Licensing

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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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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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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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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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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 off-

shoot 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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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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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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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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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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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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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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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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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 non-

allowable 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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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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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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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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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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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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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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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 patent-

related 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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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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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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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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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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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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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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