Drafting Effective Intellectual Property Indemnity Provisions
With increased advocacy for broad fee-shifting reform in patent infringement litigation, companies often overlook one of the most significant fee-shifting mechanisms at their disposal—the indemnity provision. Indemnity is a powerful tool to offset risk of litigation arising out of intellectual property disputes. But the groundwork for recovering on an indemnity claim is laid well before litigation begins or is even anticipated. This article explores the origins of indemnity, the obligations imposed in typical indemnity provisions, and some of the critical issues that should be addressed when drafting intellectual property indemnity provisions.
Written by AUSTIN CHAMPION
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 where the "insurer"—the indemnitor—promises to protect the indemnitee from losses sustained as a result of some specified act or omission.
Parties to an agreement commonly negotiate indemnity provisions to shift risk associated with breaches in representations or warranties, failures to perform certain obligations, and liabilities arising from employee benefits, environmental claims, and taxes. While boilerplate indemnity provisions may apply to claims associated with a party's alleged infringement of intellectual property rights, sophisticated entities are increasingly negotiating customized indemnity provisions designed to address and accommodate the myriad issues that arise in intellectual property disputes.
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, which are discussed in more detail below.
II. SOURCES OF INDEMNIFICATION
An obligation to indemnify may arise from a contractual relation, an implied contractual relation, or out of liability imposed by law.[i] Where an agreement does not contain an express obligation to indemnify, state contract laws may apply.
A. UCC Warranty of Title Against Infringement
In the absence of an express indemnity provision, the UCC may provide some protection in intellectual property disputes. Enacted by virtually every state, Article 2, Section 312(3) of the Uniform Commercial Code provides:
"Unless otherwise agreed[,] a seller who 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 who furnishes specifications to the seller must hold the seller harmless against any such claim which arises out of compliance with the specifications."[ii]
The UCC warranty against infringement only arises with: (1) a sale or contract to sell; (2) where the seller is a merchant; and (3) the seller regularly deals with the goods of the kind in question. In addition, the claim for infringement must be a "rightful claim." A rightful claim must be a non-frivolous claim of infringement that has a significant and adverse effect, through the prospect of litigation or otherwise, on the buyer's ability to use the purchased goods.[iii] A rightful claim does not require a trial on the merits.[iv]
The UCC warranty against infringement only covers the goods themselves—not the buyer's use of the goods.
While the UCC can be helpful in the absence of an express indemnity, it has its limits. For example, the seller's warranty pertains to good title. A breach of the warranty is determined at the time of sale when title passes to the buyer. Accordingly, the warranty will not apply when a good infringes an intellectual property right after the sale is complete. In addition, the UCC cannot be applied to claims for induced or contributory infringement if the goods themselves do not directly infringe. The UCC also fails to adequately protect a buyer faced with allegations of infringing a business method patent. The UCC warranty against infringement only covers the goods themselves—not the buyer's use of the goods. Finally, the UCC warranty against infringement does not apply if the buyer provides a seller with specifications for the goods. Indeed, the UCC actually requires the buyer to indemnify the seller.
Sophisticated parties are encouraged to avoid the default provisions of the UCC. Express intellectual property indemnity provisions reduce uncertainty, allow both sides to assess the allocation of risk, and increase the likelihood of recovery from an indemnitor.
B. Contractual Indemnity Obligations
A contractual indemnity obligation is necessary when the parties involved in the purchase and sale of goods do not wish to be bound by the UCC or where the parties are involved in a transaction that would not be covered by the UCC. For example, parties to a license agreement are encouraged to negotiate express indemnity provisions because they are not buyers or sellers of goods. Likewise, where the seller is not a merchant, an express indemnity provision will be necessary.
Under a contract for indemnification, an indemnitor promises to hold the indemnitee harmless for loss or damage of some kind.[v] Generally, no particular language is required to support indemnification, and a written agreement can be established without specifically expressing the obligation as indemnification.[vi] An indemnification agreement is created when the words used express an intention by one party to reimburse or hold the other party harmless for any loss, damage, or liability.[vii]
III. DRAFTING INTELLECTUAL PROPERTY INDEMNITY PROVISIONS
Indemnity provisions are powerful tools for allocating risk among parties to an agreement. And while no "magic words" are required, an effective intellectual property indemnity provision will address the parties, their obligations, limitations on any such obligations, and the procedures for initiating and discharging their obligations.
A. Define Covered Parties and Obligations
1. Identify the Parties
An intellectual property indemnity provision 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. The parties 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, the parties should additionally consider whether such third parties will be indemnified. Finally, the parties should consider whether the buyer will indemnify the seller, and if so, the circumstances that will trigger such an obligation.
2. Identify the Obligations
A typical indemnity provision might provide that the seller agrees to indemnify, defend, and hold the buyer harmless from losses associated with certain claims. But the traditional boilerplate indemnity contains three distinct duties, which should be independently assessed and negotiated.
Indemnify / Hold Harmless. An indemnity is an obligation to reimburse the indemnified party for any loss incurred as a consequence of a party or third person. Like any contract, parties have great freedom to negotiate an indemnification obligation. The traditional rule of strict indemnity requires the indemnitor to reimburse only actual loss and not to discharge the liability of the indemnitee.[viii] An obligation to hold harmless, however, is a contractual arrangement whereby one party agrees to hold the other without responsibility for damages or liability arising out of a transaction or occurrence.[ix]
The distinction is minor, but it can be meaningful. Some courts have concluded the inclusion of "hold harmless" language is akin to a release—whereby the indemnitor agrees to indemnify the indemnitee's own negligence.[x] Additionally, a hold harmless provision places the indemnitee in the same position that it would have been absent a claim for infringement. Accordingly, a promise to hold another harmless may obligate the indemnitor to reimburse the indemnitee for lost profits and other consequential damages. Prudent counsel should address these concerns with language limiting liability to, perhaps, only the amounts finally awarded by a court or agreed to in settlement.
In addition, the distinction between an obligation to indemnify and an obligation to hold harmless may affect the timing of recovery for an indemnified party. In Texas, the duty to indemnify arises no earlier than the date judgment is entered against the indemnitee or a settlement is reached between the parties.[xi] But to determine the actual accrual date of an indemnity claim, courts look to the language in the indemnity provision.
In Texas, indemnity provisions fall under one of two categories: those that indemnify against liabilities and those that indemnify against damages.[xii] Liability indemnity agreements are broader and often include language holding the indemnitee "harmless" against "all claims" and "liabilities."[xiii] Under a liability indemnity agreement, the indemnitee's right to sue does not accrue until liability becomes fixed and certain, as by rendition of a judgment, whether or not the indemnitee has yet suffered actual damages (as by payment of a judgment).[xiv]
Damages indemnity agreements—or strict indemnity agreements—are not as broad. The right to sue does not accrue until the indemnitee has suffered damage or injury by being compelled to pay a judgment or debt.[xv]
Defend. The obligation to defend is an agreement to assume the defense of the indemnitee in the event the indemnitee is sued. The obligation to defend is typically triggered by the filing of a lawsuit asserting claims covered by the indemnity.
Under Texas law, an indemnitee may recover litigation expenses incurred defending a covered claim even if such expenses are not specifically addressed by the indemnity provision.[xvi] Texas courts have rationalized that if defense costs were not recoverable, the indemnitee would not be fully protected and saved harmless against the claims covered by the indemnity.[xvii] Because state laws vary, it is prudent to expressly address whether the indemnitor will be obligated to reimburse the indemnitee's defense costs.
Because state laws vary, it is prudent to expressly address whether the indemnitor will be obligated to reimburse the indemnitee's defense costs.
To determine whether a claim otherwise gives rise to the duty to defend, Texas courts utilize the "eight corners rule." Under this rule, the duty to defend is determined by the language of the policy—or contract—and a liberal interpretation of the allegations in the pleadings.[xviii] The cause of action alleged does not determine coverage; the facts giving rise to the alleged actionable conduct is determinative.[xix] Absent language to the contrary, the obligation to defend typically requires the indemnitor to defend immediately and defend completely—even if the underlying litigation includes claims that are not covered by the indemnity.
B. Define the Scope of Coverage and Liability
1. Limitations on Claim Scope
A well-drafted intellectual property indemnity provision will expressly identify the scope of covered intellectual property claims. For example, prudent counsel should specify that the provision applies to claims for infringement of any patent, trademark, or copyright. Claims related to trade secrets may be included, too. But what constitutes infringement?
The Patent Act authorizes three varieties of patent infringement—direct infringement, inducing infringement, and contributing to infringement.[xx] The Lanham Act and Copyright Act do not expressly authorize claims for inducing or contributing to infringement, although courts have held such claims exist.[xxi]
Indemnification for intentional or knowing acts are generally prohibited as contrary to public policy.[xxii] Claims for induced infringement require proof of knowledge and intent. Contributory infringement requires proof of knowledge. 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 where a third party also alleges direct infringement. When drafting indemnity provisions, counsel should consider expressly addressing these issues and, if necessary, creating a framework for allocating defense costs associated with claims for direct, indirect, and willful infringement.
2. Limitations on Use
Additional issues arise when a buyer or licensee combines or modifies a product or technology in a way that exposes the buyer to claims for infringement. Buyers often integrate products into larger systems, which they, in turn, use or sell to others. The component supplier or manufacturer may often be unaware of the eventual intended use of its products. Sellers commonly attempt to mitigate this risk by specifically limiting liability associated with combinations, modifications, and the parties' compliance or failure to comply with specifications.
For example, a seller may specify it will have no obligation to indemnify a buyer with respect to any claim based on: (1) adherence to specifications, designs, or instructions furnished by the buyer; (2) the combination, operation, or use of any purchased products with any other products, software, or data; (3) the alteration of any purchased products or modification of any software provided with the products; or (4) the buyer's use of any superseded or altered software if infringement would have been avoided by the use of subsequent unaltered software provided to the purchaser.
Because sellers may often anticipate specific uses and combinations of their products, buyers may likewise insist on a provision allowing for certain combinations of purchased products with products, systems, services, processes, or methods not furnished by the seller but only to the extent such combinations are normal or reasonably anticipated in product literature, instructions, specifications, or the like.
Finally, counsel should consider whether to address claims for infringement arising out of patents essential to an industry standard. Because infringement of certain essential patents may be unavoidable when selling products that comply with industry standards, sellers often desire to allocate the risk of litigation to the buyer.
3. Limitations on Liability
With the explosive growth of patent infringement litigation, sellers are increasingly seeking to offset at least a portion of risk to buyers. In addition, as buyers increasingly seek broad indemnification obligations with hold-harmless provisions, sellers are similarly facing increased risk of exposure to outsized loss from actual and consequential damages. To mitigate this risk, sellers often employ a variety of liability limitation techniques.
Deductibles. Much like a claim under an automobile or property insurance policy, a deductible—or floor—may discourage buyers from making claims for defense and indemnification in small disputes. Additionally, a properly sized deductible may offset all or a portion of the risk associated with "patent troll" litigation to buyers, reserving a seller's obligations to only the most serious matters.
Liability Caps. Liability caps limit liability per asserted claim of indemnification, in the aggregate, or both. Liability caps can address any aspect of a party's obligation to defend or indemnify another. Liability caps enable the seller to quantify its maximum exposure under an agreement, which may also enable the indemnitor to acquire insurance coverage or set aside reserves in anticipation of potential claims.
Co-Payments. A co-payment provision requires the buyer to pay a proportionate share of defense costs—as well as settlement amounts or judgments—as they accrue, forcing the indemnified party to consider—and bear—the consequences of continued litigation. Co-payments force buyers to have "skin in the game," which may encourage increased cooperation between the indemnitor and indemnitee. Increased cooperation may lead to a better result with less cost. A typical co-payment provision might require the buyer to contribute 10% of all defense and indemnity obligations.
Proportionate Caps. A proportionate cap limits the seller's total obligations to all, a portion, or some multiple of the amounts actually paid under the contract. For smaller licensors or sellers, a proportionate cap may be imperative, as it ties potential liability to the actual value received under the contract.
For smaller licensors or sellers, a proportionate cap may be imperative, as it ties potential liability to the actual value received under the contract.
Sellers may also seek provisions that reduce reimbursements by the amount of any insurance proceeds received by the buyer, any third party payments to the buyer, and any tax benefits received as a result of a judgment or settlement.
4. Geographic Limitations
Geographic limitations on indemnity limit the field of intellectual property that can trigger a claim for indemnity. Geographic limitations are especially important where an agreement provides for indemnity of sub-licensees or downstream buyers/sellers. A geographic limitation should exclude coverage for claims arising outside the intended or expected area of use or sale.
5. Additional Considerations
Multiple Indemnitors. A claim for patent infringement often implicates complex systems comprised of multiple, discrete products or technologies. Multiple indemnitors may be implicated as a result. Counsel should consider whether to specifically address situations involving multiple indemnitors. For example, who controls the defense? Who controls settlement? How are costs apportioned among the indemnitors—especially if one or more indemnitors refuse to pay? Acknowledging and addressing these issues before a dispute arises can eliminate future conflict.
Remedial Measures. A remedial measures provision allows 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. Sellers obtain the right to stop the sale of an allegedly infringing product, capping damages and potentially reducing the appeal of continued litigation. Buyers receive substitute goods of comparable functionality with minimal business interruption. And if litigation terminates quickly, all parties benefit.
Pre-existing Threats. Sellers should seek to exclude any pre-existing threats of litigation from coverage unless they are disclosed to the seller prior to execution of the underlying agreement.
Choice of Law. In drafting intellectual property indemnity provisions, parties should 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 as discussed above, some states may impose obligations to reimburse defense costs even in the absence of an express obligation to defend.
C. 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.
1. Providing Notice of a Claim
Every indemnity provision should include a notice requirement, which requires the indemnitee to notify the indemnitor of a claim for indemnification. The notice requirement should specifically outline the type of claim that gives rise to an obligation to indemnify as well as the procedural requirements for informing the indemnitor of the claim.
Sellers typically insist on a prompt notice provision, which requires the buyer to notify the seller of a claim within a specific period of time after becoming aware of the claim. Typically, the failure to provide prompt notice will not relieve the seller of its obligation to indemnify the buyer unless the failure to provide prompt notice materially prejudices the buyer. Material prejudice could arise, for example, when the buyer fails to raise certain counterclaims or defenses or fails to seek certain time-sensitive remedies (such as an inter partes review or stay of litigation) prior to providing notice to the seller. Some sellers may seek an express provision relieving them of any obligation to indemnify where notice is not provided promptly, regardless of prejudice. Sellers may also exclude any obligation to reimburse a buyer for defense costs incurred prior to providing the seller with notice of a claim.
Parties should additionally require notice to be in writing and directed to a designated individual or department. The notice provision should require the buyer to provide information sufficient to assess the claim for indemnification, including, for example, copies of the complaint, infringement contentions, and other publicly available case materials.
Regardless of who controls the defense, the indemnity provision should require the controlling party to select competent and conflict-free counsel.
2. Identify the Controlling Party
Where an indemnity provision includes an obligation to defend, the parties should also expressly address which party will retain control of the defense. Typically, a large or sophisticated seller will desire to retain control in litigation. Often, plaintiffs in patent litigation will sue downstream sellers of allegedly infringing goods in an effort to seek increased damages through, for example, higher royalty rates and allegations of convoyed or derivative sales. A seller may be highly motivated to invalidate the patent or develop global noninfringement defenses that account for future or co-pending litigation with other indemnitees. Conversely, a single buyer may lack motivation to pursue certain onerous defense strategies, especially where it lacks any "skin in the game." By retaining control, the seller can best coordinate a global defense strategy and mitigate damages arising from multiple suits.
On the other hand, sophisticated buyers often purchase numerous products and services from multiple large and small companies, often combining them into complex systems, which may be susceptible to claims for infringement. Any one supplier may lack the capacity or motivation to coordinate a comprehensive defense for the buyer. Additionally, the buyer may question whether any one seller is capable of fully representing its interests in litigation—especially where litigation implicates a core business component of the buyer. Where multiple indemnitors have been implicated in litigation, it is often practical for the buyer to retain control and apportion its defense costs and any amounts paid in settlement or satisfaction of a judgment among the various indemnitors. For example, the indemnitee may seek the option to apportion costs based on an internal market share approach, which accounts for the relative contribution of each indemnitor to the overall claim for infringement.
Regardless of who controls the defense, the indemnity provision should require the controlling party to select competent and conflict-free counsel. Additionally, the controlling party should take all reasonable steps to investigate, defend, and resolve the claim. Finally, the non-controlling party should be required to fully cooperate with the controlling party.
3. Identify Parties with Settlement Authority
The party controlling the defense of a claim generally retains the right to settle the claim. In some cases, however, a settlement could adversely affect the interest of the non-controlling party. For example, a settlement that includes an agreed injunction against future sales of a product could be detrimental to a manufacturer or buyer, especially if an ongoing royalty is a viable alternative.
To account for potential conflict arising out of settlement, parties often negotiate consent provisions. For example, the controlling party may have authority to settle any claims subject to the consent of the non-controlling party, such consent not to be unreasonably withheld. Because the indemnitor ultimately bears the burden of payment, the parties may require additional limitations when the indemnitee controls the defense. For example, a controlling indemnitee may not settle absent the express written consent of the indemnitor, such consent not to be unreasonably withheld. Where one party objects to settlement, the parties may desire a provision addressing whether the objecting party is obligated to contribute to any additional defense costs or amounts paid in settlement or satisfaction of a judgment above and beyond those amounts accrued up to the point of reaching the objectionable settlement agreement. Finally, the non-controlling party may require the controlling party keep it fully informed of all settlement negotiations and potentially retain the option to participate in settlement discussions if desirable.
4. Identify Obligations to Cooperate
A cooperation provision ensures the controlling party's efforts to defend litigation are not undermined by others. A typical cooperation provision requires all parties to fully cooperate with the defense of litigation, providing assistance, authority, information, and resources where applicable. A buyer may resist onerous cooperation provisions—especially where an alleged failure to cooperate could relieve the seller of its obligations to defend and indemnify.
5. Specify Timing for Reimbursement
Reimbursement provisions specify the timing and method of reimbursing the indemnitee. A seller will commonly seek a provision requiring reimbursement only upon actual payment of any damages or settlement amounts to a third party. A seller will likewise insist on reimbursing any defense costs at the completion of litigation, including any appeals. Conversely, a buyer should seek reimbursement of defense costs as they accrue. Buyers may also desire the indemnitor to pay any damages or settlement amounts directly to the third party. Finally, both parties should address whether the indemnitor is obligated to reimburse the indemnitee for consequential or incidental damages arising out of the litigation.
A well-drafted intellectual property indemnity provision is an excellent tool to allocate the risk of litigation arising out of the alleged infringement of intellectual property rights. By addressing issues unique to intellectual property law during contract negotiations, both parties can minimize uncertainty and avoid the potential for conflicts should litigation arise.
[i] Bush v. City of Laurel, 215 So. 2d 256, 259 (Miss. 1968).
[ii] U.C.C. § 2-312(3) (2012).
[iii] Pac. Sunwear of Cal., Inc. v. Olaes Enters., Inc., 84 Cal. Rptr. 3d 182, 194 (Cal. Ct. App. 2008).
[iv] Phoenix Solutions, Inc. v. Sony Electronics, Inc., 637 F. Supp. 2d 683, 696 (N.D. Cal. 2009).
[v] McNally & Nimergood v. Neumann-Kiewit Constructors, Inc., 648 N.W.2d 564, 570 (Iowa 2002).
[viii] Hernandez v. Great Am. Ins. Co. of New York, 464 S.W.2d 91, 93 (Tex. 1971).
[ix] Amoco Canada Petroleum Co., Ltd. v. Wild Well Control, Inc., 889 F.2d 585, 587 (5th Cir. 1989).
[x] Bonner County v. Panhandle Rodeo Ass'n, Inc., 620 P.2d 1102, 1105 (Idaho 1980).
[xi] Smith Int'l, Inc. v. Egle Group, LLC, 490 F.3d 380, 388 (5th Cir. 2007) (applying Texas law).
[xiv] Id. at 389.
[xvi] Tubb v. Bartlett, 862 S.W.2d 740, 751 (Tex. App.—El Paso 1993, writ denied).
[xviii] Am. States Ins. Co. v. Bailey, 133 F.3d 363, 369 (5th Cir. 1998) (applying Texas law).
[xx] 35 U.S.C. § 271 (West 2014).
[xxi] E.g., Gucci Am., Inc. v. Frontline Processing Corp., 721 F. Supp. 2d 228, 248 (S.D.N.Y. 2010) (discussing induced trademark infringement); Columbia Pictures Inds., Inc. v. Fung, 710 F.3d 1020, 1032 (9th Cir. 2013) (discussing induced copyright infringement).
[xxii] City of Montgomery v. JYD Intern., Inc., 534 So. 2d 592, 594 (Ala. 1988) ("Agreements that purport to indemnify another for the other's intentional conduct are void as a matter of public policy").