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.
Table of contents
- A warranty is essentially an insurance policy
- Someone else’s patent can be as destructive as a hurricane
- A would-be warranting party should consider asking for a “policy limit” on its patent-indemnity liability
- The sweet spot: (a) A representation of no known patent infringement, plus (b) a warranty with a limited indemnity obligation
- Footnote: Copyright- and trade-secret warranties are different
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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).