WINTER 1998

YEAR 2000 LITIGATION: HOW HARD WILL THE MILLENIUM BUG BITE?
by
Doug Ey & Mark McGraf
Smith Helms Mulliss & Moore

Fueled by sensational predictions of widespread computer failures and economic disaster, the Year 2000 problem has begun to capture the popular imagination as few recent events have. Although cooler heads are prevailing in most quarters, it is becoming increasingly apparent that anxiety over Y2K is approaching panic in some segments of the population. The question of the year in the popular press has become, what kind of havoc are these ghosts in the machine capable of wreaking?

The Year 2000 problem has been drawing the attention of much of corporate America for some time. America’s largest corporations are spending staggering amounts of money to eradicate the Millennium Bug in their computer systems. The Gartner Group recently estimated that upwards of $600 billion will be spent worldwide to address Year 2000 issues. Other estimates set the price tag as high as $3 trillion. Citibank, Federal Express and Bank of America anticipate that they will each spend more than $500 million to attack the problem. Duke Energy plans to spend more than $65 million.

Even the most composed pundits concede that we will experience some measure of disruption when computer date settings roll to January 1, 2000. Litigation is an option that will surely be explored as businesses scramble to recoup these losses. Moreover, the magnitude of Year 2000 remediation expenditures will inevitably encourage creative strategies for recovering these costs.

Attorneys are gearing up for the expected blitz of Year 2000 litigation. Emboldened by predictions that Year 2000 litigation will make the lawsuits spawned by asbestos, tobacco and breast implants combined pale in comparison, many firms have created specialized practice groups to handle the anticipated flood of lawsuits. Indeed, a significant number of Year 2000 lawsuits have already been filed, as discussed below. The question is no longer whether the Year 2000 problem will produce litigation but, rather, what kinds of litigation should we expect to see.

It would be a mistake to assume that small businesses clients are immune from Year 2000 litigation. Because even the smallest companies are heavily dependent on technology to handle critical functions, they are vulnerable to the bite of the Millennium Bug, and are potential parties to a Year 2000 lawsuit, either as plaintiffs or defendants. Accordingly, even attorneys who have no plans to specialize in Year 2000 litigation should anticipate client inquiries regarding Year 2000 liability issues.

The universe of scenarios that might give rise to Year 2000 litigation is limited only by the imagination; however, most lawsuits will fall roughly into the following six categories:

Claims against Vendors of Computer Systems and Software

Vendors of software and computer systems will be primary targets in Year 2000 litigation. Many businesses depend on such systems to handle payroll, inventory, accounts payable and receivable, and other core functions. Any Year 2000 glitches in the programming codes of these date-sensitive software packages have the potential to cause significant mayhem. Non-compliant hardware poses a similar threat. Also, because an increasing number of businesses outsource many of their information technology functions, providers of these services will also be likely defendants in Year 2000 lawsuits. Since there will usually be a contractual relationship between the plaintiff/purchasers and vendor/defendants in these cases, most claims will be for breach of contract and breach of warranty. Ambitious plaintiffs may also attempt to assert claims for negligent misrepresentation, fraud, negligence and other torts. These cases are likely to involve issues arising under Article 2 of the Uniform Commercial Code, including the implied warranties of merchantability and fitness for a particular purpose, and the validity of warranty disclaimers and limitation of remedy provisions.

In this era of just-in-time inventory, there is frequently little margin for error in a company’s supply chain. The example provided by last year’s General Motors’ strike provides a stark illustration of the devastating effect such failures can have. A strike at a single General Motors plant brought the entire General Motors system to a halt within a matter of days. Similarly, a small business client could experience a significant business interruption if one of its critical suppliers were to experience a Year 2000 failure. Litigation might prove to be the only viable option for recovering such losses. If the client is a supplier of goods or services (as most are), it is also a potential defendant in these kinds of cases, and its exposure to Year 2000 liability is an issue that should be addressed before December 31, 1999. Contract claims will again be a likely focus, though the frequent use of requests for certification of Year 2000 readiness may well put negligent misrepresentation, fraud and unfair trade practices in play.

Year 2000 failures conceivably could result in personal injuries and damage to property. In this category, the class of potential defendants is virtually without limit. Imagine the hospital whose heart/lung machine fails because of a Year 2000 defect in the embedded chip that operates it, or the insulin-dependent diabetic whose prescription is not filled because of a Year 2000 malfunction in a pharmacy system. Similarly, the failure of a security system could expose property owners to assault and other premises liability claims. It is extremely unlikely that plaintiffs’ attorneys will fail to appreciate the potential that these cases offer.

Claims Against Year 2000 Consultants and Solution Providers

Companies offering Year 2000 consulting and remediation services have proliferated in response to the demand. Typically, these firms perform an assessment of their customers’ systems to determine their Year 2000 compliance status, and then work to remediate any deficiencies in those systems. Many businesses have entrusted their Year 2000 compliance programs to these service providers, almost always at considerable expense. When these businesses experience Year 2000 failures, the first demand letters will likely be headed in the direction of these outside consultants. One hurdle that will have to be overcome by aggrieved customers is the paucity of protection that is typically provided for in the consultants’ service contracts. Almost without exception, the contracts of Year 2000 solution providers are brimming with warranty disclaimers and limitation of remedies provisions. Attorneys will be called upon to test the enforceability of these contracts in the context of Year 2000 litigation.

Liability of Corporate Directors and Officers

Corporate officers and directors also have considerable exposure to Y2K-related liability. This is especially true in publicly traded corporations that are subject to federal securities laws. Public corporations are required to file quarterly 10-Q and annual 10-K reports with the Securities and Exchange Commission. These reports require management to disclose material events and uncertainties that might impact the financial viability of the corporation, and 1998 SEC guidelines make it clear that Year 2000 issues are material, requiring detailed disclosure. Material omissions or misleading statements will expose corporate officers and directors to potential liability under the federal securities laws, including Section 10b of the 1934 Act.

Shareholder derivative suits pose another threat to directors and officers. If a corporation experiences disastrous losses because of a Year 2000 failure and its stock price falls, shareholders may seek redress. Unless directors and officers are able to document a vigorous, even if unsuccessful, program to attain Year 2000 compliance, they will be vulnerable to shareholder claims.

Insurance Coverage Disputes

Are Y2K-related claims covered under liability insurance policies? As always, the analysis will be driven by the policy language. In an effort to limit their potential exposure, some insurance companies have begun to add exclusions for Y2K-related losses to their renewal policies. An even more fundamental question is whether Year 2000 failures will be deemed "fortuitous" events -- the accidents and occurrences that traditionally trigger coverage. Insurers may take the position that, because Y2K has been long expected and anticipated, it is not a chance event, such that there is no coverage for Year 2000-related claims. These issues are likely to arise under CGL professional liability, E&O and D&O liability policies. Because carriers are taking a variety of underwriting approaches, the only certainty is that there will be no shortage of coverage litigation following in the wake of the other lawsuits described above.

In light of the tremendous costs that are being incurred by businesses as they strive for Year 2000 readiness, some companies may attempt to defray these expenditures by submitting claims under their first party property policies. Even more likely are claims for business interruption in the aftermath of Year 2000 disruptions. Whether such losses are recoverable under a first party coverage also is a matter of considerable debate. With such big money at stake, however, it is inevitable that some insureds will seek to have the issue resolved by the courts.

Whether a Year 2000 litigation blizzard actually settles in remains to be seen. However, the early data does little to discredit such predictions. Through mid-February 1999, nearly four dozen Year 2000-related lawsuits and arbitrations had been publicly reported. Several Internet web sites contain useful resources for tracking Year 2000 lawsuits. For example, check the web site of the Federation of Insurance & Corporate Counsel at www.thefederation.org/public/y2k/ lawsuits.htm.

What do the early lawsuits tell us? Here are the early returns:

The bulk of the early lawsuits involve claims by businesses or individuals against software companies that recently sold non-compliant versions of their products, or that have charged significant fees for Year 2000 upgrades - or both. In many of these cases, plaintiffs seek a free upgrade and make claims that the vendor misrepresented its products. Several such cases have been filed against Intuit, the manufacturer of the popular Quicken™ financial software package, and against Medical Manager Corp., the vendor of a popular medical practice software package.

Most of the pending claims against software vendors are filed as class actions. Understandably, the plaintiffs’ lawyers want to gain the maximum leverage, and lay the groundwork for maximum fees. Many are being filed by prominent national plaintiffs’ class action law firms that cut their teeth in the securities arena, and that have reinvented themselves as Year 2000 lawyers. Creative selection of class representatives is underway. For example, in a New York state court class action against Lucent Technologies alleging that Lucent violated warranties and committed unfair trade practices in the sale of non-compliant telecommunications products, the plaintiff/class representative is a law firm, represented by former members.

More than half a dozen securities and shareholders derivative claims have been filed, illustrating that a company may face waves of litigation problems if its products experience Year 2000 difficulties. Having settled a series of class action suits seeking free upgrades, Medical Manager Corp. now faces a shareholder class action that names the company, its president, CFO, general counsel, certain directors and the investment bankers that handled its IPO as defendants.

A number of the early lawsuits, most notably several of the claims against Intuit regarding Quicken™, have already been dismissed. The first line of defense on a motion to dismiss typically is that no damage has yet accrued, such that the claims are not yet ripe. These decisions will have significant impact on the statute of limitations analyses in later cases, which will have to sort out when claims actually occurred.

The first insurance coverage declaratory judgment action arising from an underlying Year 2000 claim was filed in U.S. District Court for the Northern District of Iowa by Cincinnati Insurance Company in late 1998. Cincinnati seeks a declaration that it has no duty to defend or indemnify its insured for potential Year 2000 compliance liability.

To date, there have been no verified reports of or lawsuits filed regarding Year 2000-related personal injuries or property damage.

Not unexpectedly, ADR has already been a significant factor in the first wave of Year 2000 lawsuits. The results of one arbitration proceeding have been widely reported. Mediation led to resolution of a declaratory judgment action filed by Arthur Andersen, the world’s largest consulting firm, against a client that had only threatened to assert a claim for the cost of installing a nearly 10-year old computer system that was not Year 2000 compliant.

Finally, with so much on the line in the litigation context, liability-limiting legislation will be explored in this session of Congress. At least half a dozen bills had been introduced in the House and Senate by mid-February 1999, taking a variety of approaches. Some specify standards of liability, while others place caps on economic damages, prohibit punitive damages or require notice periods before a suit may be filed. Any legislation that seeks to limit liability will undoubtedly face significant opposition from the plaintiffs’ lawyer lobby. If a legislative solution does emerge, it undoubtedly will be a compromise measure -- and likely one that will raise as many questions to litigate as it answers.