Drafting And Negotiating Intellectual Property Defense And Indemnification Provisions - What You Don't Know Could Cost Your Clients Millions
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Sales agreements and licenses may by the driving force for a significant number of companies generating revenue today, but it is a properly drafted intellectual property ("IP") defense and indemnification provision that will enable management of certain liability risk and protection for a client down the road. Whether acting as outside counsel drafting a license agreement for a client or as in-house attorney looking to update an employer's standard sales and services agreements, IP defense and indemnification clauses are an area that is often overlooked until it is too late. Particular industry customs and the concerns of important customers play a large role in shaping IP defense and indemnification provisions in purchase and/or license agreements. However, proactive private practitioners and in-house counsels should use these provisions to manage a clients' risk of liability by narrowing and carefully drafting and negotiating these often glanced-over provisions.
This article addresses important considerations for reasonably narrowing defense and indemnification provisions alone, as well as in combination with corresponding representations and warranties provisions. In most circumstances, considerations for IP defense and indemnification provisions in purchase agreements for the sale of goods is equally applicable to the license agreement for services, technology and/or software. Accordingly, throughout this article, the term "Seller" denotes both a seller of goods or services as well as a licensor of technology or software. Likewise, the term "Buyer" is used for a corresponding buyer of goods and/or services or the licensee of technology or software.
The IP defense and indemnification issues addressed herein relate to IP generally, i.e., patent, trademark, copyright and trade secrets, associated with the sale of goods and services or licenses of technology and software. However, primary focus is provided on those provisions that limit liability in patent infringement lawsuits. The larger litigation defense costs and complex issues in play in patent litigations usually dwarf those of other types of intellectual property actions. While liability for copyright infringement or trade secret misappropriation actions are often successfully avoided or managed by corporate policies prohibiting intentional malicious acts, patent infringement actions often arise without the intentional acts of copying or the like by the Seller and therefore require greater attention in the drafting of IP defense and indemnification provisions.
While it is not possible or at least highly improbable that all of a Seller's risk can be eliminated in the context of a business transaction, the risk at last can be managed and minimized. This is particularly true because boilerplate IP defense and indemnification provisions are typically overly broad in favor of protecting the buyer or licensee. The following sections highlight important issues to be considered by a Seller for reasonably narrowing these provisions that are applicable in most industries for managing the Seller's inherent exposure to liability associated with the sale of good and/or the licensing of intellectual property.
A. Intellectual Property Defense and Indemnification - General Terms and Triggers
A well constructed IP defense and indemnification provision should clearly set forth the terms, scope and breadth of a Seller's defense and indemnification obligations, and include the events and conditions by which such obligations are triggered. For example, language for a boilerplate IP defense and indemnification provision may include:
Seller will defend, indemnify and hold Buyer harmless against a third-party action, suit or proceeding ("Claim") against Buyer to the extent such Claim is based upon an allegation that a Product, as of its delivery date under this Agreement, infringes a valid United States patent or copyright or misappropriates a third party's trade secret.
This seemingly innocuous provision creates potential liability in the form of an unbounded indemnification and hold harmless statement that may include lost profits or business interruption damages. On the other hand, this same example limits the triggering event that creates the Seller's defense and indemnity obligation as well as limits the type and geographic scope of the defense and indemnity, which are addressed in greater detail below.
As evident in the above example, a critical element is the term that creates or triggers a Seller's defense and indemnification obligations. A well-drafted provision must make it clear as to whether a Seller's obligation is triggered upon the filing of a complaint, or the receipt of a letter alleging infringement or merely offering a patent license. Seller's counsel should advocate that the triggering event is limited to the filing of a claim, lawsuit or proceeding. The Seller can then also determine, on a case-by-case basis, whether to step in and defend or indemnify for mere allegations of infringement or offers to license. Such a decision is often dependent upon the business relationship with the Buyer as well as the perceived stature and merit of the patent and the party alleging infringement.
In contrast, a Buyer's goal is the mitigation of resources it has to expend in dealing with a third-party patentee alleging infringement. By requiring the Seller's defense and indemnification obligation to trigger early, i.e., upon the receipted of a letter or other communication, the Buyer effectively diverts a potential problem directly to the Seller, with little expenditure of resources. It is typical for a purchase agreement or license agreement to create Seller's IP defense and indemnification obligation based upon the filing of an action, claim or proceeding. However, recently we have seen Buyers more aggressively seeking contract language creating Seller's IP defense and indemnity obligation upon an allegation of infringement, particularly in market segments with patent troll activity.
B. Defense Obligations and Indemnification Obligations are Separate, but Related Obligations
Historically for certain industry segments, protection afforded Buyers of goods from third-party patent infringement was in the form of IP indemnification only. In the last decade sales and license agreements have extended the Seller's obligations to include both defense and indemnification obligations. Of late, it is not unusual for such agreements to extend to create obligations for the Seller to defend, indemnify and hold the Buyer harmless. Each of these separate, but related, obligations increases the exposure to liability for the Seller. Although industry custom may dictate this arrangement, deciding whether to tie one's defense obligation to the obligation to indemnify should be critically evaluated. The two obligations are completely separate yet are often combined. Indemnification does not merely create a "pay the way" obligation for the Seller. In assuming a level of risk, the Seller must be able to determine and contract for the amount of involvement it wishes to undertake in a claim for IP infringement made against a Buyer.
For example, a prudent way to provide specific limitations to the Seller's defense and separate indemnity obligations is to substitute the blanket statement to "defend, indemnify and hold the Buyer harmless" with:
Seller will defend, at its expense, a third-party action, suit or proceeding against Buyer ("Claim") to the extent such Claim is based upon an allegation that a Product, as of its delivery date under this Agreement, infringes a valid United States patent or copyright or misappropriates a third party's trade secret. Seller will indemnify Buyer for any judgments, settlements and reasonable attorney's fees resulting from a Claim as provided in this Section.
The Seller should also consider making its defense and indemnification obligation conditioned on: (1) Buyer promptly notifying Seller of the Claim in writing upon Buyer's being made aware of the Claim; (2) Buyer giving Seller sole authority and control of the defense or settlement of the Claim; or (3) Buyer providing all information and assistance requested by Seller to handle the defense or settlement of the Claim.
C. Important Defense and Indemnification Exceptions to Consider
Sellers should consider explicit exceptions to their defense and indemnification obligations. Examples of limiting or obviating exceptions to creation of an obligation include exclusions for: (1) a product that has been modified by someone other than Seller; (2) a product that has been modified by Seller in accordance with the Buyer's provided specifications or instructions; and (3) a claim of infringement based on the Buyer's other products or third-party products. In association with these exceptions, Sellers should also consider obtaining a reverse defense and indemnification obligation from Buyers. Such a reverse obligation could include, for example, an agreement to defend the Seller against third-party claims, judgments, settlements or attorney's fees resulting from a claim against the Seller's product that has been modified by someone other than Seller or a product that has been modified by Seller in accordance with the Buyer's provided specifications or instructions. Seller should also consider expressly limiting or excluding liability when the alleged infringement results from the negligence or willful misconduct of the Buyer.
D. Hold Harmless and Limitation of Liability Provisions
Since it now has become common for defense and indemnification provisions to hold Buyers harmless from IP infringement, Sellers are now facing large potential damages including the Buyer's lost profits, business interruption expenses and other consequential damages. Drafting of hold harmless provisions to impose reasonable limitations should be evaluated, otherwise the Seller could be responsible for more then it bargained for. A Seller's holding of a Buyer harmless against IP infringement allegations is to ensure that the Buyer is placed in the same position that it would have been absent the infringement allegation and not to ensure that its potential profits are protected. To manage this risk, the scope of the IP defense and indemnification hold harmless provision should have well-defined limitations of liability that excludes lost profits, indirect, consequential, incidental and business interruption expenses.
For example, it is in a Seller's interest to include a limitation of liability disclaimer following an IP defense and indemnification provisions that states, for example,
No Other Remedies Regarding Infringements - The foregoing states SELLER's entire liability, and BUYER's sole and exclusive remedy with respect to any infringement or misappropriation of any intellectual property rights of any other party.
Likewise, a Seller should make it clear that any indemnification obligations are limited to the amount finally awarded by a court or agreed to in a settlement.
In addition to excluding certain types of damages, it may also be reasonable for Sellers to consider a limitation of liability provision that sets a maximum cap on its liability. It is quite common in the licensing of off-the-shelf software products, for example, to cap liability to the price paid by a Buyer for use of the software. In other industries, it is common to set a liability cap to a multiple of the sale or transaction price.
E. Combination Exclusions
Products are often used as components integrated into a larger system by the Buyer. Simply supplying a single component without the Seller knowing how it will be used in a system can create significant liability and hardship for a Seller when the Buyer seeks defense and indemnification from all its component suppliers in response to patent infringement lawsuit brought against its system. In order to manage such risk for component manufacturers, manufacturers often include combination exclusions in their IP defense and indemnification obligations. An example combination exclusion may state that: "Seller shall have no defense or indemnity obligation for a Seller furnished product that has been used with or in combined with hardware or software not furnished by Seller."
Blanket combination exclusions may be problematic for products specifically designed to operate with other products not supplied by the Seller, e.g., software designed to operate with a computer, or a memory designed to operate with a microprocessor or microcontroller. Accordingly, the scope and extent of combination exclusions can and should be tailored to the particular products licensed or sold. Factors to consider in drafting combination exclusions include whether the product is a staple good in commerce, the use of the product as a stand-alone item, the licenses held by the Seller from other third-parties regarding the use of the product, and the ability of the Buyer to modify or customize the purchased product for its particular product.
F. Geographic Limitations on Defense and Indemnity Obligations
Another consideration for IP defense and indemnification clauses is specific geographic scope restrictions. For example, if a product is sold to a Buyer in the United States for use in the United States then the contractual IP defense and indemnification should reasonably be limited to infringement of United States intellectual property, e.g., U.S. patents in U.S. Courts. If a Buyer ships the received product overseas for use in its United Kingdom ("U.K.") factory, then the Seller should not have to defend or indemnify against third-party infringement allegations arising in the U.K. regarding infringement of a U.K. patent.
Geographic limitations may further help eliminate Seller's obligation to defend against some oddball infringement allegations made by third parties. For example, a third party may attempt to allege that a Buyer's use of the product in the United States, in some fashion, infringes the third-parties foreign patent. Although there is little chance that a U.S. Court would find that it has jurisdiction over infringement of foreign patents, a Seller with an unbounded duty to defend and indemnify could still be required to expend resources and incur unnecessary outside counsel expense merely to respond to the meritless allegations in a foreign court or otherwise. Geographic limitations would provide the Seller with a graceful way to decline to defend and indemnify in such instances without disrupting important business relations.
G. Remedial Measures: Seller's Ability to Provide Non-Infringing Substitute or Modified Goods
A Seller should consider provisions that explicitly enable the substitution of a modified non-infringing product or services that provides the necessary functionality for the Buyer to mitigate or terminate the impact of IP infringement claims. For example, the Seller may wish to add a provision that includes one or more of the following obligations.
Seller, at its own expense and option may: (1) procure for Buyer the right to continue use of the Product; (2) replace the Product with a non-infringing product; or (3) refund to Buyer a pro-rated portion of the applicable Fees for the Product based on a linear depreciation monthly over a (X) year useful life, in which case Buyer will return to Seller the Product and cease all use of it.
Such provisions, with the possible exception of the refund, are likewise advantageous for the Buyer. These provisions allow the Buyer to maintain functionality of the purchased good by using the substitute product without the headache of being subject to a full patent infringement action, diverting significant resources from the Buyer's business.
H. Coordinating IP Defense and Indemnification with IP Representations and Warranties
Narrow IP defense and indemnification provisions can easily be undone by the inclusion of broad representations and/or warranties due to the conflicts the two create. For example, the standard UCC provisions that have been adopted under the laws of virtually all states provide that in any contract for the sale of goods, it is inherent that the seller warrant against infringement of a third-parties property rights. Such implicit rights trump the narrow provisions of a carefully drafted IP defense and indemnification provision. Fortunately, most reasonably sophisticated sales agreements appropriately and explicitly disclaim such UCC warranties. However, all too often, in addition to disclaiming such UCC warranties, many carefully and not so carefully drafted IP defense and indemnification provisions are rendered of little or no value when the contract itself further includes an explicit warranty against IP infringement. In such instances, a Buyer may seek indemnification from a Seller under either or both of these provisions. Accordingly, any restrictions on the Seller's potential liability set out in the IP defense and indemnification provisions will be rendered moot in view of the provided blanket representation and warranty against patent infringement with no limitations.
It is therefore prudent from the Seller's perspective to refuse to include a representation or warranty against IP infringement, if a well structured IP defense and indemnification section is provided. During negotiations, to the extent such provisions are discussed, the Seller's counsel may argue that the warranty against IP infringement is unnecessary for two reasons: 1) the IP defense and indemnification provisions set forth the extent of the Buyer's IP indemnification, and that the warranty against patent infringement therefore provides an unnecessary second cause of action under the Agreement; and 2) of a more practical nature, it is not possible for the Seller to evaluate every third party patent in force to make such a representation and warranty, even when an extensive patent clearance study has been performed. Finally, to the extent that a Buyer still demands that a representation and warranty against patent infringement be included, then it is wise to include such provision with the explicit statement that the sole remedy for breach of this representation and warranty is provided under the patent indemnification section.
The purpose of a well-drafted arms length defense and indemnification provisions is not to afford the Buyer or Seller the opportunity to take advantage of the other. Rather it is an opportunity to apportion appropriate risk inherent in any sale or license. This can be accomplished by employing some of the practice tips discussed in this article with the understanding that no matter how many scenarios are considered, there is always a risk of the unknown that cannot be contracted away.
1. UCC § 2-312 (2) Unless otherwise agreed, a seller that is a merchant regularly dealing in goods of the kind warrants that the goods shall be delivered free of the rightful claim of any third person by way of infringement or the like but a buyer that furnishes specifications to the seller must hold the seller harmless against any such claim that arises out of compliance with the specifications.
2. A warranty under this section may be disclaimed or modified only by specific language or by circumstances that give the buyer reason to know that the seller does not claim title, that the seller is purporting to sell only the right or title as the seller or a third person may have, or that the seller is selling subject to any claims of infringement or the like.
3. It should be noted that since a finding of infringement would constitute a direct breach of the warranties in the agreement between the Buyer and Seller. A Buyer would potentially have a direct claim for breach of contract against the Seller, separate and apart from the claim raised by a third party asserting a claim of infringement. A carefully crafted IP defense and indemnification provision should therefore make indemnification the sole and exclusive remedy for the breach of contract, thereby cutting off any additional claims between the Buyer and the Seller.