Shifting liability

Editor's Note: As globalization intensifies, companies from different countries are increasingly connected because of the different roles they play in an industry chain. But at the same time patent litigation risks also rise. For example, many Chinese companies sell components to manufacturers or assemblers in China, which then incorporate the components into machines and export the machines to the United States. By exporting the machine containing a patent infringing component, the machine manufacturer or assembler makes itself liable for infringement.

Nowadays many companies have to increasingly look to legal tools, such as contract indemnification, to shift liability patent infringement. Brian Kacedon, an attorney at the US law firm Finnegan, and Connie Chang, a former attorney at the firm, talk about tools for managing risks associated with such sales contracts or licenses in this article.

China Business Weekly is running the article in two issues. Below is the first part. The Chinese version of the article was published in China IP News. The views expressed here are the authors' own.

Over the last two decades, the risks associated with US patent litigation has caused many companies outside the US to rethink their approach to selling and importing products in the US. In particular, many companies have increasingly looked to legal tools, such as contract indemnification, to shift liability for patent infringement. With such agreements, companies can reduce their own liability for patent infringement by spreading that liability, in whole or in part, to customers or suppliers through the use of actions for indemnity against such customers or suppliers.

Today, many Chinese companies sell components to Chinese manufacturers or assemblers, which then incorporates the component into the machine and export the machine to the US. By exporting the machine containing the infringing component, the machine manufacturer or assembler would ordinarily be liable for infringement. However, if the machine manufacturer or assembler has included an indemnity provision in the sales contract, it could potentially force the component maker to defend or reimburse it for any liability and expenses.

When a manufacturer or assembler purchases a component from a seller and incorporates that component into a machine that the buyer makes, the buyer needs to recognize that it may be liable for patent infringement by selling or importing the device including that component even if the alleged infringement is caused solely by the component.

When a machine manufacturer purchases and assembles the "infringing" component into its machine, this manufacturer or assembler could face lawsuits resulting in monetary damages, including treble damages, attorney fees and permanent injunctions.

Manufacturers or assemblers can address this issue by including appropriate protections in their sales contract. Such contractual protection can include representations and warranties from the component supplier that the component does not infringe any third parties' intellectual property rights or that it is not aware of any claims of infringement made against such components.

It may also include "indemnification" provisions that provide if any infringement actions are brought against the manufacturers or assemblers for infringement by the components, the component maker will defend and indemnify the manufacturers or assemblers against that claim and will pay for any expenses and costs, including attorney's fees.

There are several key elements of an indemnification clause. In drafting such a clause, the manufacturer or assembler should carefully consider addressing:

What are the factors triggering and terminating the indemnification liability?

What is the scope of intellectual property covered by the indemnification clause?

What is the extent of financial liability provided by the component supplier, for example, will the supplier be responsible for all or only part of any potential damages?

Can the component supplier meet its financial obligations and what ability will the manufacturer have to obtain recovery from the component supplier?

Who has control of the infringement lawsuit and settlement of any dispute?

It is also particularly important, from the manufacturer's perspective, to consider what circumstances will cause when the indemnification obligation to terminate.

Common terminating factors include:

Manufacturer's failure to notify the component maker within a certain period of receiving notice of a potential infringement claim or threat of such lawsuit,

Any modification of the component by the manufacturer that results in the infringement,

Failure to exclusively assemble or install the component on certain specified machines or hardware,

Failure to comply with particular user restrictions in the license.

In addition to requesting the component maker to indemnify them for potential infringement actions, the machine manufacturers or assemblers may also wish to require their component makers to obtain all necessary licenses to make, use, sell, offer for sale, or import the component-at-issue and any products incorporating the component-at-issue.

In such circumstances, the machine manufacturers or assemblers can consider ceasing the purchase of the components from the component makers until the appropriate licenses are obtained.

However, there are various kinds of licenses that the component makers could get, and such licenses do not necessarily allow the machine manufacturer or assemblers to legitimately use the components without being sued by the licensors later. Therefore, manufacturers or assemblers should carefully ascertain the scope of any license obtained by their component manufacturers.

For example, a component manufacturer who receives a "covenant not to sue" or "nonassertion agreement", may not provide the manufacturer who includes such a component with any freedom from suit.

Generally, a "covenant not to sue" provides only a promise from the patent owner that it will not assert the patent-at-issue against the recipient of that covenant. It is typically considered personal to the recipient and therefore, may not extend to customers of the component manufacturer, such as manufacturers who incorporate components in their devices.

Moreover, normally, the recipient cannot assign its rights under "covenant not to sue" to any third party, including the machine manufacturer or assembler in our case, without the grantor's permission.

Thus, the scope of such an agreement may be very limited and may allow a patent owner to pursue any downstream customers for their use or sale of the patented invention.

To be continued

(China Daily 11/03/2008 page9)