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Licensing of Intellectual Property
Jay Dratler, Jr.
Copyright © 1994, 1995, 1996, 1997, 1998, 1999, 2000, 2001 NLP IP Company
Law Journal Press, a division of American Lawyer Media, Inc., New York,
New York
Chapter 10. Allocating the Risks of Infringement s 10.02 RISKS OF THIRD-PARTY INFRINGEMENT CLAIMS AGAINST
LICENSEES
Once a licensing agreement has been consummated, the licensee would like to have the absolute right to use the licensed intellectual property in accordance with the terms of the agreement. Yet reality may intervene. Unbeknownst to the parties to the license, a third party may have prior rights in the licensed subject matter. Another possibility--although this occurs less commonly-- is that the licensor may have purported to grant a license that it did not in fact have the legal right to grant. In either case, a third party may claim rights in the licensed intellectual property superior to those of licensor or licensee. Based on that claim, the third party may sue the licensee for infringement solely for exercising purported rights under the licensing agreement.
Third-party claims of this sort can arise in virtually every licensing arrangement, whether it involves patents, copyright, trademarks, trade secrets, mask works, or some other form of intellectual property. Whatever the kind of intellectual property licensed, a third party may claim that it, rather than the licensor or its privies, rightfully owns that intellectual property, and therefore that the license in unavailing.
The problem of conflicting patent rights arises most often. If a license includes technology, whether or not patented, a third party may claim that the licensee's use of that technology infringes a patent held by the third party. The asserted patent may be a
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726947806 dominant patent, of which the licensed patent represents an improvement, or simply an independent patent whose existence was unknown at the time the license agreement was made. The third party may sue the licensee for infringing a copyright in an underlying work of which the licensed material is claimed to be a derivative work. Similarly, the third party may claim that a licensed trade secret was misappropriated from it, or that a licensed mask work was copied from its own design.
Licensees try to protect themselves against the risk of claims of this sort by asking licensors for warranties of noninfringement. They may also ask the licensor to agree, at its expense, to indemnify or defend the licensee against those claims. This sort of warranty or covenant to indemnify or defend is generally enforceable, subject to certain rules of interpretation.
Contractual obligations to defend and indemnify a licensee also may have certain legal consequences. As a matter of procedure, their existence may affect the right to intervene, the presence of personal jurisdiction or declaratory judgment jurisdiction, the right to sever and transfer claims to another forum, and the binding effect of prior judgments
(i.e., the doctrines of res judicata and collateral estoppel). As a matter of substance, the existence of an indemnity may increase the risk of a court finding that infringement was induced or was willful (thereby justifying the augmentation of damages and/or liability for attorneys' fees), or that the license agreement is an executory contract subject to rejection by a party as debtor in bankruptcy. Thus the mere use of warranties and indemnities against intellectual property infringement entails certain legal risks, wholly apart from the commercial and monetary risk against which they are designed to protect.
Yet the damages--not to mention attorneys' fees--in intellectual property litigation can be very high. Accordingly, these legal risks seldom influence the decision whether or not to use warranties or indemnities, although they may influence their structuring and drafting.
[1]--The Risk of Infringement of Third-Parties' Rights
From a licensee's point of view, a third party's claim of infringement or misappropriation is an unwanted and unexpected intrusion. Even if the claim is frivolous, it may require considerable time, inconvenience, trouble and money to resolve. United
States law offers several different means of protection against frivolous claims, but none
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726947806 in practice is fully effective. In federal court, Rule 11 of the Federal Rules of Civil
Procedure purports to protect all litigants against frivolous claims, and Rule 38 of the
Federal Rules of Appellate Procedure seeks the same end on appeal. In patent, copyright, semiconductor chip, trademark, and trade secret cases, frivolousness may be a factor in deciding whether a court should require an unsuccessful plaintiff to pay the victorious defendant's attorneys' fees. Finally, if the infringement suit was in bad faith, its frivolousness may support an antitrust counterclaim for monopolization or attempting to monopolize a defined market under Section 2 of the Sherman Act.
In practice, however, these measures for fighting frivolous claims have significant disadvantages. The antitrust laws and the court rules require the party asserting frivolity to bear a heavy burden of proof. Although the standard of proof for recovering attorneys' fees under the intellectual property statutes is not so high, the uncertainty of outcome is great because the outcome is generally committed to the trial court's discretion. As a result, either a high burden of proof or substantial uncertainty, or both, face a defendant in an infringement suit who hopes to recover her legal fees and expenses. For these reasons, even frivolous claims of infringement--let alone substantial or meritorious ones-create significant risk, uncertainty and inconvenience for licensees.
In any event, licensees seek protection not only against winning claims, but against all third-party claims of infringement or misappropriation relating to the licensed subject matter. That is, they would like to be free to use the licensed intellectual property in accordance with the terms of their license agreements, without fear of interference from third parties, liability to them, or the necessity of defending infringement actions, however weak the claims asserted. In essence, licensees crave the same sort of protection that a full warranty deed with a guarantee of quiet enjoyment provides a purchaser of real property.
In the field of intellectual property, however, such complete protection may not be reasonable or appropriate. The protection of a full warranty deed in a sale of real property is justified in part by the operation of land title recording systems, which require all legal instruments affecting title to real property to be available for public inspection and copying as recorded documents in centralized, public files. Simply by reviewing the recorded documents, parties to a prospective grant relating to real property should be able to determine whether any third-party claim is likely to have reasonable foundation. The grantor thereby can gain the confidence necessary to provide a full warranty. Moreover,
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726947806 since real property also has tangible substance, a grantor may even assess the risk of unrecorded claims, such as prescriptive easements and adverse possession, by inspecting the property visually and having a survey made.
Determining the state of title to intellectual property, however, is not so easy. The difference is most apparent in the field of patents, in part because the precise metes and bounds of a patent's claims are normally uncertain. Determining the scope of patent claims requires not only construing the claims themselves in light of complex patent specifications and the patent's prosecution history --which may require the assistance of expert testimony --but also applying the elusive doctrine of equivalents.
More important, unlike land office records, the records of intellectual property offices do not always reveal all potential conflicts, even in theory. There is often an irreducible amount of unknown and inherently unknowable risk, which varies with the type of intellectual property at issue. The following subsections discuss this risk and its uncertainty in the major fields of intellectual property law.
[a]--Patents
Patents held by third parties create the highest level of unknown and inherently unknowable risk of unintended infringement of third parties' rights. There are two reasons for this. First, unlike other major forms of intellectual property, patents protect against independent creation of the same subject matter. Therefore, a licensee of technology, whether or not patented, may infringe a third party's controlling patent by practicing the licensed technology, even if the licensor developed the technology independently of the owner of the asserted patent or acquired it from someone who did so.
The scope and extent of a rival patentee's prior rights depend on how the claims in the patent are interpreted in light of their language, the patent specification, the patent's prosecution history, and expert testimony, as well as upon application of the elusive doctrine of equivalents. These points are always matters of judgment, often subject to considerable uncertainty. It is therefore impossible to know with the precision of a land survey exactly what technologies a rival's patent may encompass.
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A party to a patent license may reduce the level of this uncertainty by securing an infringement opinion from competent counsel. Even in theory, however, he cannot control the risk of infringing the claims of pending patent applications, for pending applications create an inherently unknowable risk of unwitting infringement. They exemplify the uncertainty of patent licensing and demonstrate the inaptness of any analogy between land office records and the public files of domestic and foreign patent offices.
Pending patent applications, both at home and abroad, create unknowable risks of unwitting infringement. In the United States, they are kept secret by statute.
Consequently, parties to a license may have no warning of the sudden issuance of a patent that controls the licensed technology. Abroad, pending national and international applications are generally published within eighteen months after the application or priority date. Yet many foreign patent laws give the inventor the right to be compensated for unauthorized practice of the invention after publication of the patent application but before issuance of the patent, as long as the patent eventually does issue. As a result, the effect of publication abroad is much the same as that of issuance in the United States: a sudden and intrinsically unforeseeable increase in the risk of monetary liability for patent infringement.
Moreover, by virtue of the priority provisions of international conventions to which the
United States is party, pending applications in foreign or international patent offices may have priority for purposes of patent novelty over the licensed technology. If unpublished, they are likely to be unknown to the parties to the license agreement at the time it is concluded, notwithstanding their priority for patent purposes. They therefore may mature without warning into dominant patents controlling the licensed technology.
Inside the United States, the first-to-invent rule creates an additional risk of inherently unknowable conflict. If pursued with reasonable diligence, a rival inventor's unknown and unsuspected conception of a dominant invention may ripen into superior patent rights even though there is no record of the invention in any patent office at all. For all of these reasons, a patent licensee who has no contractual protection by way of warranty or indemnity generally undertakes an unknown and inherently unknowable risk of infringing superior rights of third parties.
In some cases, fairness may suggest that the licensor share or assume this risk. For
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726947806 example, the licensed patent may lie in a field of research in which the licensor has long been a leading player, and the licensee may be a start-up company or newcomer to that field. Then the licensor ought to have some knowledge--or at least more knowledge than the licensee--of both domestic and foreign developments that might cause unforeseen conflict. Under these circumstances it is reasonable for the licensor to provide the licensee some comfort in the form of a warranty, indemnity, or agreement to defend against possible third-party suits for infringement.
On the other hand, the licensed patent may be a serendipitous development in an offshoot technology, which is not a significant part of the licensor's business, or the licensor may simply be an upstream party in a long chain of licenses and sublicenses. Under these circumstances, the licensor may know little more than the licensee about the patented technology and the risks of infringing third parties' rights. In that case, the licensor might reasonably limit its contractual obligations to known infringement risks, i.e., it might warrant only that the licensed subject matter is free from infringement of third parties' rights "to the best of its knowledge and belief."
In general, however, patent licenses must allocate a degree of risk for which neither party can fully be held responsible, because the risks of patent infringement are inherently unknowable. Where the licensor is fairly chargeable with greater knowledge of potential, if unknown, infringement risks, or where the licensee simply has enough bargaining power under the circumstances, the licensee may insist upon a full warranty and indemnity with respect to potential third-party claims of infringement. If accompanied by a covenant to defend the licensee against such claims at the licensor's expense, the contractual provisions may resemble an insurance policy, under which the licensor is responsible not only for making the licensee whole in the event any damages are assessed, but also for defending the licensee from third parties' claims of infringement and paying ongoing legal expenses as incurred. While the negotiation and drafting of these clauses is generally a matter of freedom of contract, their enforcement and interpretation are subject to certain rules applicable to warranties and indemnities generally.
[b]--Trademarks
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Trademarks are similar to patents in that certain risks of unwitting infringement are inherent and irreducible. Although independent creation of a trademark is one of several factors bearing upon the likelihood of confusion with conflicting marks, and therefore upon infringement, it does not by itself avoid infringement where likelihood of confusion exists. Moreover, in the United States, common-law rights in trademarks still derive from use in commerce, even without registration. Prior trademark rights based upon use may be undiscoverable, even in comprehensive searches of trademark registries. For example, a business that uses a trade name or trademark locally or regionally without either state or federal registration may have common-law rights in the locality or region at issue, which supersede the rights of federal registrants based upon later applications for registration, as well as the common-law rights of later users. Not knowing of such
"hidden" prior use, a trademark licensee might unwittingly infringe a prior user's rights by using the licensed mark in the prior user's locality or region under the license.
Thus, the structure of trademark law in the United States creates risks of unwitting infringement similar to, although perhaps less severe than, those created by the patent system. The rights of use in trademark law are analogous to the hidden rights of a prior inventor who has not yet filed for a patent but, under the first-to-invent rule, will receive priority upon doing so. These risks only augment the considerable factual and legal uncertainty in applying the standard for infringement in trade symbol cases.
As in the case of patents, the risk of unwitting infringement has the potential for causing a licensee significant financial loss. An injunction based upon a third-party's unsuspected prior rights, for example, might require the licensee to cease using the licensed trademark, either in a designated area or altogether. It therefore might force the licensee to incur the expense of changing its trademark and developing new goodwill for a new mark, perhaps on an emergency basis. If the licensee already had built up substantial goodwill for its products or services under the licensed mark, the expense and loss of goodwill in changing the mark could be substantial. In order to reduce these risks and the related burden of disposing of third-party claims, a trademark licensee, like a patent licensee, ordinarily seeks a warranty, indemnity, or covenant to defend it against third-party claims of infringement.
Yet for several reasons the risks of unwitting infringement of third-party rights are not as acute for trademarks as they are for patents. First, unlike pending patent applications, trade symbols subject to pending applications for registration are neither unpublished nor
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726947806 kept secret. In the United States essential information from applications for registration of trademarks is made available in the public search room of the Patent and Trademark
Office in Washington, D.C. shortly after the applications are filed. As a result, diligent searches of public records should provide a much better idea of the risks of infringing third-party rights in trademark than in patent cases. Moreover, the Trademark Law
Revision Act of 1988 in time should enhance the exhaustiveness of public trademark records by encouraging earlier application for registration based on each owner's intent to use a registrable mark. Second, under United States trademark law, the standard for proving damages arising out of trademark infringement is stricter than the standard for claiming injunctive relief. Therefore an unwitting trademark infringer is less likely to be liable for substantial damages than an unwitting patent infringer. Finally, as a practical matter, unwitting trademark infringement is less likely in general than unwitting patent infringement simply because trademarks are by nature used openly and are therefore publicly known. A trademark licensee familiar with the industry in which it intends to use the licensed mark is likely to be aware of its competitors' trademarks and hence of any potential trademark conflicts. Indeed, the more widely a competitor's marks are used, and therefore the greater the risk of liability, the more likely the licensor, at least, is to be aware of them. The same is not true, however, of patentable inventions, particularly patentable processes, which may be kept secret while used in production without significant public exposure. Accordingly, trademark licensees generally require a lower level of protection from third-party claims than patent licensees.
Under ordinary circumstances, a trademark licensee might reasonably be content with a warranty that the licensor knows of no conflicting trademarks. Alternatively, the licensee might request termination or reduction of royalties in the event its use of the licensed trademark is wholly or partly enjoined. Any provision for reduction of royalties, however, would require more elaboration in a trademark license than in a patent license, because limited and regional injunctions are far more common in trademark infringement litigation than in patent litigation. In any event, the greater certainty available from searches of the Patent and Trademark Office's records should reduce the need for full warranties, indemnities, and covenants to defend in trademark licenses as compared to patent licenses.
[c]--Copyrights, Mask Works, and Trade Secrets
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Insofar as unwitting infringement of third-party rights is concerned, copyrights, mask works, and trade secretsdiffer from patents and trademarks in two important respects.
First, although the records of the Patent and Trademark Office provide some basis for assessing a licensee's risk of infringing patents and trademarks, the risk of unwitting infringement of copyrights, mask works, and trade secrets generally cannot be determined from public records at all. Trade secrets are never recorded or registered with any governmental body, and the registers for copyrights and mask works provide insufficient information to assess the risk of infringement. Although the substance of copyrighted works and registered mask works may be available through deposit copies, the indices and search systems for deposited materials are designed to trace chains of title, not to resolve substantive questions of infringement by comparing registered works with pre- existing works or so-called "prior art." Moreover, in the case of special materials such as computer programs and secure tests, the Copyright Office's secrecy procedures make such comparison impossible even in theory. Consequently, there is no way for a licensee of a copyright, mask work, or trade secret--even in theory--to determine by examining public records whether the exercise of rights under the license would infringe any third- party's rights.
The second salient difference between copyrights, mask works, and trade secrets on the one hand, and patents and trademarks on the other, cuts in the other direction. The risk of unwittingly infringing copyrights, mask works, and trade secrets is generally less than that of unwittingly infringing patents or trade symbols because independent creation is a complete defense to a claim of infringement of a copyright or mask work or misappropriation of a trade secret. A third party claiming that a licensee's use of licensed subject matter infringes a copyright or mask work, or constitutes misappropriation of a trade secret, must establish not only substantial similarity of the licensed intellectual property to that in which the third party claims rights, but also the access or other process by which the licensee came into possession of the allegedly protected material.
For example, unless she can show direct evidence of copying, a copyright claimant must show that a licensee named as a defendant in the infringement action had access to the copyrighted work allegedly infringed, or something derived from it. Similar principles apply to mask works, but the defendant in a mask work infringement action can raise the issue of derivation by asserting reverse engineering as a defense. As for trade secrets, a successful claim of misappropriation requires a showing that the defendant acquired the
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726947806 trade secret by improper means, either directly or through a culpable intermediary with knowledge of its tainted character. Because of these legal requirements, the chance that a licensor's copyright, mask work, or trade secret will infringe a third party's rights unwittingly is ordinarily small indeed.
Because independent creation is a complete defense, the licensor of a copyright, mask work, or trade secret ordinarily should know, or at least be in a position to evaluate, the risk of a successful claim of infringement by a third party. If the licensor developed the subject matter of the license independently, without copying or misappropriation of others' work, that risk should be negligible. On the other hand, if the material was taken or derived from the work of others, or if employees or consultants may have a claim in it, the licensor should be sufficiently aware of the basis of those claims to be able to evaluate them. In any event, because the risk of third-party claims depends on how the licensor or its privies obtained the licensed material, rather than on the nature of the material itself, the licensor nearly always has greater information than the licensee with which to evaluate the risks of infringing the rights of third parties. Public records, which are virtually useless in determining the risks of infringement of mask works, copyrights, and trade secrets, can do little to cure this inherent disparity in information and therefore to level the playing field as between licensors and licensees of these types of intellectual property.
Under these circumstances, it is fair for the licensee to request a full warranty, indemnity, and/or covenant to defend from the licensor, and it is reasonable for the licensor to give one. Indeed, full warranties are common in copyright licenses, where they often cover, or are accompanied by, warranties against defamation. The same reasoning also justifies full warranties in licenses of mask works and trade secrets as well.
Nevertheless, there may be circumstances under which full warranties and indemnities in copyright, mask work, or trade secret licenses are inappropriate. For example, an intermediary in a chain of licensing or (for copyrights) a chain of derivative works may have little knowledge of the source or origin of the licensed material or the underlying work. If the intermediary itself has not received a warranty or other legal protection from an upstream source, it will be unable to offer a full warranty or indemnity to those downstream in the chain of licensing or derivative works. Apart from such special circumstances, however, there is little reason for the owner of a copyright, mask work, or
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726947806 trade secret to refuse to give a licensee more complete protection than a warranty to the
"best of the licensor's knowledge or belief."
[2]--Implied Warranties and Indemnities
Warranty obligations with respect to third-party infringement claims appear not only in explicit covenants in licensing agreements; they also may be implied. The most common implied obligation occurs under the Uniform Commercial Code, in connection with the sale of goods. Based in part on that paradigm, some courts, under very limited circumstances, have found implied warranties in other kinds of transactions.
[a]--The Uniform Commercial Code's Implied Warranty of Noninfringement
The Uniform Commercial Code provides an implied warranty of noninfringement in every sale of goods. Under Section 2-312(3) of the Uniform Commercial Code, a merchant's sale of his or her usual merchandise includes an implied warranty against infringement, while a sale of goods made to the buyer's specifications does not. The relevant provision reads as follows:
"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."
Although the official comments to this section mention only patent and trademark infringement, the section applies to other kinds of intellectual property as well. The statutory reference to "infringement" is broad enough to encompass rights in copyrights and mask works, and the phrase "or the like" should be broad enough to encompass claims for misappropriation of trade secrets.
The implied warranty under Section 2-312(3) does not arise in every sale of goods. It arises only "[w]hen the goods are part of the seller's normal stock and are sold in his normal course of business[.]" No implied warranty arises in a "sale by a person other
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726947806 than a dealer." This is consistent with the Code's definition of the term "merchant" on which the statute depends.
The UCC's implied warranty can be excluded by agreement. It arises only "[u] nless otherwise agreed[.]" One court has held that detailed contractual provisions for defending third-party patent claims preempt it. If the warranty does apply, its breach is an arbitrable issue, at least if the agreement provides broadly for arbitration of issues relating to the agreement. The operation of the statute is not, however, preempted by the patent marking statute, [FN102.1] even if the party claiming warranty or indemnification may not be liable for damages because of the patentee's failureto mark. [FN102.2]
Recovery under the UCC's implied warranty is conditioned upon notice of a claim being given to the seller "within a reasonable time[.]" When the seller is named in the infringement action as codefendant with the buyer, however, the filing of that suit suffices to satisfy this notice requirement.
Where the warranty applies, it permits recovery of damages paid by the buyer in an infringement action brought by a third party. Whether and (if so) when it permits recovery of amounts voluntarily paid in settlement of a third party's infringement claim is a more difficult question. The words "rightful claim" [FN105.1] imply that frivolous or even unlitigated claims may not be covered. [FN105.2] The Federal Circuit, however, has refused to give those words a restrictive interpretation, [FN105.3] on the ground that doing so would contravene sound public policy by discouraging settlement. [FN105.4]
Although the Federal Circuit is not necessarily the final authority on matters of state law, as a practical matter most claims raising the issue will end up before the Federal Circuit, so its views will be decisive. [FN105.5] Unfortunately, its brief opinion on this point
[FN105.6] provided little gloss on the statutory language beyond a refusal to require an infringement claim that is certain to win. [FN105.7]
At a minimum, the Federal Circuit's refusal to interpret "rightful claim" as "winning claim" appears justified by policy. If a winning claim were required, there could be no valid claim for breach of warranty or indemnification unless the person claiming it carried the litigation to its bitter end and lost. [FN105.8] For example, if a buyer of infringing merchandise litigated without compromise and won, there would be no
"rightful claim" of infringement on which to ground a demand for indemnification.
Therefore, no matter how strong the infringement claim, the seller could argue that any
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726947806 settlement made by the buyer deprived it of a chance, however small, of escaping any warranty liability at all, and therefore that the settlement amount--whatever it might be-was not causally connected to the breach of warranty. By giving short shrift to arguments of this sort, the Federal Circuit's approach encourages settlement.
Nevertheless, arguments of that sort cannot be totally neglected. There may be cases in which the buyer's and seller's reasonable assessments of the merits of the infringement claim and related liability for damages differ substantially, by an amount well in excess of foreseeable litigation expenses. In that case, the seller may have reason to urge the buyer to litigate the infringement claim vigorously (at the seller's expense), [FN105.9] while the buyer may have reason to settle quickly and be done with it. Under such circumstances, the best approach is for the seller (or buyer, if it is the indemnitor) to approve the settlement. If the party paying the tab approves the settlement, the statute should require a warranty or indemnification however uncertain the claim that spawned the settlement. If there is no agreement, however, where justice lies may depend upon the circumstances.
In any event, for reasons of economic efficiency, the warranty normally should cover reasonable attorneys' fees and other litigation expenses, even though the Code is silent on the subject. Case law so far is consistent with this view. Recovery of fees should be denied, however, under circumstances in which their award would be inequitable or would lead to economically inefficient incentives.
The scope of the UCC warranty, however, has its limits. A selling merchant does not impliedly warrant noninfringing goods against the kind of infringement that occurs when the buyer includes those goods in infringing products or uses them to perform infringing processes.
The direction of the warranty is reversed when the buyer supplies specifications for the goods. Then the buyer "is under an obligation in good faith to indemnify" the seller.
Thus a buyer purchasing special-order goods has a greater duty to the seller than an ordinary merchant has to an ordinary buyer: the special-order buyer grants an indemnity, while the ordinary merchant provides only a warranty.
[b]--Implied Warranties in Licensing Agreements
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There is no general statutory provision, like that in Section 2-312(3) of the Uniform
Commercial Code, which provides for implied warranties of noninfringement in licensing agreements. Nevertheless, implied warranties of noninfringement may arise in four kinds of cases. First, where the license agreement is associated with a sale of goods, courts may apply Section 2-312(3) directly, either by considering the sale a separate transaction or by characterizing the license agreement as a sale of goods. If the license and sale are part of a single transaction, however, the license must be incidental to the sale of goods, which must be the predominant purpose of the transaction; [FN115.1] otherwise, the Uniform Commercial Code generally will not apply. [FN115.2] Second, courts may imply warranties of noninfringement in other transactions related to licensing, based on the same general principles on which Section 2-312(3) is based--the rule of reason that applies in contract interpretation generally. Third, courts may infer such warranties from ambiguous language in licensing agreements, particularly where the language is drafted by attorneys unfamiliar with intellectual property matters. Where a license was drafted by nonpatent attorneys and the parties' conduct was consistent with the interpretations, one court interpreted a reference to defense of "validity" of a licensed patent as connoting defense of the licensee's right to practice that patent against a third party's claim, and therefore restricted the licensor's obligation to the first successful defense of an infringement action. Finally, courts also may impose implied warranty or indemnification obligations based upon conduct. For example, one court upheld an implied indemnity for copyright infringement based upon a printer's use of infringing materials supplied by a third party at a customer's request. Another imposed a continuing obligation on the licensor to defend the licensee where the licensor had discontinued its defense of an infringement action without notifying the licensee or obtaining the licensee's approval, had entered a settlement license with the third-party patentee, had refused to pass through its newly acquired license rights as required by the original license agreement, and had attempted to extract from the licensee additional consideration.
As the last two examples demonstrate, however, implied warranties and indemnities are disfavored at common law and are by nature rare. This is as it should be. At least where the parties are adequately represented by counsel or familiar with their industry, the absence of a warranty or indemnity may represent as much a conscious allocation, of risk as one's presence. Courts are properly reluctant to disturb the parties' legitimate and
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726947806 bargained-for expectation in either case.
[3]--Business Justification for Covenants to Indemnify or Defend
In theory, a licensor's warranty against infringement of third parties' rights in intellectual property should give the licensee complete protection. In practice, however, even a full warranty has deficiencies in this regard. To cure these deficiencies, licensees often insist on more than a pure warranty of noninfringement; they ask licensors to agree to indemnify or defend them against third-party infringement claims.
The business justification for a licensee's insisting on an indemnity is not hard to discover. Strictly speaking, only infringement breaches a warranty of noninfringement.
The beneficiary of the warranty, however, cannot conclusively demonstrate the existence of infringement until the conclusion of the infringement litigation.
To the extent the courts recognize it, this paradox of warranties has three consequences, all of them undesirable for the beneficiary of the warranty. First, it compels the beneficiary to expend its own funds to defend the suit for infringement until a finding of infringement is made. Second, it exonerates the warrantor entirely if the beneficiary ultimately prevails in the infringement suit, for, in that case, there is no legally cognizable infringement. Thus, a warranty provides no recompense for fees incurred in weak or frivolous actions for infringement, which are among a licensee's primary concerns.
Finally, it discourages settlement--at least without the warrantor's consent --by permitting the warrantor to argue that no infringement was proven and hence the amount to be paid in settlement was not the result of a breach of warranty. Because litigating intellectual property claims is expensive, a warranty that protected only against successful third-party claims, and then only on their completion, would fail to provide what most licensees naturally expect: freedom from the worry, inconvenience, and expense of all claims involving the licensed subject matter.
Pure warranties in licensing also have other disadvantages. If a third party wins in litigation and enjoins the licensee from further activities under the purported license, the licensor may refuse to pay the licensee's expenses of shutting down and restructuring its production facilities, or even its expenses of litigation, on the grounds that they are
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726947806 unforeseeable consequential damages.
To avoid any risk of illusory protection, licensees normally request--and licensors often grant--indemnities with respect to, and/or covenants to defend, actions for infringement or misappropriation brought against licensees by third parties. Often these contractual provisions describe in some detail the expenses for which the licensor may be liable in the event of a third-party claim, and the manner in which expenses of defense and settlement are to be shared. Typically covered expenses include the cost of defending a third-party claim (including reasonable attorneys' fees), damages, settlement costs, and the costs of any license fees or royalties that the licensee may have to pay third parties for the right to continue exploiting the licensed intellectual property under the terms of the licensing agreement. Only seldom does indemnification cover a licensee's costs of terminating or restructuring an enjoined business, but these costs also are a legitimate item for discussion.
[4]--Interpretation and Enforcement of Indemnities
In theory, courts interpret and enforce indemnities against infringement much like other contractual terms. General rules of contract construction generally apply, and unambiguous language is construed in accordance with its plain meaning and the evident intent of the parties.
Both interpretation and enforcement, however, are matters of state law, and there is considerable variation in interpreting indemnities among the several states. Some states require indemnities to be construed narrowly, while others take a more generous or neutral approach. Variability among states particularly affects courts' attitude toward attorneys' fees, both those incurred in the infringement action indemnified against and those incurred in enforcing the indemnity itself.
Once the meaning of the indemnity has been ascertained, there is less variability among states in enforcing it. A general rule of reason applies, under which courts review the amount of settlement and expenses that indemnitees claim for reasonableness and good faith. Although one 1994 decision refused to enforce a clear indemnity against copyright infringement, that decision should be limited to its special facts and should not apply in
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726947806 the patent field.
[a]--Interpretation
In interpreting infringement indemnities, there is considerable variation among the several states. All purport to apply much the same general rules of contract construction, but a particular state may construe indemnities broadly, narrowly, or neutrally. Often its attitude toward infringement indemnities derives from precedent involving injuries or worker's compensation, fields well beyond the scope of this book.
In order to predict a court's attitude toward infringement indemnities, it therefore may be necessary to research the attitude of the relevant jurisdiction in areas of law quite remote from intellectual property. Doing this in all fifty states, plus the District of
Columbia, would be a task worthy of a book in itself. Therefore this Section provides only an overview of attitudes and arguments; it does not purport to be exhaustive.
Variability among states in interpreting indemnities is particularly noticeable with regard to attorneys' fees, whether those incurred in defending the indemnified infringement action in chief or those incurred in enforcing the indemnity itself. It is less noticeable in determining how fees are to be apportioned between allowable and nonallowable claims, as courts seem to allow any reasonable method of apportionment, regardless of jurisdiction.
[i]--General Rules
The general rules governing the interpretation of contracts of indemnity are the same as those governing the interpretation of contracts in general. Where the obligation to indemnify is clear, courts usually interpret infringement indemnities as written. If the words of an indemnity are clear and unambiguous, it can be enforced without reference to extrinsic evidence, even by summary judgment.
There is, however, considerable variability among the states in interpreting indemnities.
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Some construe indemnities broadly once the right to indemnification has been established. Others construe indemnity agreements narrowly or place the burden of proving a favorable construction on the party claiming a right to indemnification. And some take a neutral stance, in neither party's favor. Common interpretive rules may be applicable, such as the rule that typewritten riders supersede standard printed forms to which they are attached.
Whatever the rule of interpretation, applicable state law supplies it. If the contract is silent on the choice of law, "[t]he right to indemnity is determined under the law of the state where the act giving rise to the right of indemnification occurred."
Like other contractual provisions, indemnities are construed in accordance with their language and the apparent intentions of the parties. Thus, the precise language of an infringement indemnity is of signal importance in determining its effect. For example, it makes a difference whether the indemnity covers liability for infringement or merely a material impairment of rights; a mere threat of protracted litigation may suffice to invoke the latter language. Similarly, where an indemnity covers acts of the indemnitor prior to a specified date, claims based upon the indemnitor's later acts, or upon acts of the indemnitee, are not covered. Among the most important language in an indemnity is the language governing what sorts of proceedings are covered; the word "actions," for example, does not generally cover arbitration proceedings.
However important the wording may be, it often cannot be construed without reference to the parties' intent. Sometimes that intent can be inferred from the language of the agreement itself. Thus, broad language in indemnities is generally construed broadly, in accordance with the apparent intent of the parties. Yet courts may look to the economic incentives that an asserted interpretation would create and may reject that interpretation if the incentives seem perverse.
Timing may also be an important issue in interpreting indemnities. For example, a patent infringement indemnity in the sale of a product line, which was limited to claims accruing during the first year after closing of the sale, was construed to cover damages for all infringing sales of goods occurring during the one-year period. Similarly, an indemnity covering "events, acts, omissions, conditions or a state of facts occurring or existing on or prior to the Closing Date" could not be construed as covering losses arising out of sales of infringing products after the closingdate, notwithstanding the argument
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726947806 that legal liability already had been established in litigation on which the lower court's judgment had been pending at the time the indemnity was granted.
However strong the principle of freedom of contract, the language of indemnities is not infinitely malleable. Infringement of intellectual property is a complex and technical field, and therefore courts are inclined to interpret technical language in indemnities in accordance with its technical meaning. Thus, for example, an indemnity with respect to
"infringement" does not cover the indemnitee's expenses in prosecuting a patent interference action asserting priority over a rival inventor. For this reason, it is generally advisable to draft indemnities in broad nontechnical terms; if technical terms are used, they should be drafted or reviewed by an attorney well versed in the branch of intellectual property law at issue.
[ii]--Coverage of Attorneys' Fees
An oft-recurring and commercially important question in interpreting infringement indemnities relates to attorneys' fees. When does an indemnity, silent or ambiguous on the subject, allow the indemnitee to recover these litigation expenses?
As is the case with interpretation in general, the answer often depends upon the choice of law. In Iowa, fees are included unless explicitly excluded. In other jurisdictions, the right to attorneys' fees, when not specifically covered, may depend upon the precise language used. For example, an indemnity against infringement "suits" covers fees as part of the action, even if the indemnitee, with the indemnitor's approval, takes over the defense. If, however, the indemnitor has an obligation to defend only, it may not be liable for litigation and settlement expenses incurred by the licensee without consultation.
[iii]--Coverage of Fees for Enforcing the Indemnity
The question of liability for attorneys' fees often arises in disputes over the indemnity itself. Where the indemnitee is forced to sue the indemnitor to recover indemnification and wins, the right to recover fees depends, like the interpretation of other aspects of the
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726947806 indemnity, upon both the language of the agreement and the governing law. Where the contract is silent on the subject of fees generally, fees for enforcing the indemnity are likely to be denied. One court, however, allowed the indemnitee to recover such fees where the contract was silent, on the theory that not doing so would give him less than the agreement had promised.
When the indemnity includes an explicit, albeit general, reference to attorneys' fees, some jurisdictions permit recovery of fees incurred in enforcing the indemnity itself. In
New York, however, coverage of fees in general does not permit recovery of fees for enforcing the indemnity itself, on the theory that the "American rule" precludes fee shifting unless the agreement to shift fees is unmistakably clear from the language of the contract itself.
This last approach, which is based in part upon strict construction of indemnities generally, seems overly parsimonious. When an indemnity explicitly covers fees in general, in addition to damages, denying fees incurred in connection with successful enforcement of the indemnity itself seems contrary to the evident spirit of the agreement: that the indemnitee be made fully whole.
[iv]--Apportionment of Fees
When attorneys' fees are awarded as part of indemnification, they often must be apportioned among various aspects of the litigation. Indemnities, whatever their language, normally do not support recovery of fees in connection with aspects of the litigation for which damages would not be covered by the indemnity. Under special circumstances, however, one court awarded fees for defending antitrust and other claims that were related to the exercise of intellectual property rights.
When litigation involves both claims subject to indemnity and claims not subject to indemnity, some apportionment of fees must be made. The indemnitee claiming reimbursement has the burden of proving the proper apportionment of fees, as well as of damages in chief. Where billing records do not permit specific apportionment based upon the time spent, fees may be apportioned upon another reasonable basis. Courts are reluctant to scrutinize trial tactics in detail to determine the impact and success of each
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726947806 day's or hour's work.
One common method of apportioning fees is in proportion to the amount of damages recovered in the various claims. Fees should not, however, be apportioned in proportion to the ratio of damages obtained to damages claimed. There are two good reasons for this rule. First, claims are often inflated for various tactical reasons having nothing to do with their merits. Second, where indemnification is concerned, the infringement claim is made by a third party, over which the indemnitee normally has no control. It would be unjust to reduce the indemnitee's award of fees in proportion to a claim made by a stranger for tactical reasons, often having little to do with the merits of the case.
For purposes of apportionment, fees for enforcing the indemnification agreement itself may be treated much like other fees. They may be apportioned among successful and unsuccessful aspects of the attempt to enforce the indemnity, and amounts of time that are relatively negligible may be ignored.
[b]--Enforcement
There is less variation among the several states in enforcing indemnities that in interpreting them. Once a court has found an indemnity applicable to the case at hand, it ordinarily enforces the indemnity like any other contract. The most salient feature of enforcement, as distinguished from interpretation, is the rule of reason: the fact finder may scrutinize the amount of indemnity requests under standards of reasonableness and good faith. Although a 1994 decision of a federal court of appeals refused to enforce a clear copyright indemnity, that decision should be narrowly construed and should have no bearing on patent indemnities.
[i]--General Principles
In accordance with the principle of freedom of contract, courts ordinarily enforce recorded infringement indemnities as written. An indemnity that is sufficiently clear may be enforced even if the infringement indemnified against was ultimately induced by the
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726947806 indemnitee's own tortuous conduct. Similarly, where an indemnity required the licensee to share the costs of defending third-party infringement actions, one court enforced it even though the licensed patents allegedly were invalid. Oral indemnities, however, require clear evidence of their existence and terms before they will be enforced.
Generally only the indemnitee can enforce an indemnity. A third party claimant who is a stranger to the indemnity cannot bring a claim for infringement directly under it but must sue the infringer, who, in turn, will have a right of action for indemnification.
Although courts interpret broad language in indemnities broadly, they have no trouble enforcing explicit limitations. For example, when a copyright indemnity explicitly covered a particular commercial jingle, the court would not construe it to extend to a successor jingle, at least not where the indemnitee had an apparent policy of requiring a separate written indemnity for each project. Similarly, where a rider to a copyright warranty and indemnity prohibited the indemnified publisher from withholding royalty payments for more than twelve months, an alleged breach of warranty did not permit the publisher to withhold payment for a longer time; instead, the publisher had to bring a separate claim for breach of warranty. Clauses conditioning indemnification on giving the indemnitor timely notice of the claim also affect enforcement of the indemnity.
Although enforcement of indemnities is common, it does not necessarily require litigation. An arbitration clause in an agreement covering disputes "relating to" the agreement may be applied to infringement warranties and indemnities, just as to other contractual provisions.
[ii]--The Rule of Reason Governing Amounts Paid
Perhaps the most important principle governing enforcement of infringement indemnities is the "rule of reason" governing the amount for which indemnification is claimed. This general principle allows fact finders to review amounts requested by indemnitees for reasonableness and good faith.
Under familiar contract doctrine, courts do not scrutinize the amount of consideration given before enforcing a contract. Therefore a relatively small consideration suffices to
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726947806 support an obligation to bear much larger expenses of indemnification or defense. In short, nothing in basic contract doctrine constrains the amount of reimbursement by way of indemnification that an indemnitee may seek.
There are two reasons, however, why some judicial review is desirable. First, the indemnitee may have misjudged the strength of the infringement claim and may have litigated where it should have settled or overpaid in settlement. To take extreme examples, the indemnitee may have run up extravagant legal bills and a large damage award litigating a losing case, or it may have paid a substantial sum to settle a frivolous claim. Second, an indemnitee normally has little or no incentive to keep the amount of a damage award or settlement low, or (if the indemnity covers attorneys' fees) to conserve legal expense, because it can look to the indemnitor for reimbursement. Therefore, if left to its own devices, an indemnitee may well make economically undesirable misjudgments. In order to avoid both unfairness to the indemnitor and economic inefficiency, courts must scrutinize each amount of indemnification that an indemnitee requests, unless the indemnitor has approved or ratified that amount.
The principle that courts have developed for this purpose is a general rule of reason, involving two standards: reasonableness and good faith. "A party seeking indemnity after settling a claim upon notice to the indemnitor must show that its settlement was reasonable and made in good faith." Under this rule of reason, courts review decisions made by indemnified parties to incur expenses in defending or settling actions for infringement or misappropriation.
In making their review, courts must consider both the amount likely at stake and the likelihood of a judicial decision unfavorable to the indemnified party. That is, courts must balance the likely costs against the likely benefits of the indemnitee's action in settling the case--seen prospectively, not in hindsight--to determine whether the expenses incurred, as well as the amount of any damage award or settlement, were reasonable. The party claiming indemnification bears the burden of proving that these tests have been satisfied.
Whatever the amount claimed, the fact finder must award only a reasonable amount.
This rule applies even where the indemnitor refuses to participate in settling the case. If the settlement is reasonable, the indemnitee should be entitled to prejudgment interest; any other result would simply encourage the indemnitor to delay and stonewall.
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The rule of reason reflects both fundamental fairness and economic good sense, for it prevents the indemnitee from gambling with the indemnitor's money. From an economic perspective, it prevents indemnitees from distorting the efficient use and exploitation of intellectual property rights by incurring excessive transactions costs, knowing that someone else must pay them.
The rule of reason, however, does not give courts carte blanche to engage in second guessing and hindsight. Evaluation of the risks of litigation is an inherently uncertain business, and the scope of reasonable business discretion is broad. Courts may be reluctant to question an indemnitee's settlement, for example, where the indemnitor was invited to participate in the settlement process but declined to do so.
There are, however, limits to an indemnitee's business discretion, broad though it may be. Where an indemnitee exceeds those limits, its recovery will be reduced or eliminated entirely. For example, if an indemnitee, without the indemnitor's knowledge or consent, waives a defense, even though it may be disputed, the indemnitor may be released from the indemnity entirely.
[iii]--The Olan Mills Decision and the Indemnitee's Duty to Investigate
The 1994 Olan Mills decision raises the question whether indemnitees with notice of possible infringement have a duty to investigate the facts and, if they fail to do so, waive the right to indemnity. The raison d'etre of indemnities, however, argues against such a general rule, let alone extending it beyond the field of copyright.
In Olan Mills, Inc. v. Linn Photo Co., the Eighth Circuit condemned a photofinisher's copying of a copyrighted photograph that was clearly marked with a portrait studio's copyright notice. The portrait studio's private investigator had submitted the photographs for copying, after signing the photofinisher's standard "hold harmless" agreement, which the portrait studio had authorized him in writing to do. In holding that the indemnity was unenforceable, over a vigorous dissent, the Eighth Circuit relied on two facts: (1) the portrait studio had asked the photofinisher to stop infringing copyright in its products, and (2) the photofinisher had developed the indemnity agreement, without assistance of
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726947806 counsel, for the purpose of avoiding infringement liability.
While the Eighth Circuit's decision may have had some rational basis, it had little justification in the economics of indemnities. The private investigator had concealed his assignment from the photo finisher --a fact made much of by the dissent. Consequently, for all the photo finisher knew, the investigator was just like any other customer, agreeing through the indemnity to accept the risk that copying the photograph would infringe a third party's copyright. By shifting this risk to the customer, the photofinisher sought to avoid the burden of investigating the copyright pedigree of each photograph proffered by a customer for copying, and thereby sought to lower its cost of doing business.
Risk-shifting of this sort is economically desirable because the customer in this case was the least-cost investigator. By implying that the photofinisher, under these circumstances, had an unwaivable duty to investigate copyright protection, the court in effect precluded contractual risk shifting, thereby raising the photo finisher's cost of doing business and probably its prices as well.
Not only in this case, but also in the general case, the least-cost investigator of copyright protection is generally the customer, not the copier or other putative infringer. By burdening the photo finisher with a duty to investigate that could not be shifted by contract, the Eight Circuit at a stroke decreased the efficiency and increased the cost of doing any business involving copying within its jurisdiction. In an attempt to decrease the cost of investigating infringement, the court likely increased the cost of doing normal business in the industry.
No doubt Olan Mills exemplifies the apothegm that hard cases make bad law. Yet even if its holding is correct, it should be confined to the narrowest possible limits. In particular, it should be limited to cases in which an indemnitee seeks to enforce the indemnity indirectly against the copyright owner, not a third party, despite having been warned of the risk of infringement both by letter and by a copyright notice clearly appearing on the item whose copying is at issue. If received more expansively, Olan
Mills could seriously undermine the use of indemnities, as well as certain time-worn methods of doing business in the publishing and entertainment industries.
Whatever its scope of application in the field of copyright, Olan Mills should not be
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726947806 allowed to invade the field of patents. There are two reasons for this. First, there is no single, simple device, analogous to the use of copyright notice, by which a patentee may authoritatively warn a suspected infringer. Assessing patent infringement is always an uncertain business, requiring the advice of competent patent counsel and skilled investigation of facts to determine whether infringement exists at all. It is not something that can be determined, as might be possible in a case like Olan Mills, with a single telephone call. A major purpose of indemnities is to shift the burden of inconvenience and expense--not to mention the irreducible uncertainty--of assessing patent infringement. Interference with freedom of contract in this regard would only distort established methods of doing business, with adverse effects on the efficiency of virtually all industries that depend upon patents.
The second reason why Olan Mills should not apply in the patent field is that persons warned of patent infringement already have a duty, by virtue of substantive patent law, reasonably to investigate the claim. This duty relates not to patent infringement in chief, but to potential liability for augmented damages and attorneys' fees. Notwithstanding this duty, however, patent indemnities are routinely enforced, even--indeed especially--when granted after knowledge of a third party's claim arises. Refusing to enforce a clear indemnity because of the indemnitee's knowledge--actual or constructive--of a risk of infringement would distort the economics of patent-dependent businesses in three ways:
(1) by foreclosing means of shifting risk to the least-cost investigator; (2) by increasing the uncertainty of enforcement of indemnities and therefore the risk of entering patentrelated transactions; and (3) as a result of the increase in uncertainty, by raising transaction costs, both for deciding whether to enter proposed transactions and for litigating their significance after they occur.
[5]--Legal Consequences of Infringement Indemnities
Infringement indemnities have a number of legal consequences besides the obvious--the obligation to pay losses. Their mere inclusion in the licensing agreement may affect courts' decisions on a number of legal issues, both procedural and substantive. While the presence of an indemnity is not necessarily decisive on these issues, its influence on them is significant enough to merit consideration in planning both the timing and extent of indemnification.
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Sometimes the absence of indemnification also may have legal consequences. For example, failure to indemnify licensees of disputed intellectual property may justify their settlement with other claimants to the same intellectual property, despite covenants in the licenses not to impair the licensor's ownership rights.
[a]--Procedural Issues
The mere presence of infringement indemnities may influence courts' decisions on a number of procedural issues unrelated to the merits of the infringement claim for which indemnification is sought. Although this influence may occur in many unpredictable ways, it generally follows two broad themes. First, it helps courts determine whether a party has sufficient financial interest in the outcome of the litigation to claim the right to intervene, to pursue a declaratory judgment, to merit severance and/or a transfer to another venue, or to be bound by a prior judgment. Second, examination of indemnities helps assess a party's active involvement, either in purposefully availing itself of a forum state's laws for purposes of personal jurisdiction, or in participating fully and fairly in prior litigation so as to be bound by a prior judgment. Although the influence of indemnities in deciding these issues is by no means conclusive, indemnities have a definite effect on the resolution of these procedural questions.
[i]--Personal Jurisdiction
A person's status as indemnitor or indemnitee enters the jurisdictional calculus at two levels--in determining whether the person has sufficient minimum contacts with the forum to meet the constitutional requirements of due process of law and in applying state long arm statutes, typically in determining whether the person has committed a tort (such as infringement) within the forum. With respect to the constitutional issue, the fact that a person has "purposefully availed" itself of the protection of the forum state's laws is one factor suggesting the existence of minimum contacts necessary for due process of law.
Although it is generally not decisive by itself, indemnification of persons within the forum may provide evidence of the necessary "purposeful availment" and therefore may
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726947806 support the exercise of personal jurisdiction over the absent indemnitor. The significance of the indemnity--which, after all, is usually cumulative evidence of the necessary purposeful availment--is that it indicates a deliberate business relationship with a person inside the forum, as distinguished from the fortuity of a product or service finding its way there by chance, in the stream of commerce. Evidence of an indemnity may be particularly important to demonstrate the intent of persons operating abroad to invoke the protection of the laws of a specific one of the United States.
Indemnity plays a similar role in resolving the applicability of long arm statutes that turn upon the commission of a tort in the relevant forum. In the typical case in which a foreign person sells infringing merchandise to a person in the forum, such a tort may be hard to find, because the sale--and therefore the technical infringement--may be deemed to have taken place outside the United States. Under those circumstances personal jurisdiction may be based not on direct infringement, but on the foreign party's inducing infringement by the in-forum buyer. Indemnification by the foreign seller, which is a factor considered in demonstrating inducement to infringe, may, if that demonstration is successful, also provide a basis for personal jurisdiction over the absent indemnitor. In that case, however, the procedural effect depends upon the substantive--the establishment, at least with sufficient certainty at the early procedural stage of litigation, of the indemnitor's secondary liability.
[ii]--Declaratory Jurisdiction
Similar considerations apply to jurisdiction over an action for a declaratory judgment of patent invalidity or non-infringement. As part of the "case or controversy" requirement of the United States Constitution, as embodied in the federal Declaratory Judgment Act, an applicant for declaratory relief must show that she had a sufficiently real and concrete interest in the subject matter of the action to render the case a genuine controversy, as distinguished from a request for an advisory opinion on a hypothetical state of facts.
When an indemnitor sues for a declaratory judgment of patent invalidity or noninfringement, the fact of indemnification provides evidence of a genuine interest in the outcome of the case, thereby suggesting satisfaction of this "case or controversy" requirement. Although the effect of indemnification is strengthened if the party seeking a
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726947806 declaratory judgment is accused as a contributory infringer, the impact of indemnity alone may be sufficient, at least as long as the indemnitor's products are sold in the
United States.
As in the case of personal jurisdiction, however, this factor is not necessarily decisive.
Moreover, even if sufficient basis for jurisdiction exists, a court has the discretion to refuse jurisdiction over a declaratory judgment action. A fortiori, an alleged implied indemnification does not provide ground for declaratory jurisdiction when the conditions for applying it are not met, when indemnification is only offered and never provided, when no acts of alleged infringement have yet occurred on which indemnification might be predicated, or when the acts on which a claim of infringement might depend are cancelled or discontinued despite the indemnity. At best, indemnification is one of the factors that courts consider, among many others, as demonstrating the indemnitor's interest in the controversy and thereby supporting satisfaction of the constitutional requirement for declaratory jurisdiction.
[iii]--Right to Intervene
Under Rule 24(a) of the Federal Rules of Civil Procedure , a party's intervention as of right in a pending lawsuit depends, absent an applicable federal statute, on the applicant for intervention:
"claim[ing] an interest relating to the property or transaction which is the subject of the action ... [such] that the disposition of the action may as a practical matter impair or impede the applicant's ability to protect that interest, unless the applicant's interest is adequately represented by existing parties."
In short, in order to claim the right to intervention, rather than leave of the court, the applicant for intervention must show a concrete interest in the dispute that is unlikely to be adequately protected by existing parties.
If the applicant for intervention is the indemnitor of a defendant in a suit for infringement or misappropriation, these conditions are satisfied almost as a matter of course. The indemnitor's interest in the dispute is demonstrated by the very fact of the indemnity, under which the indemnitor will have to satisfy the defendant's liability, if any, and perhaps pay the defendant's legal expenses. At the same time, the indemnity
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726947806 demonstrates the inadequacy of representation by existing parties: since the defendant is indemnified in any event, its incentive to fight hard to avoid liability or reduce the award is decreased. For these reasons, courts should grant indemnitors of defendants in intellectual property disputes the right to intervene in those disputes to protect their interests.
[iv]--Severance and Transfer of Venue
Under the federal transfer-of-venue statute,
28 U.S.C. § 1404
, a federal court, upon the request of any party, may transfer a case to a more convenient forum. Indemnities can play a significant role in a court's determination which forum is more convenient.
The typical case is one in which a manufacturer sells its goods to customers in fora other than that in which it is located and indemnifies them against infringement. If a patentee sues one or more of the customers for infringement, the manufacturer-indemnitor may seek to intervene, to transfer the case to a more convenient forum--typically the forum in which the manufacturer is located or does most of its business, and to sever and stay the suit against the customer, pending the outcome of the transferred case against the manufacturer.
Courts are receptive to petitions for transfer and severance of this kind. This is particularly true when the indemnity is complete, or the manufacturer is responsible for, or in fact undertakes, the defense of the infringement claim. For in that case, the manufacturer is the real party in interest and the center of gravity of the evidence and witnesses regarding infringement often turns out to be in or near the manufacturer's plant, and therefore in the transferee forum.
Transfer is not always granted, however; it may be denied, based on other facts and circumstances, if the transferee court is not the most convenient forum. In one copyright case, the court even refused to sever the question of the right to indemnity itself.
[v]--Res Judicata and Collateral Estoppel
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The preclusive effect of a prior judgment depends, at a minimum, upon two things.
First, the party to be precluded must have had a sufficient interest in the prior litigation to make it fair for the result in that litigation to bind that party. Second, there must have been a "full and fair opportunity" for the party to be precluded to litigate in the prior action.
In intellectual property cases, indemnities are relevant to both of these issues. They demonstrate an obvious interest on the part of the indemnitor in the outcome of the suit for infringement or misappropriation. At the same time, they suggest an invitation, if not an opportunity, for the indemnitor to have protected its interests in the prior litigation by such means as intervention or controlling and bankrolling the defense of the indemnitee.
Accordingly, indemnitors are commonly held to be bound by prior judgments in cases involving their indemnitees, or to have the benefit of judgment in their indemnitees' favor. Few courts find binding effect as a matter of course, simply by virtue of the indemnity. However, many apply the doctrine of res judicata or collateral estoppel based upon the natural consequences of indemnity--the indemnitor's interest in the prior action and its consequent participation in and control of the conduct of that action.
This approach, however, only goes as far as its rationale allows; privity for purposes of preclusion is a question of fact, and preclusive effect may be unwarranted where the indemnitor's and indemnitee's interests are not congruent, or where the indemnitor did not participate fully in the prior action. A fortiori, an indemnitee is not necessarily bound by an earlier judgment against the indemnitor, because the indemnitee would not have had insufficient interest in the prior litigation to insure its effective representation there.
Therefore the mere fact of indemnification is not necessarily decisive in determining the preclusive effect of a prior judgment. A few courts, however, have applied preclusive effect of prior judgments to indemnitees.
Similar considerations may affect a court's decision as to whether the doctrine of assignor estoppel applies. Under this doctrine, the assignor of a patent, and those in privity with her, are estopped to argue that the patent assigned is invalid. Indemnities are among the factors--and sometimes a vital factor --that courts consider in determining whether a person is in privity with the assignor for purposes of applying this doctrine.
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[b]--Substantive Issues
Just as the presence of an indemnity influences courts' decisions with respect to a number of procedural issues, so it may affect courts' decisions on substantive issues. As in the case of procedure, however, this influence is not always decisive; rather, it is an important factor to which courts advert when the facts suggest its significance. The primary substantive issues to which indemnification relates are proof of inducement to infringe (and the culpability necessary for liability), willfulness of infringement, leading to augmented damages and liability for attorneys' fees, and characterization of the licensing agreement as an "executory contract" for purposes of its rejection by a debtor under the Bankruptcy Code. The principles are most highly developed in the field of patents, in which most of the decided cases have occurred.
[i]--Inducement to Infringe
Under Section 271(b) of the Patent Act of 1952,
35 U.S.C. § 271(b)
, a person who actively encourages and aids another in infringing a patent is liable for inducing infringement. Similar rules apply in copyright and trademark actions, despite the absence of a special statute governing inducement to infringe in those fields.
In all of these fields, the defendant's state of mind is an element of inducing infringement. That state of mind can be demonstrated only by circumstantial evidence, and indemnities are among the pieces of circumstantial evidence on which courts rely in determining whether the necessary culpability has been shown. Indemnities may be given great weight in finding infringement by inducement, particularly in the case where a manufacturer or supplier indemnifies a customer as a condition of the customer's purchase of the manufacturer's or supplier's products. In copyright cases, the possibility of obtaining indemnification may be a factor justifying the imposition of vicarious liability without actual fault.
By itself, an indemnity, which is a standard tool of business in the intellectual property field, hardly indicates an intent to induce infringement or the necessary state of mind.
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Under certain circumstances, however, it can provide cogent evidence of a culpable state of mind or of responsibility for infringement. In the field of copyright, however, an indemnity by itself is insufficient to demonstrate inducing infringement through the sale of copying equipment. In addition, the equipment must be shown to have no substantial noninfringing use.
The chief circumstance that makes an indemnity suspicious is its timing. If the indemnity arises before a claim of infringement is made, it is likely a standard business arrangement designed to insure against hidden risks. When it arises after a claim is made, however, an indemnity may be tantamount to a monetary inducement to the indemnitee to continue infringement at the indemnitor's expense. Even then, it may not prove inducement to infringe, but only a desire to maintain the status quo, or to protect a financially weak customer, while uncertain questions of validity and infringement are resolved in the courts. Yet indemnification against known and existing claims can add heavy weight to any other evidence of willfulness or knowledge and tip the scale toward a finding of inducement to infringe.
[ii]--Willfulness of Infringement
Just as indemnification may suggest a culpable state of mind on the indemnitor's part, so may it suggest willfulness on the part of the indemnitee. An indemnitee whom the indemnity relieves of any monetary liability for infringement has little incentive to avoid infringement as long as infringement is profitable for the moment. Accordingly, indemnities weigh as one factor in deciding whether an indemnitee's infringement is willful. As in the case of inducement to infringe, however, the inference is strongest when the indemnity is offered and received after the claim of infringement arises, or as a condition of making a sale or other business arrangement. In such cases, indemnities can demonstrate willful infringement even on the part of indemnitors.
Indemnities made before a claim arises, however, are not so easily condemned; they likely represent just a standard method of dealing with unknown risk. This is particularly true in copyright cases, in which indemnities are ubiquitous in publishing agreements.
To infer willfulness of infringement in a copyright case from the mere existence of a contractual indemnity would make no sense at all. Similar reasoning should apply in
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726947806 mask work and trade secret cases, for which the risks are similar and therefore the indemnities play a similar role.
By influencing determinations of willful infringement, indemnities impact two issues.
First, they affect augmentation of proven damages in patent and trademark cases and in statutory trade secret cases, and statutory damages in copyright cases. Second, they influence courts' exercise of their discretion in deciding whether or not to award a prevailing party its attorneys' fees under the applicable federal and state statutes. Their influence is most pronounced in patent cases because "willfulness" of infringement in patent law connotes a state of mind closer to negligence than to purpose or deliberation.
Once warned of patent infringement, every defendant has a duty to investigate the infringement claim, preferably with the aid of competent patent counsel, and to act in accordance with the results of the investigation. If the response to a claim of infringement is simply to seek indemnification and mutter "damn the torpedoes, full speed ahead," this standard is unlikely to be met. As a result, post-claim indemnification of patent disputes weighs strongly in favor of a finding of willfulness, at least in the absence of exonerating circumstances, such as the receipt of credible advice that the claim may be meritless, or good-faith attempts to modify products to avoid infringement.
[iii]--Characterization of Licensing Agreement as "Executory Contract"
Under Section 365 of the Bankruptcy Code, a debtor in bankruptcy proceedings in the
United States is entitled to reject any "executory contract" to which it is a party, and to treat the other party's claim for breach of contract as an unsecured claim in bankruptcy.
Amendments to the Bankruptcy Code made in 1988 permit a licensee of intellectual property whose license is so rejected to continue to exercise rights--including exclusivity--under the license with respect to the licensed intellectual property. The licensee, however, must continue to pay royalties as agreed, waiving any claim of setoff, and the debtor- licensor's other executory obligations may be rejected.
This amendment assuaged the primary fear of parties to licensing agreements: that bankruptcy could pull the rug out from under their use of most licensed intellectual property. Despite these amendments, however, licensees may still reject licensing agreements if they are executory, and licensors' obligations other than the bare license
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726947806 rights are still subject to rejection. Accordingly, what obligations render a licensing agreement an "executory contract" for purposes of bankruptcy proceedings is still a significant issue, although less so now than before the 1988 amendments.
Indemnities are among the provisions whose cumulative presence in licensing agreements may render them executory for this purpose, although an indemnity may not be executory when it is the bankrupt's only remaining obligation. Accordingly, an indemnity's presence in a licensing agreement increases the risk that a party, if a debtor in bankruptcy proceedings, can reject the agreement under the so-called "business judgment rule," i.e., based on a good-faith business judgment that rejection would benefit the bankrupt estate.
[6]--Common Risk-Sharing Provisions
Decades of negotiating indemnities in licensing agreements have produced approaches that often provide a good compromise for both licensor and licensee. One common approach allows the licensor to respond to a third-party infringement claim against the licensee in one of four ways. First, the licensor may defend or indemnify the licensee, taking responsibility for any damages, settlement costs, licensing fees, royalties, and attorneys' fees required to dispose of the third-party's claim. Second, the licensor may attempt to modify the licensed invention to avoid infringement of the third party's patent, without impairing the functionality of that subject matter of the license. Third, the licensor may procure a license from the third party claiming infringement, thereby allowing the licensee to continue its activities unimpeded within the scope of the original licensing agreement. Finally, the licensor may terminate the license agreement and refund any unused royalties that were prepaid by the licensee. Since this last option may result in a loss of the licensee's investment in commercialization of the patented technology, however, the contract usually specifies that the licensor may exercise this option only if none of the other three options is reasonably available. Within this basic structure, negotiation proceeds over such issues as which party has the right to choose between the three options, when the first three options are to be deemed unavailable so that the last may be invoked, and how the parties share the expenses and control of litigation if the first option is chosen. Negotiation of these points within this basic structure often permits the parties to reach a reasonable accommodation with respect to
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726947806 the sharing of costs and risks of third-party infringement claims.
If the license agreement involves the payment of running royalties, there is often an alternative, simpler approach. In the event of a third-party infringement claim, the licensee may be allowed to withhold an amount equal to the costs and expenses of disposing of the claim, including damages, settlement costs, licensing fees, royalties, and attorneys' fees. Variants of this alternative require that the burden of the claim be shared: they permit the licensor to withhold only a fixed percentage (often 50%) of these costs and expenses, while absorbing the remainder.
In some cases, however, the full burden of handling the claim may exceed the licensee's out-of-pocket costs. The additional burden, for example, may include the inconvenience and business disruption occasioned by infringement litigation and the risk that an injunction may devalue the licensee's sunk investment in commercializing the licensed technology. When this additional burden is great, the licensee may be allowed to deduct from royalties a multiple of its out-of- pocket costs to compensate for expenses that may not appear on the balance sheet.
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