Managing Risk in Technology Licensing

By Richard E. Neff, May 17, 2010: Reprinted and/or reposted with the permission of Daily Journal Corp. (2010).

In technology licensing the most difficult jumble of contractual issues generally involve the relationship between indemnification and limitation of liability, particularly the question of the patent indemnity. This is the “negative” lottery in technology contracts, a “loser pays all” provision if not drafted properly.

At the heart of this issue is the great unknown surrounding software and business method patents. The United States took the lead in patenting software and computer-implemented inventions, and also in patenting business methods, often used to protect business methods used in the financial and e-commerce sectors. Much of the world believes that the US Patent and Trademark Office ran amok in issuing such patents; over 200,000 software patents issued over the past decades. The bogeyman for business method patents was the patent over a single mouse click: Amazon patented a system allowing consumers to purchase items by clicking an order button on a website. However, a much anticipated decision of the US Supreme Court in Bilski v. Kappos may narrow the scope of such patents.

The problem for technology licensors is that the cost of determining if a particular piece of software, or some business method, infringes any issued patents is too high, and the results are very uncertain. Even if a software developer hires a patent attorney to perform a clearance search, and provide a clearance opinion, there is no guarantee that the search would be complete. A patent or published application may use very different terminology to cover the same concept, and thus searches can be inconclusive. Patent infringement allegations frequently come out of left field. Furthermore, an opinion of counsel will not prevent the suits from happening; it will just make defending your case easier. A typical patent case might cost $1.5 million to defend.

Unsophisticated companies often license their technology without giving adequate consideration to the issue of how to protect their company against costly patent claims. This may give them a temporary competitive advantage, provided they don’t lose the “patent lottery.” More sophisticated companies often reach stalemates in negotiations with licensees, because their technology pricing does not contemplate paying out hundreds of thousands or even millions of dollars in “hold harmless” indemnity payments to the licensee and in attorneys’ fees.

The obvious answer is insurance, but patent insurance is costly because of the unpredictability and high cost of an incident, somewhat akin to earthquake insurance. Insurance should always be considered; often patent infringement coverage can be a rider to an “errors & omissions” policy. Apart from insurance, which may not be a viable option or even available in all cases, the following are some of the considerations that come into play when representing a technology licensor:

  1. Geographical limitations: It is worthwhile to try to limit patent indemnification to patent claims arising under U.S. law. There is less worry about copyright or trademark claims as they are less costly to defend. Although the United States probably is the most dangerous jurisdiction for patent claims it is very difficult for a US company to avoid giving some kind of U.S. patent indemnity. Generally one should avoid giving an open-ended, worldwide patent indemnity; it is best to try to limit its reach to patent rights arising under the jurisdictions where the licensee uses the technology, and list specific countries. While litigation in the developing world is often best avoided, the truth is that few patent claims originate there.
  2. Representation and warranty avoidance: It is best to avoid giving a representation or warranty that the technology being licensed does not infringe the rights of any third party. The point is that nobody knows for sure, and most states follow the New York rule in CBS Inc. v. Ziff-Davis Publishing Co. that a warranty is a promise of indemnity if a statement of fact is false. Further, the measure of damages is generally the benefit of the bargain, often lost profits. It is better to avoid the issue, and merely to state: if you get bitten by the patent infringement bug, we’ll indemnify you and hold you harmless. That’s what an indemnification clause does. The licensee should be happy with the promise to pay that is contained in the indemnity provision without requiring a questionable statement that the technology does not infringe third party rights.
  3. Consequential damages elimination: It is definitely better risk management for the technology licensor to state that the licensor will defend and indemnify the licensee and hold it harmless, but not to agree to cover consequential, special or indirect damages, which might greatly expand the scope of the loss that must be compensated by the licensor beyond recovery of damages that result directly from the breach, e.g., the cost to repair or complete the work in accordance with the contract documents. Consequential damages might include loss of product and loss of profit or revenue and may be recovered if it is determined such damages were reasonably foreseeable or “within the contemplation of the parties” at the time of the contract.
  4. Cover the Unmodified Technology: Be careful that the indemnity has exclusions or carve-outs for modifications to the technology not made by licensor or with its authorization, or usage that varies from the technology specifications, especially to the extent any infringement claim would have been avoided had no such modifications or variant use taken place. Better still, limit the indemnity to the software as provided, i.e., uninstalled, if possible.
  5. Capping the Limitation of Liability: This is where the negotiating parties often end up at loggerheads. If the scope limitations described above are achieved, it may be acceptable not to cap the liability limitation provision with respect to indemnification for infringement of third party rights (or breach of confidentiality), but to try to cap liability faced by the licensor for all other third-party claims, with the possible exceptions of injury to person or tangible property, or death. The cap for all other claims generally is based on the contract value, often an amount measured by the amounts paid under the contract during the year preceding the claim having arisen. From the licensor perspective, in the best of all possible worlds, there could be two different liability caps, one for most claims, limited to amounts paid under the agreement over a 12-month period, and one for all other claims, perhaps limited to five (5) times amounts paid during a 12-month period.

Careful attention to these issues will enable a technology licensor to better manage and limit its own risk.

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