Authored by Ming-Tao Yang and Christopher B. McKinley
Suppliers, particularly non-U.S. suppliers, frequently take comfort in rejecting and successfully excluding indemnity provisions from their agreements with U.S. buyers. They may, however, be dismayed to later learn that liability for indemnifying a buyer’s defense against patent infringement claims remains with them. U.S. state laws, frequently elected as the governing laws in many supply agreements, generally provide an implied warranty that holds buyers harmless from patent infringement claims against the supplier’s products. The warranty applies even when the agreement is says nothing about the suppliers’ indemnity obligations. Suppliers who instead rely on a general “disclaimer” to exclude the warranty against infringement rarely fair better than those who remain silent because courts have casted doubts on whether a general disclaimer can disclaim such a warranty. To remove such significant, uncertain, but real risks, silence is not an option. Suppliers intending to disclaim warranty against patent infringement must do so expressly, leaving no room for a contrary interpretation.
By default, the Uniform Commercial Code (“UCC”), adopted most states in the United States, shifts to suppliers the liability and cost for patent infringement. This requires suppliers (i.e., sellers of goods), domestic or foreign, to warrant that the goods they supply do not infringe others’ rights. That warranty, when breached, makes suppliers responsible for costs incurred by the buyer in defending infringement claims.
Most U.S. states have adopted UCC Section 2-312(3) or some form of it, which sets out the warranty against infringement:
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.
In applying this section, courts have held that a breach of the warranty against infringement requires buyer to show that: (1) the seller is a merchant; (2) the goods were subject to a rightful claim of infringement; (3) the buyer did not provide the seller with specifications to manufacture the infringing good; and (4) the parties have not “otherwise agreed.” 84 Lumber Co. v. MRK Techs., Ltd., 145 F. Supp. 2d 675, 679-80 (W.D. Pa. 2001). Suppliers, on the other hand, frequently challenge the second and fourth elements, arguing that the patentee’s infringement allegation is not a “rightful claim,” and the parties “otherwise agreed” to exclude such warranty. However, most states set a very low threshold for what a “rightful claim” is, and a general disclaimer is frequently not specific enough to exclude the warranty.
Regarding the “rightful claim” requirement, the Federal Circuit has held a rightful claim is not one that requires the patentee to prevail on the merits. See Cover v. Hydramatic Packing Co., 83 F.3d 1390, 1394 (Fed. Cir. 1996). Most states consider an infringement claim rightful if it is not frivolous. See 84 Lumber, 145 F. Supp. at 680; Pac. Sunwear of California, Inc. v. Olaes Enters., Inc., 167 Cal. App. 4th 466, 481, 84 Cal. Rptr. 3d 182, 193 (2008) (“A rightful claim under section 2312(3) is a nonfrivolous claim of infringement that has any significant and adverse effect, through the prospect of litigation or otherwise, on the buyer's ability to make use of the purchased goods.”) (emphasis added); Phoenix Sols., Inc. v. Sony Elecs., Inc., 637 F. Supp. 2d 683, 697 (N.D. Cal. 2009). Because it is difficult to prove that a patent infringement claim is frivolous (i.e., no reasonable basis for bringing suit), courts rarely find infringement claims as such. In other words, the “rightful claim” requirement is an easy one to meet.
Some state courts, however, appear to raise the standard by requiring the claim to be one of “substantial nature” that casts a “substantial shadow” on the buyer’s use of the product. Under this standard, showing an adverse effect on a buyer’s ability to use the purportedly infringing goods is generally sufficient. Sun Coast Merch. Corp. v. Myron Corp., 393 N.J. Super. 55, 79-80 (App. Div. 2007). Buyers frequently can assert that because a third-party infringement claim disrupts the buyer’s business, increases its costs, and impacts the value or re-salability of goods, the claim is of “substantial nature” that casts a “substantial shadow” on its use of the product.
Therefore, the difference between the “non-frivolous” and “substantial shadow” standards is minimal. A buyer meets the former standard by demonstrating that there is a reasonable basis for the patentee’s infringement claim, and meets the latter by showing that the infringement claim adversely impacts its business, such as by risking damages, injunctions, reputational harm, or loss of consumer’s confidence.
To establish that a claim is rightful, often find themselves in the precarious position of having to argue against infringement (to defend itself) and for infringement (to establish an its indemnity claim). On the one hand, buyers argue to the patentee that the its claim is deficient to avoid liability for infringement. On the other, buyers argue to the supplier that the infringement claims is non-frivolous or casts a substantial shadow, and is therefore “rightful.” Luckily, courts recognize that buyers have to defend themselves, so arguing invalidity or non-infringement to the patentee in an infringement action does not estop the buyer from asserting that the patentee’s claim is “rightful” in a breach-of-warranty claim against the supplier. See Phoenix Sols., 637 F. Supp. 2d at 696.
Nevertheless, suppliers do have additional defenses, including (1) the timeliness of a buyer’s breach-of-warranty claim; (2) a buyer’s demand of building a product to its specification; and (3) disclaimer language that expressly excludes warranty against infringement.
As to the first defense, a supplier’s indemnity obligations become limited if its buyer fails to timely file a breach-of-warranty claim . A buyer must do so within a reasonable time from receiving notice of suit. For example, if the buyer waits until after a judgment of non-infringement, the claim is no longer rightful because it does not cast a shadow over the buyer’s use of the product and is indeed without a reasonable basis. So, the buyer’s efforts to recover litigation costs from the buyer will fail. Suppliers should therefore take note of whether the buyer’s breach-of-warranty against infringement claim is timely.
As to the second defense, suppliers may also avoid or minimize indemnity obligations when the basis of an infringement claim stems from a buyer’s actions, such as modifying the goods or providing a specification for their manufacture. This issue often arises in disputes over the third element (i.e., buyer-provided specifications). For example, a supplier has little or no indemnity obligation where it manufactures the purchased goods exactly as a buyer specifies and the specifically-demanded feature or process forms the basis of an infringement claim. The same is true where a buyer’s post-delivery modification forms the sole basis of an infringement claim. However, liability likely falls on the supplier when the modification or use of the product is intended by the supplier; or when the basis of infringement rests on the supplier’s own independent implementation or iteration of the buyer’s specification. Suppliers wanting clarity or minimized risks should carefully identify the scope of its obligations, leaving no undefined territory. Again, silence does not minimize risk, and often times may cause additional and unexpected harm.
As to disclaimers, a general disclaimer language is frequently insufficient as a defense. Language that disclaims almost everything but without any specificity as to the warranty against infringement does not do suppliers any good. Examples include: “the supplier disclaims any other liability not otherwise expressly recited in the agreement;” “no other damages shall be available aside from those provided in the agreement;” and “any relief not otherwise provided in the agreement shall be excluded.” These general disclaimers are insufficient to exclude the warranty against infringement, because they do not specifically exclude such warranty, which exists under the UCC by default or by the parties’ silence. State courts generally agree that a general disclaimer does not waive or exclude the warranty against infringement. Few courts have the minority view that a general disclaimer, including one made orally, is sufficient. See, .e.g., Landis & Staefa (UK) Ltd. v. Flair Int'l Corp., 60 F. Supp. 2d 14, 23 (E.D.N.Y. 1999) (finding sufficient a general disclaimer stating “[t]here are no warranties, expressed or implied, written or oral . . . with respect to any device manufactured or sold by [the supplier], except as herein set forth”).
Notwithstanding the foregoing, some suppliers have a unique bargaining position resulting from scarcity, quality, price, or other market conditions, that they may also use as leverage to avoid indemnity obligations. When present, these beneficial conditions can be leveraged to negotiate for future business relationships or increased sales/cooperation in exchange for the resolution of or limitations on indemnity claims, or a revised agreement.
Given the rising costs of defending patent infringement claims and the risks of significant damages, suppliers should avoid leaving indemnity issue unaddressed in their supply or sales agreements. They should instead avail themselves of the opportunity to eliminate unpredictable liabilities and significant losses when drafting or renegotiating their agreements. The implied warranty against infringement discussed above arises frequently to benefit buyers to the detriment of suppliers, resulting in unwritten but real indemnity obligations. The risk is real especially when the parties’ agreement is completely silent or unclear, or when the parties transact without any agreement. To the surprise of many, the warranty against infringement is implied and therefore applies to all contracts involving the sale of goods. When no warranty is intended, suppliers need to disclaim any such warranty, both expressly and specifically.
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