Whether you know it or not, the Uniform Commercial Code imposes a warranty of non-infringement on every product you as a product manufacturer sells.
Essentially, the law requires to you to guarantee that your products are free of any claims of infringement by others. It's also likely that your customer contracts impose even more onerous obligations. These obligations may require you to provide a legal defense to your customers, reimburse them for any settlements and judgments that may be imposed on them as a result of a lawsuit, and even pay for expert fees, travel, and other incidental costs of litigation.
These litigation costs can be staggeringly high. In 2015, the average all-in cost to defend a patent infringement lawsuit was $2,000,000 where the amount in dispute was under $10,000,000. And this only covers one lawsuit. When multiple customers are on the receiving end of patent litigation arising out of your products, the results can be devastating. To mitigate these risks, sophisticated manufacturers negotiate specialized intellectual property indemnity clauses with their customers.
An indemnity is insurance—an obligation by one party to make another party whole for a loss incurred. Much like an automobile insurance policy, which protects the policy holder from loss associated with theft or accident, indemnity protects the "insured"—the indemnitee—from covered losses. A typical indemnity is a private agreement between two parties in which the "insurer"—the indemnitor—promises to protect the indemnitee from losses sustained as a result of some specified act or omission.
In the intellectual property context, the manufacturer, seller or licensor of a product, technology or service will often agree to indemnify the buyer or licensee against any losses sustained by virtue of third-party claims for infringement of a patent, trademark or copyright. A well-drafted intellectual property indemnity clause will account for a number of issues unique to intellectual property law.
Define the Parties and Obligations
First, the indemnity should expressly identify the parties and the scope of claims covered by the provision. Ordinarily, the seller or licensor will indemnify the buyer or licensee. But you should also consider whether parents, subsidiaries, affiliates, officers, directors, employees and agents—as well as successors, heirs, and assigns—should be covered.
If a transaction allows for sublicensing or resale, consider whether those third parties will be indemnified. Also address whether—and when—the buyer will indemnify the seller, and if so, the circumstances that will trigger such an obligation. For example, it is common for a buyer to indemnify a seller when the buyer provides specifications for a product and those specifications are the subject of a subsequent lawsuit for infringement.
After the parties are clearly identified, you should identify the obligations of each party. A typical indemnity provision might provide that the seller agrees to: (1) indemnify; (2) defend; and (3) hold the buyer harmless from losses associated with certain claims. Each of these duties is unique. For example, the unchecked obligation to hold harmless might expose a manufacturer to liability for consequential damages suffered by the buyer, including lost profits. It is important to assess and negotiate each duty.
Define the Scope of Coverage and Liability
A well-drafted intellectual property indemnity provision expressly identifies the scope of covered intellectual property claims. For example, the Patent Act authorizes three varieties of patent infringement—direct infringement, inducing infringement and contributing to infringement. The Lanham Act and Copyright Act do not expressly authorize claims for inducing or contributing to infringement, although courts have held such claims exist. Claims for induced infringement require proof of knowledge and intent. Contributory infringement requires proof of knowledge. But indemnification for intentional or knowing acts is generally prohibited as contrary to public policy.
As a result, courts may be unwilling to enforce a claim for indemnification arising out of allegations of willful, induced or contributory infringement. An indemnitor's obligation to defend such claims, however, may not be prohibited—especially when a third party also alleges direct infringement.
When drafting indemnity provisions, specifically address these issues and, if necessary, create a framework for allocating defense costs associated with claims for direct, indirect and willful infringement.
Other important considerations that affect coverage and liability include:
- Limitations of use—Additional issues arise when a buyer or licensee combines or modifies a product or technology in a way that exposes the buyer to infringement claims. Sellers commonly attempt to mitigate this risk by specifically limiting liability associated with combinations and modifications and the parties' compliance or failure to comply with specifications or instructions for use.
- Limitations on liability—Sellers are increasingly seeking to offset at least a portion of litigation risk to buyers. To mitigate this risk, sellers often employ a variety of liability limitation techniques, including deductibles, liability caps, copayments and proportionate caps.
- Geographic limitations—You can use these to limit the field of intellectual property that can trigger a claim for indemnity and exclude coverage for claims arising outside the intended or expected area of use or sale. These are especially important when an agreement provides for indemnity of sub-licensees or downstream buyers/sellers.
- Multiple indemnitors—Patent infringement claims often implicate complex systems comprised of multiple, discrete products or technologies. Consider specifically addressing situations involving multiple indemnitors. For example, who controls the defense? Who controls settlement? How are defense costs, judgments, and settlements apportioned among the indemnitors—especially if one or more indemnitors refuse to pay? Acknowledging and addressing these issues before a dispute arises can help eliminate future conflict.
- Remedial measures—These provisions allow the seller to mitigate damages by providing non-infringing substitute goods or services that provide comparable functionality to the buyer. Remedial measures provisions generally benefit buyers and sellers.
- Pre-existing threats—Sellers can seek to exclude any pre-existing threats of litigation from coverage unless they are disclosed to the seller before the underlying agreement is executed.
- Choice of law—When drafting intellectual property indemnity provisions, be especially mindful of the implications of various states' laws. For example, some states may require an indemnified party to prove it would have been liable to a third party as a precondition to recover amounts paid in settlement without the consent of the indemnitor. Other states may only require proof that the settlement was reasonable under the circumstances. And some states may impose obligations to reimburse defense costs even in the absence of an express obligation to defend.
Define Procedures for Initiating and Resolving Claims
Effective intellectual property indemnity provisions clearly outline the roles and obligations of each party as well as the procedures for fulfilling the parties' obligations. They should:
- Provide for notice of a claim. Specify how and when the indemnitee is required to notify the indemnitor of a claim.
- Identify the controlling party. Where an indemnity provision includes an obligation to defend, specifically address which party will retain control of the defense.
- Identify parties that have settlement authority. Often the non-controlling party may require that the controlling party keep it fully informed of all settlement negotiations and potentially retain the option to participate in settlement discussions.
- Identify obligations to cooperate. A typical cooperation provision requires all parties to fully cooperate with the defense of litigation, providing assistance, authority, information and resources where applicable.
- Specify the timing for reimbursement. A seller will commonly seek a provision requiring reimbursement only upon actual payment of any damages or settlement amounts to a third party. Buyers, on the other hand, should seek reimbursement as their obligations, including defense costs, accrue.
A well-drafted intellectual property indemnity provision helps allocate the litigation risk of alleged infringement of IP rights. While no "magic words" are required, an effective IP indemnity provision will address the parties, their obligations, and the procedures for initiating and fulfilling those obligations. By addressing these issues during contract negotiations in a product manufacturer/customer relationship, both parties can minimize uncertainty and avoid the potential for conflicts and litigation.
Austin Champion is a partner with Griffith Bates Champion & Harper in Dallas, Texas, where he helps companies and individuals navigate complex business and intellectual property disputes. Austin can be reached at [email protected]