Musings on the Eternal Question of Patent Indemnities

If there is a heaven for technology licensing lawyers, it is a perfect place where patent indemnities don’t exist. I have been advised, by those who know me best, that I am not going there, and undoubtedly they are right. Where I go, presumably, I will spend eternity negotiating a patent indemnity in a dark, cramped conference room in an airport hotel — against a real estate lawyer.

Patent indemnities are fundamentally impossible to negotiate correctly. Accepting this truth is an important milestone in any licensing lawyer’s career. Asking what is “normal” or “right” in a patent indemnity negotiation is like asking the meaning of life. We can, and should, consider it. But we can’t ever truly know.

What to do about this eternal question is one of the one of the most common requests I get from clients, many of whom are experienced lawyers.  To analyze the question, it’s helpful to step back to consider why and how one allocates risk in an agreement, to begin with. In most contract provisions, both parties are trying to minimize uncertainty and risk. But indemnity provisions don’t limit risk, they just move it around.

Indemnities are therefore hard contract terms to negotiate; they are often the last bridge to cross in negotiating a deal. At that point in the deal, all the business people have left the conference room, or started answering their emails on their phones, or just expired of boredom. The IP lawyers must soldier on. Allocation of risk provisions like indemnities and liability limitations are difficult to negotiate because they are zero-sum games. One party wins and the other loses. Unlike the business terms of contracts, they don’t lend themselves to win-win outcomes.

Mindful of the difficulty of the task and the lack of a true answer, here are some comments that might help you deal with this eternal question.

He who calls the tune pays the piper. One oft-quoted theory of indemnities is that the party who can better control a risk should bear it. This is sensible on face. It creates the right incentives, and makes lots of sense for negotiating risk allocation for IP infringement like copyright and trade secret. But in fact, ability to control third party patent infringement risk is mostly theoretical. IP lawyers know this, but most other people don’t (nor should they be burdened with such horrific knowledge). You can infringe a patent without doing anything wrong, and without knowing you are doing anything wrong, and without any reasonable means to figure out whether you are doing anything wrong.

If you accept that the provider of technology is not in a position to control this risk, the parties should share the risk.  Depending on context, that usually means the licensor indemnifies up to a cap. If the counterparty in a negotiation does not understand how patent infringement works (i.e. that it can happen without a wrongful act) one needs to respectfully explain that.

Follow the Money. Another, sometimes simultaneously applied, theory is that the party that gets the money bears the risk.  Theoretically, the party getting money can take a risk-discounted reserve against its revenue to offset the cost of the indemnity. Under this rule, the vendor bears liability in commercial transactions, particularly where the volume of sales (and thus infringement damages) is correlated to revenue.

Buy Insurance.  This is the most economically efficient approach but rarely feasible, because there is little insurance available to defend patent claims that is not prohibitively expensive. If you could allocate liability for patent infringement by insuring against the claim, it would reduce the negotiation to a simple money discussion. This is another thing that happens in licensing heaven, I guess.

Vendor Bites the Bullet.  This applies mostly to commercial deals selling products. In reality, most vendors would not want their customer defending patent claims. Those claims are likely to be crucial to the vendor’s business. Out of self-defense, many vendors will undertake defense of their own products regardless of what their contracts say about indemnities.  Placing the onus on the customer can actually be risky for the vendor. There is material conflict of interest for customer to handle infringement claims; the customer will be too willing to settle, possibly for a small amount per units associated with the customer’s modest use. Patent plaintiffs find it easier to sustain claims and get damages if they have successful licenses under their belts. This sets a dangerous precedent for the vendor, whose heavier practice of the patent can add up to significant damages. Also, at least for legal fees (rather than damages), it is cheaper for a vendor to handle the claim than for a bunch of customers to form a defense group.

Rule One: Sue People With Money. There are a couple of other considerations to keep in mind, to prevent you from fighting to gain advantages that don’t really exist. Never forget that you can’t get blood from a stone.  A serious patent claim can bankrupt small vendors. As one of my clients said once, “I’ll agree to a liability cap of $10 million. I only have $1 million in capital. Hey, let’s make it $100 million!”

Don’t be an Ostrich. There is a subtler reality to keep in mind. Some lawyers on the vendor side negotiate as if, when they don’t agree to an indemnity, they don’t have any liability. That is usually not true. Patent plaintiffs can sue vendors directly for infringement that they induce in their customers, and in fact, its easier for plaintiffs to do that than to sue the customers. So, by offering an indemnity, a vendor is taking on only the marginal liability consisting of the difference between inducement damages and direct damages (and of course the related fees and costs). While that delta is not zero, it is not the entire patent infringement risk from the deal. Patent infringement risk is a price of doing business, and you can’t de-risk your business completely by sloughing off liability on your customers.

It’s Good to be the King. In actual practice, bargaining power almost always wins the patent indemnity argument, regardless of other facts.  If you represent a vendor, your client is either big enough (in relation to its customers) to set terms, or not. A small vendor probably has to bear unlimited liability. A bigger one can disclaim all the liability it wants. Lawyers can burn up a lot of time and political capital negotiating patent indemnities, but vendors will usually prioritize present income over contingent and later costs, and disregard their lawyers’ warnings of risk.  That may hurt the lawyer’s feelings, but it is usually economically rational. And by refusing to concede on indemnities you can actually kill a deal, which may not serve your client.

Beyond Good and Evil. The eternal question of patent indemnity is not a moral question.  It is a business question.  Indemnities are costly because bearing risk is costly, whether or not the risk actually matures to harm — which is why insurance companies charge money. Characterizing undertaking a patent indemnity (or refusing to do so) as moral right or wrong may be an amusing negotiating ploy, but it’s not a good way to solve the question. If you are a customer and want to guarantee you will not resolve the eternal question, you should cry “You ought to stand up for your product!” Preferably while banging on the table. If you are in a negotiation and someone does this to you, you might consider offering to make them a cup of soothing herb tea.

There is no Normal. Market positions on patent indemnities are all over the map. Whether it is an M&A deal, or a commercial deal, or something in between, the allocation of risk on patent infringement can range from zero to unlimited. Anyone who says (while pounding the table), “I have never in all my career seen anyone refuse to agree to X” (where X is whichever position along that spectrum one may choose) or (with a proper show of indignity) “All our business partners agree to these terms and how dare you not do that!” either is acting, or lying, or needs to get out more. Extra points if the person uttering these words has worked at the same company for decades and is drawing from an N of one.

YMMV. These principles don’t apply in all cases, of course.  A commercial sale of semiconductors is not the same as a patent license to settle litigation or public-public M&A deal. The facts matter, and drive the most common outcomes. One significant fact that gets overlooked is jurisdiction. If a patentee cannot get jurisdiction over one of the parties in your deal, to bring an infringement claim, the other party becomes a substitute target. In some contexts, vendors can reduce risk by doing freedom to operate studies or entering patent pools, and then feel more comfortable bearing risk. But these tactics are not always available or feasible.

Enjoy! I hope this helps you with the mental torture of negotiating patent indemnities, at least until you leave this mortal coil. After than, you will either be blissfully unconcerned — or I guess I’ll see you in the airport hotel conference room.

Author: heatherjmeeker

Technology licensing lawyer, drummer, dancer

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