Micro Data Base Systems, Inc. v. Dharma Systems, Inc.

• Decision Date: 29 May 1998
• Docket Number: Nos. 97-2989,97-3138,s. 97-2989
• Citation: 148 F.3d 649
• Parties: , 35 UCC Rep.Serv.2d 747 MICRO DATA BASE SYSTEMS, INC., Plaintiff-Appellant, Cross-Appellee, v. DHARMA SYSTEMS, INC., Defendant-Appellee, Cross-Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 649

148 F.3d 649

46 U.S.P.Q.2d 1922, 35 UCC Rep.Serv.2d 747

MICRO DATA BASE SYSTEMS, INC., Plaintiff-Appellant, Cross-Appellee, v. DHARMA SYSTEMS, INC., Defendant-Appellee, Cross-Appellant.

Nos. 97-2989, 97-3138.

United States Court of Appeals Seventh Circuit.

Argued March 31, 1998.

Decided May 29, 1998.

William P. Kealey (argued), Stuart & Branigin, Lafayette, IN, for Micro Data Base Systems, Inc. in No. 97-2989.

William P. Kealey (argued), Susan K. Roberts, Stuart & Branigin, Lafayette, IN, for Micro Data Base Systems, Inc. in No. 97-3138.

Sean M. Clapp (argued), Bradley C. Morris, Johnson, Smith, Pence, Densborn, Wright & Heath, Indianapolis, IN, Joseph A. Foster, McLane, Graf, Raulerson & Middleton, Manchester, NH, for Defendant-Appellee, Cross-Appellant.

Before POSNER, Chief Judge, and CUMMINGS and KANNE, Circuit Judges.

POSNER, Chief Judge.

We have before us an appeal and a cross-appeal in a diversity suit that presents issues of contract law, trade secrets law, and conflict of laws. The underlying dispute between the parties, two software companies that we'll call MDBS and Dharma, arises out of a four-way deal. The Internal Revenue Service requested bids for a contract to improve the Service's computer capabilities. Unisys Government Systems, Inc. wanted to bid on this contract. It made a contract with MDBS for the provision of a workstation database management system designed to be used by the IRS. MDBS in turn made the contract with Dharma that is in issue in this suit. In the contract, Dharma agreed to adapt its proprietary software program known as SQL Access for use in the system that MDBS would be providing to Unisys for sale to the IRS. MDBS agreed to pay a license fee of $125,000 for use of the SQL Access program plus $125,000 for Dharma's adapting the program to MDBS's needs. The license fee was to be paid immediately. The second $125,000, which is denominated "for professional services," was to be paid in three installments. The first installment, $50,000, was due upon "Project Start-up." The second installment, also $50,000, was due upon "Beta Release," that is, when the modified SQL Access program was sent to MDBS and Unisys for "beta testing." This is a term of art in the computer industry; but in the case of custom software (our case) as distinct from commercial software, the record is unclear whether it is the penultimate or ultimate performance test before the customer's acceptance of delivery of the software. The last installment, $25,000, was due upon "Acceptance by Unisys."

The contract terms that we have just summarized are the terms as stated in a letter that MDBS wrote Dharma on July 7, 1994. They are not completely congruent with the terms set forth in a letter that Dharma had written MDBS the previous month. That letter had included a term calling for MDBS to pay Dharma a royalty on each sale of the MDBS program in which the SQL Access program (called "RDMS Emulation" in its adapted form--"RDMS" standing for "Relational Database Management System") was incorporated. The royalty was to be equal to 25 percent of the price that MDBS charged Unisys for each RDMS Emulation. MDBS's letter of July 7 makes no reference to a royalty. In between the two letters, however, Dharma had sent MDBS a draft of a License Agreement designed to limit the distribution of the RDMS Emulation, and the draft contained the royalty provision mentioned in Dharma's letter. MDBS never signed the agreement, but continually reassured an increasingly anxious Dharma (which made repeated requests) that it would do so.

MDBS paid Dharma the $125,000 license fee, and Dharma went to work. MDBS also paid both the first installment of the adaptation fee--$50,000 upon project start-up--and, on November 8, 1994, when Dharma shipped the beta version of the RDMS Emulation, the second $50,000 installment. MDBS turned the beta version over to Unisys for testing. Unisys did not report to either MDBS or Dharma any defects, though whether this is because Unisys tested the beta version and found no problems with it or didn't test it at all is not disclosed by the record. The following May, Unisys landed the contract with the IRS, and it then asked MDBS to send it six copies of the RDMS Emulation--one for it to keep and the others to sell to the IRS. The beta version of the RDMS Emulation had been on tape, and the IRS wanted it on disks, but Dharma refused to provide disks until MDBS signed the License Agreement. MDBS still refused to sign the agreement, but upon its written representation to Dharma that "it [MDBS] will not distribute this Component [that is, the RDMS Emulation] without [Dharma's] prior written consent," Dharma relented and shipped the disks to MDBS on September 20, 1995. Except for the change in the medium, the disks were identical to the tapes, that is, to the beta version which Unisys had received almost eleven months earlier.

A few weeks after this, MDBS, without seeking or obtaining Dharma's consent, shipped the six copies of the RDMS Emulation to Unisys. MDBS's cover letter stated that the shipment was for "acceptance testing," was not "a distribution," and was to be used for "quality assurance and further testing only," and "any further duplication or distribution is strictly prohibited." Two weeks later Unisys notified MDBS of ten (later reduced to nine) defects in the RDMS Emulation. Presumably these defects were revealed by testing the disk version; so we shall assume, although it is conceivable that Unisys was belatedly reporting the results of tests that it had conducted months earlier on the beta version.

The defects apparently were minor and easy to correct. But Dharma refused to correct them until MDBS signed the License Agreement. Dharma was worried that once they were corrected, MDBS or Unisys could duplicate the disks and thus sell multiple copies to the Internal Revenue Service. It is true that Dharma's programs are copyrighted, so neither MDBS nor Unisys could lawfully have copied them. But Dharma was worried that MDBS or Unisys might be able through reverse engineering to extract non-copyrightable elements in the software from which it might be able to build a duplicate of the RDMS Emulation that would not infringe Dharma's copyright. See Bateman v. Mnemonics, Inc., 79 F.3d 1532, 1546-48 (11th Cir.1996); Computer Associates Int'l, Inc. v. Altai, Inc., 982 F.2d 693, 706-11 (2d Cir.1992); Sega Enterprises, Ltd. v. Accolade, Inc., 977 F.2d 1510, 1526-28 (9th Cir.1992); Atari Games Corp. v. Nintendo of America Inc., 975 F.2d 832, 843-44 (Fed.Cir.1992).

Despite the defects, Unisys turned over five of the six copies of the RDMS Emulation to the IRS, paid MDBS the $25,000 final installment for transmission to Dharma (which MDBS kept rather than remit to Dharma), and, pursuant to its contract with MDBS, paid MDBS $413,894 in prepaid royalties generated by Unisys's contract with the IRS. Unisys had been withholding this payment until it obtained the five copies of the RDMS Emulation which it needed to satisfy its contractual obligations to the IRS.

MDBS brought this suit against Dharma seeking restitution of the $225,000 that it had paid Dharma under the contract. Dharma counterclaimed, seeking $25,000 (the unpaid final installment under the contract) in damages for breach of contract and additional damages for misuse of the trade secrets embodied in the RDMS Emulation and the underlying SQL Access program. The district court ruled as a matter of law that the substantive issues in the case were governed by the law of New Hampshire, that MDBS and not Dharma had violated the contract and owed Dharma $25,000 for this breach, and that MDBS had also violated Dharma's rights under trade secret law. A jury assessed compensatory damages for the trade secret violations in the amount of $76,867.50, the district court having ruled as a matter of law that MDBS was not liable for punitive damages.

MDBS's business is in Indiana and Dharma's in New Hampshire. The contract was made by an exchange of letters and other communications, and so has no site. But the contract was performed entirely in New Hampshire, and we agree with the district court that under Indiana's choice of law rules, which are the rules applicable to this diversity case, the law applicable to both the contract and trade secrets issues is that of New Hampshire. The standards that state courts (including those of Indiana, see Hartford Accident & Indemnity Co. v. Dana Corp., 690 N.E.2d 285, 291 (Ind.App.1997)) use nowadays, see Restatement (Second) of Conflict of Laws §§ 6, 188(2) (1971), to resolve choice of law issues are widely and we think correctly believed to be nondirective, but their administration is usually pretty sensible. The important thing, especially in a contractual setting, is that the parties should have a clear idea of which state's law will apply, NL Industries, Inc. v. Commercial Union Ins. Co., 65 F.3d 314, 327 (3d Cir.1995); Restatement, supra, § 188, comment b, since once they know this they can if they wish change the state whose law is to govern their relation by including a choice of law provision in their contract. In a case in which the contract is made as it were nowhere, because the parties are in different states (or countries) and the contract is negotiated without a face-to-face meeting, but it is entirely performed in one state, the parties will expect the law of that state to govern any contractual dispute that arises during performance (for what other state would be a more plausible candidate?) unless they specify otherwise in the contract, which they did not do here. So the district court's choice of law ruling was clearly correct with respect to the contract issues. Dohm & Nelke v. Wilson Foods Corp., 531 N.E.2d 512, 514 (Ind.App.1988). We do not understand the parties to be arguing that MDBS's claim for restitution should be treated any differently from Dharma's breach of contract...