Applicability of Article 2 of UCC, Enforceability of Limitation of Liability Clause, and Requirement of Good Faith and Fair Dealing under California Law

Author: LegalEase Solutions

Introduction

Applicability of Article 2 of the Uniform Commercial Code to a dealer agreement/contract for sale of goods and services; the enforceability of the limitation of liability clause in such a dealer agreement, and the implied covenant of good faith and fair dealing in business arrangements.  These issues require discussion of:

  1. Article 2 of the Uniform Commercial Code
  2. Applicable Washington and Ninth Circuit Case law

The Plaintiff is a corporation and acted as a master dealer for the Defendant.  As a master dealer, the Plaintiff developed a network of sub-dealers throughout the country.  The sub-dealers, in turn, secured new subscribers and sold related equipment.  The Defendant compensated the Plaintiff pursuant to a tiered commission structure, based upon the type of service plans sold to subscribers.  In turn, the Plaintiff paid its sub-dealers a commission.  For each particular region, Defendant established a quota, which dictated the minimum amount of activations required per year.  In some regions, the Plaintiff exceeded their quota. In other regions, the quota was fulfilled, and in others, the quota went unmet.

During the course of its relationship with the Plaintiff, the Defendant acted in bad faith.  Defendant personnel, in concert with direct competitors of the Plaintiff, consistently interfered with the success of Plaintiff.  For instance, the Defendant delayed approval of many sub-dealers submitted by the Plaintiff for three months or more, preventing them from securing more subscribers which thereby limited Plaintiff’s likelihood of fulfilling its quotas.  Additionally, Defendant personnel, together with Plaintiff competitors, slandered Plaintiff before its sub-dealers, by stating falsely that the Plaintiff was on the verge of bankruptcy, or in otherwise precarious financial condition.  As further evidence of bad faith, Defendant promised potential sub-dealers instant approval in exchange for signing on with competitors of Plaintiff.  Despite these challenges, the Plaintiff continued to exceed its overall activation quota.

Due to a personality clash between a Defendant executive and Plaintiff’s manager, the Defendant decided to terminate all of Plaintiff’s contracts.  Notably, a Defendant employee stated in deposition testimony that the contracts were not subject to negotiation, but rather were presented to master dealers on a take-it-or-leave-it basis.

The Plaintiff has filed an arbitration demand against the Defendant, citing breach of contract and breach of the implied covenant of good faith and fair dealing.  As a result of the Defendant’s conduct, the Plaintiff has suffered incidental damages (the cost incurred in establishing the sub-dealer network), and additional amount in lost profits and unpaid commissions.  In its defense, the Defendant has asserted that the Limitation of Liability clause in its contract with the Plaintiff prevents recovery of such damages (with the exception of the unpaid commissions) and that the clause is enforceable.

Discussion

  • Applicability of Article 2 of the Uniform Commercial Code to a Dealer Agreement Constituting a Contract for Sale of Goods and Services.

 Wash. Rev. Code § 62A.2-102 (2005) states as follows:

Unless the context otherwise requires, this Article applies to

transactions in goods; it does not apply to any transaction which

although in the form of an unconditional contract to sell or present

sale is intended to operate only as a security transaction nor does this

Article impair or repeal any statute regulating sales to consumers,

Farmers or other specified classes of buyers.

The term “goods” has been specifically defined under §62A.2-105 as follows:

  • “Goods” means all things (including specially manufactured

goods) which are movable at the time of identification to the

contract for sale other than the money in which the price is to

be paid, investment securities (Article 8) and things in action.

“Goods” also includes the unborn young of animals and growing

crops and other identified things attached to realty as described

in the section on goods to be severed from realty.

Wash. Rev. Code § 62A.2-107.

  • Goods must be both existing and identified before any

interest in them can pass.  Goods which are not both existing and

identified are “future” goods.  A purported present sale of future

goods or of any interest therein operates as a contract to sell.

The Washington Court of Appeals, Division Two adopts the “predominant factor” analysis as the appropriate test under Washington’s version of the Uniform Commercial Code (UCC).  Article 1, § 102 of the UCC provides that Article 1 shall be liberally construed and applied to promote its underlying purposes and policies.  The underlying purposes and policies of Article 1 are (a) to simplify, clarify and modernize the law governing commercial transactions; (b) to permit the continued expansion of commercial practices through custom, usage and agreement of the parties; (c) to make uniform the law among the various jurisdictions.  See Wash. Rev. Code § 62A.1-102.  The “predominant factor” test fulfills two of the purposes of the UCC by clarifying and simplifying the law.

The majority of jurisdictions, including 31 states and the District of Columbia, use the predominant factor test to analyze contracts for the sale of goods and services.  If the sale of goods dominates the transaction, Article 2 of the UCC governs.  If the sale of services dominates, Article 2 is inapplicable.  The Ninth Circuit has declared adherence to this test to be the modern trend.

In the case of Tacoma Athletic Club v. Indoor Comfort Systems, Inc., 79 Wn. App. 250; 902 P2d 175 (1995), the Appellant sold and installed a dehumidification system to the Tacoma Athletic Club (the Club).  The trial court found that Comfort Systems breached the implied warranties of merchantability and fitness for a particular purpose and awarded damages to the Club under Washington’s version of the UCC.  Comfort Systems subsequently argued that the UCC was inapplicable, because the contract was for construction, rather than for a sale of goods.  The Court held:

We adopt the “predominant factor” test used in most jurisdictions

and hold that this was a sale of goods because the predominant

aspect of this contract was a sale of goods, not the rendition of

services.

The Court further observed:

Courts have held that a mixed contract for sale of both goods and labor

can be subject to Article 2 of the Uniform Commercial Code, because

services always play an important role in the use of goods, whether it

is the service of transforming the raw materials into some usable product

or the service of distributing the usable product to a point where it can

easily be obtained by the consumer.  The formula for the predominant

factor test provides that the test for inclusion or exclusion is not whether

they are mixed, but, granting that they are mixed, whether the predominant

factor, their thrust, their purpose, reasonably stated, is the rendition of

service, with goods incidentally involved (e.g., contract with an artist for

a painting), or is a transaction of sale, with labor incidentally involved

(e.g., installation of a water heater in a bathroom).

The proper classification of a contract under the predominant factors test is

a factual question.

Id. at 258.

In the case of U.S. Engine, Inc. v Roberts, 2003 Wash. App. LEXIS 2266, U.S. Engine contended that the agreement did not involve the sale of goods but was merely a distributorship agreement articulating the terms of quotas, sales territory, and volume discounts. The court found that that argument unpersuasive since U.S. Engine sold engines that were actually purchased. Engines are goods as defined in Wash. Rev. Code §62A.2-105(1) and that even assuming, without deciding, that additional terms relating to sales territory,  customer account transfers, and other matters were part of this agreement, the dominant aspect of the agreement remained the sale of goods.

Applying these principles to the case at hand assists in the determination of whether cell phone plans are rightly considered to be “goods,” as defined by the UCC. The UCC and relevant case law support the view that goods must be tangible and existing. Even if the contract in question involves the rendering of services, and is in actuality a distributorship agreement relating to what is predominantly a sale of goods, UCC will apply. Since the sale of cell phone plans is predominantly a sale of services (with the “goods” portion of the sale being a lesser component) the applicability of UCC is limited. While the Plaintiff does also sell the Defendant’s tangible equipment, the sale is only a tangential element of the contract. Applying the “predominant factor” test to the facts of this case, it becomes clear that the UCC will most likely not apply, as the dealer Agreement is primarily one of service, and not for the of sale of goods.

(B) Enforceability of the Limitation of Liability clause

The Dealer Agreement includes a limitation of liability clause at section 10.3, which specifically precludes recovery of damages arising from the breach of contract. In light of this provision, the Plaintiff must look to Washington case law in order to find any possibility of have defeating this provision to recover its damages. Though the Dealer Agreement is not governed by the UCC, the Washington courts have recognized that the UCC may be applied to common law contract analysis by analogy, particularly when evaluating allegations of unconscionability in contracts. See Baker v. City of Seattle, 79 Wash. 2d 198, 201-02, 484 P.2d 405 (1971)

A detailed analysis of the limitation of liability clause and its applicability was undertaken by the Supreme Court of Washington in the case of Puget Sound Fin., L.L.C. v. Unisearch, Inc. 146 Wn.2d 428; 47 P3d 940 (2002). The court at the outset determined that the liability limitation was included in the contract between Factors and Unisearch, and went on to analyze whether the liability limitations were enforceable.

The court in Puget, supra, recognized that generally speaking, liability limitations

are not enforceable if they are unconscionable. M.A. Mortenson Co. v Timberline Software

Corp.; 140 Wn.2d 568, at 585; 998 P2d 305 (2000).  Whether an exclusionary clause unconscionable is determined as a matter of law. Am. Nursery Prods., Inc. v. Indian Wells Orchards, 115 Wash. 2d 217, 222, 797 P.2d 477 (1990) (citing Schroeder v. Fageol Motors, Inc., 86 Wash. 2d 256, 262, 544 P.2d 20 (1975)).

The Washington Courts have set the standard for applying warranty disclaimers in transactions involving a noncommercial entity. See Berg v. Stromme, 79 Wash. 2d 184, 484 P.2d 380 (1971). According to the decision in Berg, warranty disclaimers in a contract must be both (1) explicitly negotiated and (2) set forth with particularity. Id. at 196. The presumption leans against the warranty disclaimer, and the burden lies on the party seeking to include the disclaimer to prove its legality. Id. at 194.

Berg involved the sale of a car from a car dealer to a consumer. The car had numerous mechanical problems, but the dealer claimed that the purchaser could not recover because the purchase contract contained warranty disclaimers. Id. at 185. The Berg court noted that “printed disclaimers of warranty in the purchase of new automobiles are now regarded with increasing disfavor by the courts.” Id. at 187 (citing Norway v. Root, 58 Wash. 2d 96, 361 P.2d 162 (1961)). Accordingly, the court stated,

…unless there is proof of explicit departure from [the implied warranty of fitness with a new car], the presumption is that the dealer  intended  to deliver and the buyer intended to receive a reasonably safe, efficient and comfortable brand new car.” Id. at 195.

It is readily apparent that both ‘conspicuousness’ and ‘negotiations’ are factors, albeit not conclusive, which are certainly relevant when determining the issue of conscionability in light of all the surrounding circumstances.” Id. at 260.

Thus in Schroeder, supra, the Court adopted a “totality of the circumstances” approach for interpreting the permissibility of exclusionary clauses in a commercial setting, instead of the two-prong approach applied to warranty disclaimers in Berg for a consumer transaction. The nonexclusive factors for assessing the totality of the circumstances include:  (1) the conspicuousness of the clause in the agreement; (2) the presence or absence of negotiation regarding the clause; (3) the custom and usage of the trade; and (4) any policy developed between the parties during the course of dealing. Id. at 259-61. By extending part of Berg to commercial transactions, the court expressed the intent to prevent unfair surprise in business dealings. Id. at 260.

In American Nursery, supra, the court made another modification and extension of the Berg/Schroeder analysis. In that case the court confirmed the use of the two-prong Berg analysis for consumer transactions involving warranty disclaimers and in commercial transactions for the sale of goods where there is sufficient evidence of unfair surprise. 115 Wash. 2d at 223-24. The court also affirmed use of the Schroeder “totality of the circumstances” analysis for clauses excluding (or limiting) liability for consequential damages in commercial transactions for services where there is insufficient evidence of unfair surprise. Id. at 222-23; see also Cox v. Lewiston Grain Growers, 86 Wash. App. 357, 367-70, 936 P.2d 1191 (1997). Finding no indicia of unfair surprise, the court then specifically applied the Schroeder analysis to a contract for services between commercial parties. Am. Nursery, supra, at 224-25. In applying the Schroeder  “totality of the circumstances” analysis to determine unconscionability, the court referenced Wash. Rev. Code. §62A.2-719(3), which states that “limitation of other consequential damages is valid unless it is established that the limitation is unconscionable.”

The Washington Court of Appeals in  Unisearch 2001 Wash. App. LEXIS 993, stated that the exclusionary clause would not be valid if it was not explicitly bargained for. No. 46705-1-I, slip op. at 11-12.

The Supreme Court observed that this consideration stemmed from Berg and is, therefore, not controlling in these circumstances. Berg involved a consumer transaction for a warranty disclaimer, which has been distinguished from a liability limitation clause in a commercial transaction. In a commercial transaction, such as the ones in the cases of Schroeder and American Nursery make clear, whether the liability limitations clause was negotiated (or bargained for) is merely one factor, and not necessarily the determinative factor in assessing the enforceability of the clause. Am. Nursery, 115 Wash. 2d at 222 (citing Schroeder, 86 Wash. 2d at 260).

In Schroeder, supra the court recognized the following nonexclusive factors to consider in assessing the unconscionability of a liability exclusionary clause: (1) the conspicuousness of the clause in the agreement; (2) the presence or absence of negotiations regarding the clause; (3) the custom and usage of the trade; and (4) any policy developed between the parties during the course of dealing. Id. at 259-61. Additionally, in American Nursery, supra, the court noted that “unconscionability is determined in light of all the surrounding circumstances, including (1) the manner in which the parties entered into the contract, (2) whether the parties had a reasonable opportunity to understand the terms of the contract, and (3) whether the important terms were hidden in a maze of fine print.” Id. at 222, (citing Schroeder, at 260).

In American Nursery, supra, the court limited the application of the Berg rule for explicit policy reasons:

In consumer sales transactions, intervention is warranted to counteract the inherent inequality of bargaining power and the resultant inequities. Parties to a commercial contract, however, generally have equal bargaining power and an equal ability to seek advice and alternative offers. As a result, commercial contracts are less subject to the type of unfair surprise which may be found in consumer sales transactions. This being so, only those commercial transactions with sufficient indicia of unfair surprise in the negotiations should be subject to the Berg rule.

American Nursery, supra, at 224.

 The court in Puget, supra, concluded as follows, id at 442:

As a threshold matter, we conclude that there were no indicia of unfair surprise under these circumstances. Unlike the concern for unfair surprise, most commonly associated with a maze of fine print in warranty disclaimers, the search reports and invoices in this case were brief. The liability limitation clause printed on the invoice did not alter or change during any of the 48 transactions. Additionally, the invoices were directed to the attention of Factors’ principals and Factors’ president testified that he contemporaneously examined the invoices. Factors had received and paid numerous invoices prior to this dispute. We find all of these factors conclusive that there was no unfair surprise in this case.

With regard to the presence or absence of negotiations, the court held that it “overlaps with our evaluation of the manner in which the parties entered into the contract and whether the parties had a reasonable opportunity to understand the terms of the contract; therefore, we will consider these factors together.”

The Court of Appeals in Unisearch, supra, stated that the parties did not negotiate for the term, although it remanded the case for determination of whether the liability limitation was explicitly bargained for. Unisearch, 2001 Wash. App. LEXIS 993, No. 46705-1-I, slip op. at 10. Both parties conceded in oral argument before the court that there was no specific negotiation of the liability limitation clauses. It was asserted that, because there was no specific negotiation for the term, it should not be included in the contract. The court disagreed. While absence of negotiations may weigh in favor of the party complaining of that omission, that party had a reasonable opportunity to understand the terms of the clause, which remained unchanged throughout the course of their dealings.  The court ultimately held that that the totality of the circumstances support the conscionability and enforceability of the liability limitation clause in the contract for services between the parties.

This line of Washington decisions strongly indicates that the test for unenforceability of the liability limitation is stringent. In the case at hand, deposition testimony of a Defendant employee suggests that the contracts were not subject to negotiation, but rather were “presented” to master dealers such as Plaintiff on a “take-it-or-leave it basis.” This again has to be considered along with the other factors which governed making of the contract. As stated above, absence of negotiations will not alone negate a limitation of liability clause.

The Plaintiff in the instant case must demonstrate that the liability limitation clause was unconscionable. Further should evidence indicate that the Plaintiff was in a position to have understood the terms of the contract before entering into the same, the liability limitation clause will most likely be enforced.

In Adcock v. Ramtreat Metal Tech., Inc., 2001 Wash. App. LEXIS 863, 44 U.C.C. Rep. Serv. 2d (Callaghan)1026, respondent was a company performing metal heat-treating. Appellant owned drilling assemblies leased to drilling operators. Respondent had a contract to heat-treat parts for appellant. The terms of the limited liability statement contained in the contract defined the scope of the remedies so as to exclude compensatory and consequential damages. Upon an alleged breach, appellant filed an action for lost profits. The trial court granted respondent’s motion for summary judgment. The appellate court affirmed. Even if the limitation of liability was somehow found to be unconscionable, it was held that the trial court did not err in dismissing appellant’s claim for lost profits. Under Washington law, lost profits were recoverable when they were: (1) within the contemplation of the parties at the time the contract was made, (2) the proximate result of defendant’s breach, and (3) could be proven with certainty.  Id. at 17.  The claim was properly denied because the alleged loss was purely speculative.  Id. at 18.

(C ) Implied Covenant of Good Faith and Fair Dealing

In the case of Goodyear Tire & Rubber Co. v. Whiteman Tire, Inc., 86 Wn. App.

732; 935 P2d 628 (1997), the court of appeals discussed the scope and applicability of the basic contract principle of the implied duty of good faith and fair dealing. The court held that the implied covenant of good faith present in all contracts is inapplicable if it would contradict an express and unconditional contractual right not dependent upon an exercise of discretion.  Id. at 739.  It applies only when the contract gives one party discretionary authority to determine contract terms. Id.

In the case at hand, because the general rule in Washington is that an implied covenant of good faith cannot contradict an express and unconditional contractual right, the Plaintiff will most likely not be able to overcome the limitation of liability clause.  Only if the Plaintiff is successful in having the limited liability clause rendered unconscionable, will it be able to successfully invoke the implied covenant of good faith and fair dealing. Such an implied covenant will be afforded only secondary consideration in relation to the express provisions of the contract.

CONCLUSION

Article 2 of the UCC will most likely not apply to the Dealer Agreement, as the contract is predominantly one dealing with services and not tangible goods.  Moreover, the Washington courts have articulated stringent tests in cases where limitation of liability clauses in commercial contracts are called into question. The Plaintiff needs to establish that the limitation of liability in its agreements with Defendant was unconscionable, which will be difficult to accomplish.