RRX Industries v. Lab-Con

Citation: RRX Industries, Inc. v. Lab-Con, Inc., 772 F.2d 543 (9th Cir. 1985).

Factual Background
The action arose out of a software contract negotiated between RRX and Thomas E. Kelly and Associates (TEKA). TEKA agreed to supply RRX with a software system for use in its medical testing laboratories. The contract obligated TEKA to correct any malfunctions or “bugs” that arose in the system, but limited TEKA's liability to the contract price.

TEKA began installing the software system in January 1981 and completed it in June 1981. Bugs appeared in the software soon after installation. TEKA attempted to repair the bugs by telephone patching. Subsequently, TEKA upgraded the system to make it compatible with more sophisticated hardware. The system, however, remained unreliable because defects continued to exist.

After contracting with RRX, Kelly formed Lab-Con, Inc. in order to market TEKA's software system. Lab-Con was a successor corporation to TEKA. TEKA assigned the RRX software contract to Lab-Con.

In September 1982, RRX instituted this diversity action against TEKA, Lab-Con, Kelly, and other defendants alleging breach of contract and fraud. Following a bench trial, the district court concluded that TEKA had materially breached the software contract. Appellants appeal the judgment and award of damages. == Appellate Court Proceedings ==

Credibility of Witnesses
Appellants argue that the district court had erred by crediting the testimony of three of RRX's witnesses. They argue that the testimony was inconsistent and unreliable. The court found that this contention lacked merit. The challenged testimony was not so inconsistent that a fact finder would not credit it. Further, there wass corroborative testimony by other witnesses that supported the district court's findings.

Piercing the Corporate Veil
Appellants claimed that the district court erroneously determined that Kelly was the alter ego of TEKA. The court found that the alter ego doctrine applies where (1) such a unity of interest and ownership exists that the personalities of the corporation and individual are no longer separate, and (2) an inequitable result will follow if the acts are treated as those of the corporation alone. The court found the necessary unity of interest and ownership in Kelly's exertion of total control over TEKA. TEKA had no board of directors, employees, or stockholder meetings. TEKA was also undercapitalized. Appellants also claimed that the district court erroneously imposed liability because Kelly did not act in bad faith. The court of appeals found that a finding of bad faith was not a prerequisite to the application of the alter ego doctrine under California law.

Appellants further argued that the district court erred by imposing liability on Lab-Con The court of appeals disagreed. Kelly formed Lab-Con for the purpose of marketing TEKA’s computer software. Both corporations had essentially the same stockholders and directors and TEKA transferred all of its software and licenses to Lab-Con for no consideration. TEKA was in essence an empty shell.

Breach of Contract
Appellants argued that the district court's breach of contract finding was clearly erroneous because RRX also breached the contract. The court of appeals found that this contention lacked merit.

Consequential Damages Award
The district court relied on the California Commercial Code to award RRX its consequential damages. The appellate court held that the reliance was proper if the computer software system could be characterized as a "good" rather than a “service.” The California law defines a “good” as “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 (Division 8) and things in action. . . .” The court found that the sales aspect of the transaction predominated. The employee training, repair services, and system upgrading were incidental to the sale of the software package and did not defeat the characterization of the system as a “good.” Appellants argue that the award of consequential damages was nevertheless improper because the contract specifically limited damages to the amount paid. The appellate court held that district court's award of consequential damages was consistent with its earlier decision in S.M. Wilson & Co. v. Smith Int'l, Inc. The court concluded that “since the defendants were either unwilling or unable to provide a system that worked as represented, or to fix the ‘bugs’ in the software, these limited remedies failed of their essential purpose. . . .” Although the district court's choice of language and supporting authority created an ambiguity, it properly found the default of the seller was so total and fundamental that the consequential damages limitation was expunged from the contract. The award of consequential damages was upheld.