Providing a warranty of no patent infringement is like giving a hurricane-insurance policy

I’ve been helping a software company to negotiate a license agreement under which a Very Large Company customer would use my client’s software. The cus­tomer, of course, wants to use its own contract form.  Not un­usu­al­ly for cus­tomer paper, the Very Large Company’s contract form provides, among other things, that:

• The supplier warrants that its products — and the cus­tom­er’s use of the products — will not infringe any third party’s pat­ent; and
• The supplier will indemnify the customer against any third-party claims of patent infringement.

My client, the software-company supplier, wanted to know whether it could safely un­der­take this obligation for its software.

A warranty is essentially an insurance policy

I explained to the client that, whenever you sign a contract with a warranty or an indemnity obligation, in effect you’re giving that other party an insurance policy:  You prom­ise that, if Events X, Y, or Z should occur, then you will re­im­burse the other party for any (foreseeable?) resulting losses that it might suf­fer.  In fact, in­sur­ance policies often use the very word indem­ni­fy.

Someone else’s patent can be as destructive as a hurricane

One type of warranty and indemnity obligation should be of particular con­cern: A warranty that your product and its use won’t infringe someone else’s patent, and an obligation to indemnify the customer against third-party in­fringe­ment claims.  Agreeing to those things is not unlike giving the customer a hurricane-insurance pol­­i­cy, because:—

First: Both hurricanes (also known as typhoons or cyclones in some regions) and third-party patents can cause costly dam­­age and even destruction. As a famous example, in the 1980s Pola­roid successfully sued East­man Kodak for patent infringement, which essentially wiped out Kodak’s instant-camera business; as one of Polaroid’s lawyers later wrote in a history of the litigation, “Polaroid’s ultimate victory, as a result of which Kodak was forced to re­move its instant cameras and film from store shelves, and to pay almost $1 bil­lion in damages to Polaroid, stands as the most severe pun­ish­ment in the patent field ever meted out by a court of law.”

Second: For both storms and third-party patents, it’s an expensive prop­os­i­tion to find and assess potential threats.   To scan for hurri­canes, you need a weather-satellite net­work, and you almost certainly want to consult an ex­per­ienced meteor­ol­og­ist.  Like­wise, to scan for third-party patents, you need patent-search facilities, and you might very well want to consult an ex­per­i­enced pat­ent counsel.

Third:  You can never be sure that you’re free from threats. A third party’s pat­ent ap­pli­ca­­tion can re­main pend­­ing, and secret, for years, then suddenly make an expensive appearance on the scene.  It can be like the way that a dan­ger­ous storm might devel­op with surprising speed, or in surprising places; see, for ex­am­ple, 2001’s Trop­ic­al Storm Allison, which suddenly formed in the northern Gulf of Mex­i­co and caused devastating flood­ing in Houston and elsewhere.

A would-be warranting party should consider asking for a “policy limit” on its patent-indemnity liability

Insurance policies always include limits on how much money the insurance carrier will pay out if a covered event should occur. These limits are known colloquially as the “policy limits.”  Not so with many everyday business contracts:  In­dem­ni­ty ob­li­gations often en­tail potentially-unlimited liability. In fact, when a contract contains a lim­i­ta­tion of a party’s liability, the limitation language often expressly excludes any amounts that the party must pay under its in­dem­­ni­ty obligations.  That could subject the indemnifying party to enor­mous economic risk.

So when a customer asks a supplier to give an open-ended, unlimited war­ran­ty and indemnity against patent infringement, the supplier should seriously con­sider asking for economically-appropriate “policy limits.” (The policy limits might be in a different amount than other limitations of liability, as discussed in my post, Negotiating contractual limitations of liability: Do it risk by risk, not one-size-fits-all.)

The sweet spot: (a) A representation of no known patent infringe­ment, plus (b) a warranty with a limited indemnity obligation

As a negotiating stance, the customer is likely to argue: Aren’t you willing to stand behind your product? An appropriate supplier response might be: I’m certainly willing to represent that — so far as I know, and without having done any particular investigation — my product doesn’t infringe anyone else’s patent. But for what I’ll be charging you, I can’t afford to provide you with a no-limits insurance policy against an event that might be as devastating as a hurricane. 

If the customer insists on unlimited indemnity liability for patent infringement, the supplier could respond: Fine, but I’m going to have to hire a patent at­tor­ney to do a freedom-to-operate patent search and render an opinion; that will take time and it will be expensive, which means the price I quoted you will have to go up.  (Of course, the customer is likely to push back about a price increase, but at least the discussion will be about money, and the parties can make a business decision how much risk to take on.)

Footnote: Copyright- and trade-secret warranties are different

The risk analysis is somewhat different when a supplier is asked to warrant that its product (and/or its use as directed) does not infringe a third party’s copyright or trade secret.  In those cases, persuasive proof of independent creation will usually be a strong defense for both copyright and trade-secret claims — in contrast to the situation in patent law, where you can infringe a patent without even knowing it.

So if a supplier is rea­sonably comfortable that it can show that its people did their own work without copying from others, then the supplier might well be willing to give copyright- and trade-secret war­ran­ties, even without “policy limits” on the supplier’s indemnity obligation (although such limits would still be a good thing to ask for, of course).