If you are a vendor of software, online (SaaS) services, content of any kind, or anything else that can be the subject of an intellectual property infringement claim, then sooner or later (probably sooner), your customers will demand that you indemnify them from any claims by a third party that your customer’s use of your product infringes the third party’s intellectual property (IP) rights.
At first glance, when you look at IP indemnity clauses they may appear to be basically composed of similar boilerplate language. However, when you drill down into the details there is actually a very wide variety of such clauses, each representing a different level of liability exposure.
Infringement suits are not so common, so you may think that it’s not worth wasting valuable time to negotiate or pay a lawyer to prepare an IP indemnity clause. However, if such a clause is ever activated against you to supply the required indemnification, I can guarantee that you will wish you spent appropriate time negotiating this clause to your advantage.
The discussion below is primarily from the vendor’s perspective. However, if you are a customer seeking an indemnification, the same ideas and principles discussed below can easily be understood from the customer’s perspective as well.
Purposes of an IP Indemnification
Understand that only the customer wants an IP indemnity clause, and not the vendor. This is because its purpose is to protect the customer from liability if they are sued for IP infringement based upon their use of your product. So, if you can get away with not including such an indemnity at all, then that’s the way to go, and you will avoid all the potential liability that this clause imposes. However, if you are dealing with customers with a little sophistication, they will certainly demand an IP indemnification.
Discussion of Elements to Consider
- Identity of indemnitees
Who will be indemnified under the clause? The broader the definition of “indemnitees,” the greater the potential for liability. Many clauses will include the customer, its affiliates, directors, officers, and employees. It’s hard to argue against including those indemnitees. Nevertheless, the clause you begin with could just list the customer as the indemnitee so that it is more limited. What about end-users of the product where the product is distributed in some manner by the customer? For example, your customer is an OEM is bundling your product or service with theirs and distributing it to end-users. I would argue strongly against agreeing to indemnify end-users. With large numbers of end-users, the potential liability can become enormous. Also, your customer has the ability to limit their liability arising from infringement claims related to your product vis-à-vis the end-users. However, you don’t have this ability because there is no contractual relationship between you and the end-user.
- Scope of coverage
An indemnification can indemnify for infringement relating to some or all of the following: copyrights, patents, trademarks, and trade secrets. Copyright infringement based upon the code you have developed is under your control and therefore should be included in an indemnity. Liability from trademark infringement and unauthorized use of trade secrets is usually of the least concern. However, patents are different. Unless you’ve done a search of the U.S. Patent Office (which you haven’t and won’t do), you cannot know whether your product infringes a patent. Due to this lack of knowledge, some vendors may seek to not include patents in the indemnity, or at least limit the indemnity to U.S. patents. Some will also try to limit the indemnity coverage only to patents issued as of the date of the agreement. Beware, patent trolls are out there searching for easy prey.
- Types of costs and damages included
Indemnifications usually include an obligation to defend against the infringement claim and to reimburse for any damages and costs. Indemnifications are primarily designed to cover liability from third party claims, which includes damages awarded by a court, arbitration or settlement, penalties, fines, and expenses. Attorney’s fees are usually spelled out. However, since the one giving the indemnification will usually also have an obligation to defend, then the indemnified party would not usually incur legal fees. Legal fees would arise if the indemnifying party fails to defend, or if attorney’s fee are awarded to the plaintiff. The issue to look closely at is whether in addition to an obligation to reimburse for amounts imposed upon the indemnified party by a third party action the indemnifying party is also responsible for internal losses of the customer arising from the infringement. This can be a huge distinction. For instance, while the customer might owe $100,000 in damages in a patent infringement suit, they may have lost $1,000,000 in lost business by being enjoined from using your product. A vendor should not have to be liable for these indirect damages, especially since the agreement may generally exclude liability for indirect damages. In the rare case, I have seen vendors that only agree to defend and not be responsible for damages at all. This is a very unusual position, but certainly limits the vendor’s exposure.
- Savings obligations
(a) Modify or replace or obtain license rights
If there is an infringement, then the vendor may be able to either modify the product so that it is not infringing, replace it with another non-infringing product or obtain the license rights from the actual owner of the IP. However, it’s important to determine whether these alternatives are worded as options or obligations. There’s a big difference, because if they are obligations, then the cost of any one of those alternative solutions might be prohibitive. However, even if they are worded as obligations, they should be specifically subject to being commercially practical to accomplish. Nevertheless, the vendor would want these alternatives to be options and not obligations.
(b) Terminate
If the above alternative solutions are not commercially practical, then the vendor should have the option of terminating the license. This will stop the bleeding, because the infringing activity will then cease, and the ultimate damage amount will stop climbing.
(c) Refund
Okay, you exercise the termination option, now the customer want’s to be compensated for the loss of use of the product. Some customer-prepared clauses ask for a full refund of all fees paid. That is not usually a reasonable result because the customer has had beneficial use of the product for some time. So, I usually agree to refund license fees decreased in accordance with 3-year straightline depreciation. If there have been any maintenance fees or professional services fees, you should avoid including them in the refund amount.
- Exclusions
There are several standard exclusions to the IP indemnity that should be included. If the infringement claim arose out of any of these circumstances, then the indemnity should not apply. (a) Combination Your product will often be used in combination with other products. It’s possible that your product does not infringe IP rights, but the combination of your product and another product does result in a patent infringement. So, an infringement arising from the combination should be excluded. (b) Third party components and open source Your product may include third party components, including open source software. You don’t develop these, so you have no control whether they may contain infringing elements. What’s more, the vendor of those products might not have given you any IP indemnification. Therefore, it’s important to try to exclude third party components from your IP indemnity obligations. (c) User specifications A customer may be requesting that you develop a product or modify a product. If the product resulting from development of the specifications is infringing, then such an infringement should be excluded. (d) Out of scope use Licenses are defined by a scope of use. If an infringement arises out of a scope of use that was not permitted or anticipated, then such an infringement should be excluded from the indemnification. (e) Modifications Of course, if an infringement arises from modifications to your product made by the customer or a third party, then such an indemnification should be excluded.
- Reverse indemnification
If a customer gives you specifications that result in infringement claims against you as the developer, you can provide that the customer will indemnify you in such a case.
- Exclusive remedy
Many agreements cover IP infringement in to ways. First, there is a warranty that the product does not infringe any third party’s IP rights. Second, there is an indemnification if there is a claim of IP infringement. As you can guess, there could be separate liability under both the warranty and indemnification. Therefore, it is advisable to state that the indemnification is the sole liability of the vendor arising from an IP infringement claim. As an aside, a warranty disclaimer should include a disclaimer of the implied warranty of non-infringement due to certain remedies provided under the Uniform Commercial Code (UCC). This disclaimer does not limit the indemnification, but would limit actions under the UCC.
- Relation to liability limitations
Every vendor agreement should have a limitation of liability clause that includes an overall aggregate cap for vendor liability. A first draft of vendor agreement will usually state that this liability applies to all potential liability. In such case, the IP indemnification will also be limited to this cap amount. However, an on-the-ball customer will seek to carve out the IP indemnification, which would result in potential unlimited liability for claims of IP infringement. Many vendors will accept unlimited liability for IP infringement. However, this determination must take into account the particulars of your product and your acceptable risk profile.
- Sole right of defense, consent to settlement, obligations of notice and cooperation
Usually the customer must give the vendor the sole right to control the defense and settlement. Also, the customer must promptly notify the vendor of any claims and provide cooperation. Some clauses seek to require notice of a claim within a short period of time (e.g., 10 days). The implication being that if the customer misses the deadline, then there is no indemnification obligation. A court would probably not honor such a strict construction, unless the delay resulted in the ability to defend being prejudiced by the delay. While the vendor will control the settlement, no settlement should occur that imposes any liability or obligations/restrictions on the customer without the customer’s consent.
- Legal fees
Smart customers may include a provision that the vendor should be responsible for the customer’s legal fees and costs incurred by the customer to compel compliance by the vendor with the indemnification obligations.
Bottom Line:
IP infringement indemnification provisions are chock full of nuances that should be understood in order to put you in a good position should that indemnity ever be activated. As mentioned, the likelihood of IP infringement claims is usually remote, but if and when one happens, it comes on with a vengeance.