established procedures to identify the person who sent an electronic message or verify the absence of changes in the content of the message. Electronic commerce is fundamentally anonymous in character and depends on such procedures and their recognition in law and practice. The effect of an attribution procedure is discussed in Sections 2B-114 to 2B-117. The benefits of using an attribution procedure only pertain to procedures that are commercially reasonable. In general, a use of a commercially reasonable procedure for attribution entitles the user to a presumption that the facts are as established by the procedure.

3. "Authenticate." This term replaces "signature" or "signed" in this article. It incorporates and expands on the traditional idea and general effect of a signature. As in that definition, adoption or execution of a symbol or the taking of an action is an authentication only if accompanied by an objective manifestation of intent with which the party authenticating a record acts. Adoption or execution of electronic or other text or a symbol with intent authenticate a record that would be a signature under prior law is an authentication under Article 2B. This includes use with requisite intent of identifiers such as a PIN number. In addition, the term includes actions and sounds such as encryption of a record, voice identification, and other technologically enabled acts used to achieve the legal effects associated with a traditional signature.

The definition spells out three effects of an authentication; this enumerates the effects given to signatures under prior law. No change in law is intended. Which effect is intended must be determined, as it is under prior law, by the context and the objective indicia of intent associated with that context. Unless the circumstances indicate a different intent, authentication contemplates all three of the effects listed.

The definition is technologically neutral. "Digital signatures", recognized in some states and which rely on a specified encryption technology and a certification system, qualify as authentication for Article 2B. The Article 2B concept is broader however. It recognizes that technology and commercial practice will evolve. There is no effort to set a minimum standard of sufficiency for an authentication, rather unreliable procedures that purportedly authenticate a record are subject to evidentiary scrutiny as to whether they were used with the requisite intent, whether they were the act of the purported party, and other issues.

4. "Automated transaction." This term is new. It refers to relationships formed and made effective as a contract even though one or both of the parties are represented by an electronic system, rather than a human being. Automated contracting is widely used. While law could adopt a fiction and attribute intent to these automated activities, this Article directly recognizes that operations of automated systems can create binding legal obligations for those who use them for that purpose.

5. "Cancellation" is from existing Article 2-106. The effect of cancellation is stated in 2B-702.

6. "Computer program." This term is new and parallels the definition in the federal Copyright Act. 17 U.S.C. § 101. In this article, a distinction exists between programs as operating instructions and "informational content" communicated to people. "Computer program" refers to functional and operating aspects of a digital system, while "informational content" refers to output that communicates to a human being. There is an inevitable overlap. However, if issues arise that require a close distinction, the answer lies in whether the issue addresses functional operations (program) or communicated content (informational content). The distinction is like the made in copyright law between a computer program as a "literary work" (code) and the program interface or other output as an "audiovisual work" (images, sounds). In copyright, the distinction relates to what reference points are used in determining whether a copyrighted work was created or infringed. In Article 2B, the distinction relates to contract law issues relevant in determining liability risk and performance obligations.

7. "Consequential damages" corresponds to existing Article 2. Consequential damages do not include "direct" or "incidental" damages. Consequential loss deals with loss of benefits anticipated as a result of having received and being able to exploit the contracted performance. Conseque