IP Indemnity in Supply Contracts: Common Vexing Problems
Indemnity in Supply Contracts
Purchasers and distributors of products and software usually expect some form of protection against intellectual property infringement claims. This protection can flow from either the Uniform Commercial Code (UCC) or contract. This article addresses some of the common issues that arise when intellectual property infringement protection flows from either the UCC or contract.
UCC Default Intellectual Property Indemnity
UCC § 2-312(3) creates a default indemnity for purchasers of goods from merchants. Section 2-312(3) of the UCC provides that:
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 … .
However, Section 2-312(3) has a number of problems. First, Section 2-312(3) only provides an indemnity, not an obligation to defend or hold the purchaser harmless from these claims. While a purchaser may in some instances prefer to defend and seek indemnity from the supplier, in many instances the purchaser would rather have the supplier accept the obligation to defend the claim for infringement from the outset without the purchaser having to defend in the first instance and seek indemnity from the supplier after the fact.
Second, this provision leaves open what happens in the instance where the claim is of dubious merit (e.g., whether it is a “rightful” claim). A supplier may take the position that its indemnity obligation only extends to indemnify for infringement claims that are actually found to be true by a court by a decision that is final (e.g., gone through the entire appeal process). We have found that suppliers may be reluctant to indemnify purchasers when the infringement claim is of dubious merit causing the purchaser to have to undertake the defense, and later sue the supplier to seek indemnity. As a result, a purchaser may have to seek a remedy in court from the supplier which can be costly and time consuming. Further, a purchaser runs the risk that the second court may not agree that the supplier has an obligation to indemnify.
Third, while courts have held that software may qualify as a good under the Uniform Commercial Code (UCC), additional analysis is required to determine whether the software at issue is a good covered by the UCC. Whether software qualifies as a good turns on a number of issues including how the software is licensed, whether the software is off the shelf or customized, and the terms of payment for the software license.
Finally, Section 2-312(3) does not address the situation where the supplier’s product or software alone does not infringe a third party’s intellectual property (such as a patent), but rather the product together with another product performs all the elements of a patent claim. A typical example of this is a patent claim that requires an end user device and a system device to infringe. The problem arises when the purchaser purchases the end user device and the system components from different suppliers. We have had clients where this exact situation arises and both suppliers refuse to defend or indemnify because each supplier claims that its equipment only performs some (and not all) of the elements of the patent claim. This squarely puts the onus on the purchaser to have to defend and pay any intellectual property infringement damages without any clear remedy against either supplier. This can be costly and can lead to anomalous results – such as a court finding that neither supplier is responsible.
Enter the Supplier Contract Intellectual Property Provision
In order to address some of the shortcomings of the UCC default intellectual property, purchasers can utilize a contractual intellectual property indemnity provision which is intended to supersede (or at least supplement) the UCC default intellectual property indemnity. A typical intellectual property indemnity provision for the sale of hardware proffered by a supplier is as follows:
Supplier will defend, indemnify and hold the Purchaser harmless from and against any claim, suit or proceeding brought against Purchaser to the extent it is based upon a claim that the Product infringes upon any United States patent, copyright or trade secret of any third party. Purchaser agrees that it shall promptly notify Supplier in writing of any such claim or action. Supplier shall have the sole right to control the defense of any such claim or action and the sole right to settle or compromise any such claim or action. If Product is, or in Supplier’s opinion may be, held to infringe, Supplier may, at its option, replace or modify such Product so as to avoid infringement, or procure the right for Purchaser to continue the use of such Product. If neither of such alternatives is, in Supplier’s opinion, commercially reasonable, the infringing Product shall be returned to Supplier and Supplier’s sole liability, in addition to its obligation to reimburse awarded damages, costs and expenses set forth above, shall be a credit to Purchaser the amount paid to Supplier by Purchaser under this Agreement, as depreciated on a straight line five (5) year basis. Supplier will have no liability for any claim of infringement arising as a result of (a) installation or use of Products on, in or with products or software not provided or approved by Supplier; (b) modification or change of the Product by other than Supplier or its subcontractors or agents; (c) the Product being used in a manner not in accordance with Supplier recommended operating instructions or installation environment; or (d) interconnection to, combination with, or connection of, the Product to equipment not provided or approved by Supplier. THE FOREGOING STATES THE ENTIRE LIABILITY OF SUPPLIER TO PURCHASER CONCERNING INFRINGEMENT OF INTELLECTUAL PROPERTY RIGHTS, INCLUDING, BUT NOT LIMITED TO, PATENT, COPYRIGHT AND TRADE SECRET RIGHTS.
A contractual provision such as the foregoing is a significant improvement over the default intellectual property indemnity provided by the UCC. First, it includes the obligation to defend the Purchaser against intellectual property claims, not just indemnify the Purchaser after the fact. Second, it includes an orderly process by which the Supplier will undertake the defense provided the Purchaser provides notice. Finally, it addresses what happens if the product or software is found to infringe.
This typical provision, however, has a number of significant flaws. First, a typical provision might limit the protection to certain geographical areas – such as the U.S. If the Product is being used or sold in a different jurisdiction, the Purchaser would have no protection. Second, the typical contractual indemnity provision (such as the one above) has a number of carve-outs which can pose the same challenges to a Purchaser as the default UCC provision. For example, a typical carve-out will limit protection only to independent use of the Product. Therefore, if the Product normally is used in combination with other products, the carve-out clause (a) above would relieve the Supplier completely of liability. Further, if the Product is not being used as anticipated by the Supplier, the Supplier could be relieved of liability (if the anticipated use would not infringe). In addition, if the Purchaser is planning to modify the Product in any way, the Supplier will be completely off the hook for any claimed intellectual property infringement. Third, the typical provision will limit the amount of money that a Purchaser will be reimbursed if the Product or software needs to be returned. The typical provision will limit the reimbursement to the depreciated value of the equipment. This can pose a huge issue for a Purchaser if they are using this product or software in connection with other products or software to make a system. For example, if the product is a key component of a larger system put together by the Purchaser or software that runs on another piece of equipment for either use or sale to third parties, this could cause the larger system to be unusable with the Supplier only having to reimburse for the depreciated value of the component. The loss of value of a Product does not necessarily follow a depreciation straight line schedule.
Two additional points. Almost all contracts provided by suppliers also include a boilerplate exclusion of all implied warranties and a limitation of liability and/or limitation of remedies. These two provisions can severely limit protection from intellectual property infringement actions. First, the boilerplate waiver excludes the non-infringement warranty provided by UCC 2-312(3) discussed above. Moreover, the boilerplate waiver also excludes the implied warranty for a purchaser’s intended purpose. Coupled with a typical boilerplate entire agreement provision, without more, a purchaser can find that even stated uses of a product or software are excluded from any intellectual property infringement protection. Second, without a carve-out from a limitation of liability and a limitation of remedies, any infringement indemnity may be limited. Both of these typical provisions will need to be carefully studied to make sure that they are limited as to the UCC 2-312(3) non-infringement warranty and the indemnity excluded from a limitation of liability and limitation of remedy provisions.
The Solution
The solution to these problems is to use an intellectual property indemnity provision which takes into account these short comings, including that a product or software may be part of a larger system and thus provide indemnity and defense apportioned among and between various suppliers. The ideal provision would anticipate that a Product could infringe as part of a larger system and create a systematic way to address the relative faults of various suppliers in an intellectual infringement case. An intellectual property infringement indemnity also should take into account what the equipment or software is being used for. If the equipment or software is to be part of a process or system that includes other equipment and software, the indemnity should anticipate that use. In addition, the ideal provision would also anticipate the actual use of the equipment or software – especially if the equipment or software is being used in a way that is different than what the manufacturer or licensor anticipates. Finally, a supply contract should if possible include a warranty that the product or software does not infringe any third party rights and the supplier has no knowledge of any such claims.
Key Takeways
The following are key intellectual property issues that should be addressed in any agreement for equipment or software:
The agreement should include an intellectual property infringement indemnity which includes not only an indemnity and hold harmless clause but also a defense obligation on the part of the manufacturer/licensor
Any limitation of liability should include a carve-out for the intellectual property infringement indemnity
Any waiver of implied warranties should not include the UCC non-infringement warranty and the implied warranty of fitness for intended purpose
If possible, the agreement should include a warranty that the manufacturer/licensor: (a) has good, marketable (and licensable) title to the equipment/software, and (b) is unaware of any claim that the equipment or software is subject to any claim by a third party that it infringes their intellectual property rights
Any combination carve-out should anticipate the actual use the equipment or software is being used for and should address if the equipment or software is being combined with other equipment or software and the combination infringes how the parties will defend the claim
The indemnity should address the possibility that the product or software may infringe when used in combination with other products and software
Sample Contractual Provisions
Intellectual Property Warranty.
Supplier represents and warrants to Purchaser that: (a) there are no lawsuits pending that allege that the products and/or software covered by this Agreement infringe upon the intellectual property rights of any third party ("Third Party IP Right"); and (b) to the best of Supplier's knowledge, there is no demand or threatened suit or claim against Supplier by any third party alleging violation or infringement of a Third Party IP Right related to the products and/or software covered by this Agreement. This warranty shall survive the expiration or termination of this Agreement.
Intellectual Property Indemnity.
(a) Supplier will defend, indemnify and hold the Purchaser harmless from and against any claim, suit or proceeding brought against Purchaser to the extent it is based upon a claim that the product or software covered by this Agreement infringes upon any intellectual property rights of any third party, including any patent, copyright or trade secret of any third party. Purchaser agrees that it shall promptly notify Supplier in writing of any such claim or action and give Supplier full information and assistance in connection therewith. Supplier shall have the sole right to control the defense of any such claim or action and the sole right to settle or compromise any such claim or action. If the product or software covered by this Agreement is, or in Supplier’s opinion may be, held to infringe, Supplier may, at its option, replace or modify such product or software so as to avoid infringement, or procure the right for Purchaser to continue the use of such product or software. If neither of such alternatives is, in Supplier’s opinion, commercially reasonable given the use to which Purchaser has put such product or software, the infringing product or software shall be returned to Supplier and Supplier’s liability, in addition to its obligation to reimburse awarded damages, costs and expenses set forth above, shall be a credit to Purchaser the amount paid to Supplier by Purchaser under this Agreement plus any amounts to replace other equipment or software which is used in conjunction, or combined with, such product or software.
(b) Supplier will have no liability for any claim of infringement arising as a result of (i) installation or use of Products on, in or with products or software not provided or approved or anticipated by Supplier; (ii) modification or change of the Product by other than Supplier or its subcontractors or agents, or otherwise authorized by Supplier; or (iii) the Product being used in a manner not in accordance with Supplier recommended operating instructions or installation environment; provided, however, that notwithstanding the foregoing Supplier will be liable for any claims of infringement which arise out of, are in connection with, or result from use of the products or software by Purchaser as marketed or sold by Supplier or as intended by Purchaser.
(c) Notwithstanding anything contained herein to the contrary, if a third party claims that the product or software covered by this Agreement together with other products or software used in conjunction with the products or software covered by this Agreement infringes upon any intellectual property rights of such third party, including any patent, copyright or trade secret of such third party (“Combination Claim”), Supplier shall be responsible for providing a joint defense of such Combination Claim with the suppliers of the other products or software related to such Combination Claim, and Supplier shall indemnity and hold Purchaser harmless against such Combination Claim to the extent Supplier’s products or software contributes to such Combination Claim as determined by the Purchaser in its reasonable discretion. If Supplier or the other suppliers of products and software part of a Combination Claim refuse to provide a defense of a Combination Claim, Purchaser may defend against such Combination Claim but Supplier shall pay a portion of the defense costs, including attorneys fees, expert fees, court costs and costs of appeal, equal to the extent Supplier’s products or software contributes to such Combination Claim as determined by Purchaser in its reasonable discretion.
(d) THE FOREGOING STATES THE ENTIRE LIABILITY OF SUPPLIER TO PURCHASER CONCERNING INFRINGEMENT OF INTELLECTUAL PROPERTY RIGHTS, INCLUDING, BUT NOT LIMITED TO, PATENT, COPYRIGHT AND TRADE SECRET RIGHTS.
For more information about supply contracts, see our Corporate Law & Commercial Transactions Legal Services and Industry Focused Legal Solutions pages.
This article has been provided for informational purposes only and is not intended and should not be construed to constitute legal advice. Please consult your attorneys in connection with any fact-specific situation under federal law and the applicable state or local laws that may impose additional obligations on you and your company. © 2023 Klemchuk PLLC