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The Court of Appeals for the Eleventh Circuit recently decided a rather fascinating case, HGI Associates v. Wetmore Printing Co.. It begins:

In this case, the Microsoft Corporation (“Microsoft”), through its subsidiary, Microsoft Licensing, Inc. (“MSLI”), and business partner, Wetmore, attempted to set an ill-conceived trap to ensnare a suspected software pirate, HGI. The trap, however, only managed to ensnare Wetmore.

HGI’s business was described as the “secondary software market”. A large percentage of HGI’s software was acquired from computer manufacturers which had a surplus of software that they had purchased through authorised distribution channels. That software was original (ie not pirated), and included manuals and certificates of authenticity — together described as “software kits”.

Wetmore was at the time an “authorised replicator” for Microsoft, and was apparently licensed to create the software kits for distribution to customers such as Dell, Wal-Mart and Compaq.

Microsoft “believed that HGI was illegally selling unlicensed software”. When, in 2001, HGI contacted Wetmore inquiring about purchasing Microsoft software kits, Wetmore notified Microsoft Licensing, Inc. (“MSLI”), a subsidiary of Microsoft Corporation. MSLi requested that Wetmore help it investigate HGI’s activities.

Despite knowing that HGI was not a licensed Microsoft distributor, Wetmore invited HGI’s president (Ronald Swartz) to visit its facility. Swartz was given a tour, a credit application, and was told that Wetmore would supply him with Microsoft products. The District Court found that Wetmore was not acting bona fide, and was only pretending to do business with HGI to assist in MSLI’s investigation.

Discovered documents showed that MSLI told Wetmore to record its meetings with Swartz, and proposed a list of question to, among other things, “get [Swartz] to admit that what he is doing is not a licensed/legal way to distribute [Microsoft] products”.

Swartz told Wetmore that he was not licensed to sell Microsoft products, but believed that he did not need to be as a simple reseller. He also stressed that he only wanted to purchase original software kits. The Wetmore contract was apparently HGI’s first foray in acquiring software from an authorised distributor directly, as ordinarily the prices obtained from such distributors are “prohibitive”.

After Swartz’s credit application was approved, he requested, and Wetmore sent, sample software kits. Wetmore then told Swartz that it could begin taking HGI’s orders, and fulfilled his first order of 300 kits. Swartz then placed three orders, for 72,500, 41,000 and 11,000 software kits.

Wetmore confirmed the orders, and indicated it could ship 4,000 kits. To prepare for the shipments, HGi leased warehouse space in Colorado for three years. The 4,000 kits were defective, as they were not unbranded, and were missing manuals. Wetmore then shipped the missing manuals to HGI in Florida, rather than Colorado as requested, in an attempt to locate HGI’s warehouse there.

HGI placed a fourth order for 149,500, which was never confirmed, before Wetmore indicated that HGI was not authorised to sell the software kits, and requested that the kits already shipped be returned for a refund.

HGI sued instead.

The District Court found that: (1) Wetmore never told HGI it could not provide the software kits; (2) Wetmore never told HGI that HGI needed to be an authorised Microsoft dealer; and (3) Wetmore never told HGI that HGI would need to enter into a licensing agreement with Microsoft.

It held that only the first three orders were binding contracts, and awarded lost profits for their breach, being the profits from resale contracts it had outstanding at the time of Wetmore’s breach. The court awarded the present value of HGI’s lease payments, and also awarded HGI $50,000 in punitive damages because Wetmore “intentionally pursued a course of wrongful conduct” consisting of fraudulent representations.

However, it dismissed HGI’s claim to approximately $16.7m of lost future profits, being the likely resale value of the undelivered goods for which no resale contracts existed at the time of breach, on the grounds that the loss was too “speculative”. The case was presented for decision on that issue because HGI had not properly pleaded “benefit of the bargain” damages that would ordinarily be sought for repudiation of such a contract of sale.

Both parties appealed.

Wetmore argued that the contracts were not binding because the software that it would have provided would not have been authorised or licensed by Microsoft, and hence the contracts were in violation of public policy. The Eleventh Circuit (applying Texas law), however, correctly analysed the contract as one for software that was already licensed and authorised by Microsoft. It refused to let Wetmore try to plead its own supposed illegal conduct to vitiate the contract:

Essentially, Wetmore asks us to invalidate a contract requiring it to deliver lawful and approved goods because the goods it could supply were, in fact, not lawful or approved goods. This we cannot do. …

Although Wetmore knew its software kits did not include royalty payments to Microsoft, and Wetmore knew HGI was buying the software kits with the understanding that it had no obligations to pay royalties; Wetmore continued to mislead HGI by treating HGI as an approved customer and failing to correct the belief that the software was royalty-free. Though the violation of intellectual property rights is of great concern to public policy, it was not contemplated by this contract.

The Court correctly captured the essence of the doctrine of illegality:

Instead, we find that Wetmore’s position is a greater threat to public policy and contract law in general. As an example, suppose that two parties form a contract to purchase a car with the expressed understanding that the seller has the rights to sell that car to the buyer. In other words, the seller is not selling a stolen car to the buyer. The seller cannot, then, intentionally avoid his contractual liability to sell a car by claiming that the car he would have sold buyer was in fact stolen and thus an illegal contract that violates public policy. The agreement was not for the purchase of a stolen car, which would violate the law and public policy, but for a legitimately-owned car.

The Court upheld the award of punitive damages. It also applied the doctrine of “copyright estoppel” to forestall any claim for infringement of Microsoft’s copyright, in that Wetmore and MSLI watched as HGI relied to its detriment on Wetmore’s false representations that the software was licensed, knowing that HGI was acting under a false belief, but failing to correct it. Indeed, both Wetmore and MSLI actively sought to induce HGI’s ignorance.

Finally, the Court reversed the claim for lost profits. It held that an average resale price for the software kits could be estimated, and remanded the case to the District Court to determine this amount, subject to HGI proving that it had mitigated its loss.

The Court’s decision is notable for its (correct) insistence on properly characterising the so-called illegal contract. A contract which the parties intend to be for the sale of an illegal item is very different from a contract for the sale of an item that the supplier could supply in illegal form. Absent some indication that the parties intended the former sort of bargain, the contract will usually be of the latter form, and it is then not open to the seller to plead their own, unannounced and perfectly unilateral illegality to attempt to escape the bargain.

Of perhaps more concern to copyright owners may be the finding of copyright estoppel – in the sense that standing by and watching someone possibly violate your copyrights for the purpose of entrapping them may well deprive you of your ability to sue for violation of those copyrights if you actively induced a belief in the other person that they were acquiring licensed, non-infringing software.

Finally, from a contract law perspective, it provides a textbook illustration of the dangers of “pretending” to contract.