Opinion
Case No. 03-2393-JWL
April 14, 2004
MEMORANDUM AND ORDER NUNC PRO TUNC
On March 23, 2004, this court held a hearing to determine plaintiff's damages against defendant KFKI Systems, Inc. in connection with plaintiff's motion for default judgment. The court had previously granted the motion of defendant Interland, Inc. to compel arbitration so Interland was not a participant in the March 23 hearing and the issue of any fault of Interland was not before the court. In order to correct any mistaken impression the court may have left that it was attributing any responsibility to Interland for the damages claimed by plaintiff the court issues this Memorandum and Order Nunc Pro Tunc.
Plaintiff filed this diversity suit against defendants asserting claims of negligence, fraudulent misrepresentation, breach of contract and deceptive practices in violation of the Kansas Consumer Protection Act, K.S.A. § 50-623 et seq. After defendant KFKI Systems, Inc. failed to file an answer or otherwise respond to plaintiff's complaint, the clerk of the court entered default pursuant to Federal Rule of Civil Procedure 55(a). Thereafter, the court granted plaintiff's motion for default judgment and an order of default judgment was entered pursuant to Federal Rule of Civil Procedure 55(b)(2) with the amount of damages to be determined at a subsequent hearing. That hearing was held on March 23, 2004. Defendant KFKI Systems, Inc. did not appear at the hearing. Plaintiff appeared through counsel and provided evidence of its damages through the testimony of Robert Sherwood, president of SmartText. Plaintiff also had an economist testify on behalf of plaintiff with respect to present value calculations.
As explained below, the court finds that the total amount of loss sustained by SmartText as a result of the failure to successfully migrate the smartagreements.com website, at least according to the evidence presented at the default hearing (which may or may not be in accord with evidence that might be presented at some other hearing in the future) is $3,149,857. Moreover, because the evidence presented at the default hearing supports Smart Text's fraudulent misrepresentation claim against KFKI, the court will enter judgment in favor of SmartText against KFKI in the full amount of $3,149,857.
Mr. Sherwood testified at the hearing that Smart Text Corporation sustained several categories of losses as a result of the failure to successfully migrate SmartText's smart agreements.com website and the ultimate destruction of that website as a result of the failed migration. Those losses include the costs associated with having to rebuild completely the smartagreements.com website; losses associated with the creation and development of SmartText's key software product, Legal Point 7.0 (a product that was destroyed in the attempted migration and could not be duplicated thereafter); a loss of licensing fees associated with the licensing of Legal Point 7.0 to various companies; and lost profits as a result of the website being completely shutdown in April 2002.
With respect to the costs associated with having to rebuild the website, Mr. Sherwood testified that the smartagreements.com website was completely destroyed as a result of the failed migration of the site and that, once the website was shut down in April 2002, the website could not be recovered or restored in any way and, in fact, had to be rebuilt from scratch. According to Mr. Sherwood, nearly all of the website's 800 pages had to be recreated and each page (including all hyperlinks) had to be tested individually and in the aggregate for quality control purposes. Mr. Sherwood testified that the total amount of the cost billed to SmartText for rebuilding the smartagreements. com website in 2002 was $358,185-an amount that would be considered a "bargain" in the industry.
Mr. Sherwood also testified that the failed migration resulted in the total loss of SmartText's primary software product, Legal Point 7.0. Legal Point 7.0 constituted the "core technology" of SmartText and SmartText spent several years working with a team of software designers and consultants to develop Legal Point 7.0 for the exclusive use of SmartText. The software enabled SmartText's customers to utilize any one of roughly 100 legal or business forms available on smartagreements.com and would offer advice as to how to complete the form depending on the customer's specific needs. According to Mr. Sherwood, SmartText invested $1,425,289 in the creation and development of Legal Point 7.0 and that software was corrupted during the failed migration attempt such that it was rendered almost totally unusable to SmartText (aside from a handful of forms that could still be utilized). After determining that Legal Point 7.0 could not be fixed, SmartText has decided to convert to a completely new format and to take Legal Point 7.0 off the website entirely. Moreover, as explained by Mr. Sherwood, any value that SmartText might retain as a residual from the development of Legal Point 7.0 is exceeded by the expenses incurred by SmartText in attempting to have Legal Point 7.0 fixed (expenses for which SmartText is not seeking to recover).
The loss of Legal Point 7.0 also resulted in the loss of licensing fees for SmartText. In that regard, Mr. Sherwood testified that SmartText, prior to April 2002, had successfully licensed Legal Point 7.0 to various companies, including HR Block, to be used by those companies to create and sell forms similar to the forms available on smartagreements.com. In fact, in the five-or six-year period prior to April 2002, SmartText had received revenue of almost $2 million in licensing fees. Mr. Sherwood testified that, based on SmartText's plans to continue licensing in the future as well as its successful history with licensing arrangements, he believed that a fair and reasonable estimate of the licensing fee going forward from April 2002 that SmartTExt could have anticipated for the licensing of Legal Point 7.0 would be $150,000 per year for a 15-year period (the period of time that a typical licensing agreement would last). plaintiff's economist testified at the hearing that the present value of a stream of 15 years of licensing revenues of $150,000 per year amounts to either $671,576 or $1,433,201, depending upon the particular methodology used. Based on the evidence presented at the hearing, the court believes that the lower figure of $671,576 more closely approximates the amount of loss that SmartText likely suffered, particularly in light of the various uncertainties involved in connection with plaintiff's calculation of damages.
With respect to lost profits, Mr. Sherwood testified as to SmartText's loss of retail profits as a result of the failed migration of smartagreements.com. According to Mr. Sherwood, SmartText was generating $6000 per month in retail sales prior to April 2002 and the sales of Legal Point 7.0 products had doubled both in the 12 — to 14-month period prior to April 2002 and in the year prior to that. Thus, SmartText was clearly going through a significant growth phase at the time smartagreements.com was shut down in April 2002. In the first three months following April 2002, SmartText generated no revenue in that the website was completely shut down. For the remainder of 2002, SmartText generated roughly $6000 derived from Legal Point 7.0 (again, from the handful of documents that were still usable with Legal Point 7.0); for 2003 and the first few months of 2003, SmartText generated roughly $1300 per month from sales of Legal Point 7.0 products. As Mr. Sherwood also explained, however, SmartText will soon lose the $1300 per month revenues as it is planning on removing Legal Point 7.0 from the website entirely in light of high customer service costs. Moreover, SmartText had recently developed an affiliate program whereby other websites (affiliates) would direct their customers or traffic to smartagreements.com in return for a commission based on sales. As of April 2002, SmartText had 100 affiliates and Mr. Sherwood testified that it was a reasonable goal to project that SmartText would ultimately have 25,000 affiliates. After the failed migration, SmartText had no affiliates and SmartText had only three affiliates as of the date of the hearing. Ultimately, plaintiff's economist testified that SmartText has lost profits in the total amount of $694,807. The methodology used by the economist to calculate that figure is contained in the economist's economic loss report, which was admitted into evidence during the hearing. The court finds that the methodology used by the economist is appropriate in this case.
In sum, then, the total amount of damages sustained by SmartText as a result of the failure to properly migrate the smartagreements.com website (again, based only on the evidence presented at the default hearing) is $3,149,857. While the court had some concerns (as reflected in the court's questions to Mr. Sherwood during the hearing) about the possibility of SmartText receiving a double recovery as a result of the methodology used by SmartText in terms of seeking damages for the cost to produce Legal Point 7.0 plus lost profits plus lost licensing fees, the court ultimately is satisfied that, at least for purposes of the default hearing, the methodology used is appropriate. Finally, because the evidence presented at the default hearing supports SmartText's fraudulent misrepresentation claim against KFKI, the court awards the full amount of these damages in favor of SmartText and against KFKI on SmartText's fraudulent misrepresentation claim. As Mr. Sherwood testified, he had several conversations with representatives of KFKI during which those representatives made various fraudulent misrepresentations to Mr. Sherwood about the migration of smartagreements.com, including assurances that the website would not be shut down until it was completely and successfully migrated and assurances that KFKI had the expertise to complete the migration.
IT IS THEREFORE ORDERED BY THE COURT THAT judgment be entered in favor of plaintiff SmartText Corporation against defendant KFKI Systems, Inc. on plaintiff's fraudulent misrepresentation claim in the amount of $3,149,857.
IT IS SO ORDERED.