Intellectual property indemnification versus a warranty of non-infringement – what’s the difference?

Indemnities are used to protect against 3rd party claims for injury or damage caused to the third party by one of the parties to the agreement. Warranties are to make sure that certain facts are true or certain behaviors will continue for the term of the agreement. Both normally will be specified to survive the termination or expiration of the agreement.

Intellectual property indemnifications will normally require that the infringing party defend against the third party claim (thereby assuming the cost of the defense). They will also require the infringing party to pay any damages awarded. There may also be an issue of who controls the defense of the claim. Suppliers are normally concerned that if a Buyer controls the defense it will set a precedent for other potential lawsuits. Buyer’s may be concerned with Supplier’s controlling the defense, especially if the Supplier has limited assets as a bad defense could require the buyer to pay any damages over and above what could be recovered from the supplier. Indemnifications will require the infringing party to try to remedy the infringement. The structure and order of the remedies available to the infringing party are one of the most important aspects of the indemnification. The first issue is when does the infringing party need to take action to remedy the infringement? If it’s only after they have been found by a court of law to be infringing, that’s too late as it can interrupt the supply chain. If it’s when a claim is brought, it’s usually too soon as the claim may not have merit. The second major issue is the precedence between remedies. Remedies that would be the lowest cost for the buyer are usually the most expensive for the supplier and vice versa. I’ve seen IP indemnity remedies where they require the supplier to provide the first of the list that is practicable (meaning capable of being done), and list:
1.Obtain for Buyer the right to continue to use and sell the Product.
2. Modify the Product so it is non-infringing.
3. Replace the Products with non-infringing ones that comply with the Agreement; or
4. at Buyer's request, accept the cancellation of infringing Products without Buyer having any cancellation liability and the return of the infringing Products at Supplier’s expense and refund any amount paid.
With this language it the Buyer did not request #4, the infringement would not have been remedies and it would be a breach. IP Indemnities are normally carved out of the limitation of liability for several reasons. First, they are a third party claim, not a claim by one of the parties to the agreement and the limitation should be only for claims between the parties to the agreement. A second reason to carve the IP indemnification from the limitation of liability is under many intellectual property laws if there is willful infringement of another part’s IP rights a court may award penalties. If you didn’t carve the IP indemnification out of the limitation of liability and a penalty was ordered, the Buyer cold wind up being limited to only the direct damage awarded and have to pay the penalty portion of the award.

A warranty of non-infringement provides you with significantly less protection than if you include both the IP Indemnity and warranty. A breach of the warranty only provides for damages and does not force the Supplier to remedy the infringement. It may be cheaper for them to pay the damages and walk away from the problem. If the Buyer is sued directly for the infringement, the buyer will need to defend against the claim, pay the claim and seek to recover both their costs and any damages paid as a claim of breach of the warranty of non-infringement. The recovery under warranty will be limited under the limitation of liability as to the types of damages that may be claimed and there may be financial limits on the amount the supplier is liable to pay. If you have a financial cap on liability all of your costs to defend, and damages paid would be against that cap providing you with a reduced amount you could recover for the damages the buyer sustained. If you had to litigate to get recovery for breach of warranty, those costs would also be counted against the limitation.

In supplier proposals and negotiations I look for what I call “red flags”. These are early warning signs that there might be a problem that may require walking away from a deal, changing suppliers, or identifying a need to establish alternative sources. When I have a supplier that doesn’t want to provide an Intellectual Property Indemnity and only wants to provide a warranty of non-infringement, that’s a personal red flag for me. It tells me that they don’t have significant confidence in their product or service being non-infringing. If they don’t have significant confidence in that, it tells me that I shouldn’t have confidence in their product being non-infringing and that they will do the right thing for my company in the event an infringement claim is brought based upon their product.

SUPPLY CHAIN RISK MANAGEMENT IN CONTRACTS

A supply chain is just like any other chain. It is only as strong as its weakest link. So how do you try to protect against shortages or interruption in supply? What can you include in a purchase contract to manage risk with your supply chain? There are many things that can impact you supply of critical parts or materials such as:

• Excess demand versus available capacity.
• Reduction in capacity caused by plant closures, layoffs.
• Production problems.
• Quality yield problems.
• Changes to design that impact your ability to use the product.
• Natural disasters at manufacturing locations, subcontractor or material supplier locations.
• Strikes, Lockouts and other labor disputes.
• Loss or damage in transit.
• Import or export restrictions or bans.
• Legal problems with the parts or materials – infringement of IP rights, not complying with laws.
• Product problems such as safety problems that can halt production until a solution is found.
• Product discontinuance or end of life.
• Product transitions to newer versions.
• Enactment of laws such as environmental laws banning the use of specific substances.
• Limited sources (custom or unique items)
• Supplier or subcontractor financial problems impacting their ability to purchase needed supply or run operations.
• Custom or unique product with only one source creates risk in the event you have a problem.

There are a number of ways these risks can be managed. Some may be managed through initial part or material selection for use in your product. The fewer custom or unique parts or materials you use, the more potential sources you can have. Thorough supplier qualification helps manage some risks. Some risks may be managed by sourcing strategies such as multiple sources of supply or inventory strategies with multiple stocking locations. Some of these risks may be managed contractually. A strategy to manage potential risk may you need a combination of all the potential ways.

Most strategies to manage risk cost money and that becomes a trade-off between cost versus the risk. Dual or alternative sourcing costs money, and dual sourcing may impact the price you pay as you are splitting volumes. If you have dual qualified sources but are only buying from one, when you need that alternative supplier they may not have capacity and it will take time for them to ramp up to your needed volumes creating shortages. Inventory both ties up money and costs money. With inventory you also have the risk of loss, damage or it becoming obsolete. Some products also have limited shelf life you have to manage or it may not be usable.

As the focus of my blog is about contracts and negotiation of contracts, I wanted to share some thoughts on how to try to contractually manage some of these risks.

Excess demand versus available capacity.
You can make firm commitments for a specific quantity and spot buy for other needs to reduce the risk and the potential of winding up with excess inventory.
You could create a reserve capacity agreement where the supplier reserves a specific capacity for your purchase. You have a specific period to order your needed quantities, after which the supply may be sold to other customers
Reduction in capacity caused by plant closures, layoffs.
You could require advance notices of potential actions with the ability to increase orders and have the supplier hold inventory as a buffer against potential shortages
Production problems, Quality yield problems.
Normally if possible you would develop multiple sources of supply so if one supplier has these problems you can buy from an alternative source. If you have a single source supplier your contract should include standards the supplier must meet to retain that status and remedies they will provide in the event there are problems. For example you could require them to stock a quantity of known good product at a stocking hub. You could require them to develop a second source.
Changes to design that impact your ability to use the product or Product transitions to newer versions
You could require no changes be made to the design of the product without your advance approval. If you can’t get that you could require both advance notices of changes, and samples of the new product to determine if it will be an acceptable alternative. If it won’t be, get the right to either have the current version still be manufactured or have them build and hold inventory for the transition. They will of course want a commitment that you will buy all held in inventory and buy it within a reasonable period. In the buyer / supplier relationship its always less expensive for the supplier to hold the inventory as they hold it at their cost whereas the buyer holds it at the purchased price.
Natural disasters at manufacturing locations, subcontractor or material supplier locations.
Understand not just your supply chain but also supply chain of critical suppliers and material providers. Understand exactly where your items will be made. If you are concerned with potential risks require production be geographically dispersed. As an alternative require disbursed stocking hubs to reduce time impact of disasters.
Strikes, Lockouts and other labor disputes.
Do not allow lockouts to be considered a force majeure as the Supplier has total control over whether they exercise them. Understand when contracts will expire and work with the supplier to create a supply contingency plan to mitigate the impact.
Loss or damage in transit.
Specify packing, packaging to reduce the risk of damage. If possible select the carrier and shipping lane to reduce the risk loss in transit as different carriers and different shipping routes / lanes have different loss history.
Import or export restrictions or bans.
Most restrictions or bans do not occur immediately. For example when the EEC enacted the RoHS environmental standards banning certain materials from being used on products imported into EEC Countries, there was significant discussion before it was enacted, and one or more years in which to implement RoHS compliant products after which non-RoHS compliant products will be banned. Keep aware of any changes and at the first time you hear of anything that can potentially impact a product, ask the suppliers if they use it and what their plans are to eliminate it. The sooner you are aware the more time you have to qualify something else that complies.
Legal problems with the parts or materials – infringement of IP rights, not complying with laws.
Include IP Indemnity terms and Warranties that items comply with applicable law. Under the Indemnity require them to get a license from the IP holder if that is possible. Don’t give them a cheap way to walk away from the problem leaving you with an interruption in supply. As breach of a warranty only gives rise to damages, make sure that any financial limitation in any limitation of liability is significant enough so it will be cheaper for the supplier to correct the problem rather than walk away and pay you damages leaving your supply chain broken.
Product problems such as safety problems that can halt production until a solution is found.
These are the most difficult to protect against. Require initial testing to safety standards or certifications such as UL or CSA. Require all product contain a part number and date or lot code. Many times safety problems can be narrowed down to specific lots or dates. If you know what those are in sourcing through alternative sources such as distributors or brokers buy only those that have date codes that are not a problem. Have the supplier stock items or carry an inventory and hope that those are not impacted.
Product discontinuance or end of life.
Require a specific period that the must make the product available for purchase (and protect yourself on the purchase price). Require long end of life notices that allow you time to develop another source, qualify a new product or material. If you can’t do either, include the right to make an end of life purchase in whatever quantities you need. If you were purchasing a semiconductor or other product where the end of life is caused by a process
change such as a change in the process technology used to produce it, explore other alternatives. For example, with semiconductors I’ve used what’s called a “die bank” to purchase and have the supplier store completed semiconductor die that can be bonded, assempled and packaged at a later date to reduce the potential cost
if the full inventory wasn’t needed.
Supplier or subcontractor financial problems impacting their ability to purchase needed supply.
Qualify suppliers in advance to try to avoid this. If you can’t, consider requiring they create a second source they license to manufacture. Have them place a manufacturing package in escrow and get rights to purchase from all their suppliers in the event the escrow is released. With outsourcing you can have virtual suppliers, where they may only design the product and they contract with other parties to manage production, test, and fulfillment where if a problem occurred you could buy the completed product directly from their sources.
Custom or unique product with only one source.
While the goal may be to avoid single sources, many times it may not be avoidable. You can have single source several situations.
1. Only that supplier has what you want or need and the business is willing to accept the risks of a single source. A simple fact is many companies rush to be first to market with new products to try to lock the buyer into using them and will do that in a number of ways with things like proprietary interfaces, unique form factors, etc.
2. The buyer wants something that is unique or custom and the development with multiple suppliers is cost prohibitive.
3. The supplier is willing to assume the cost of development as long as future business is committed to allow them to recover their investment.
4. The buyer for other valid business reasons, determines that the savings and flexibility they will get from being single sourced outweighs the risk. For example a company may single source a specific piece of process equipment to reduce their spare parts inventories and have the flexibility to move production between different but compatible lines.

To manage the risk, in addition to all of the above, if your volume is high enough demand a second source. If you have financial concerns about the supplier require software of manufacturing escrow packages. In conjunction with the escrow, get a list of all their suppliers and get written agreement from the supplier that you can purchase directly from them in the event the escrow is released. For things like software, get their commitment that they will provide you with supplier or have them identify key individuals that are familiar with the code where you can hire them to support your future needs.

Applicable Law or Choice of Law

I had an individual ask me whether in contracting the applicable law or choice of law had to be where the project was located. I thought a simple blog post on this would be helpful for others to read. In contracts there are three things to be concerned with in dealing with the applicable or choice of law. The applicable law or choice of law identifies what country's law or other legislative unit’s laws such as State or Provence is to be applied in interpreting the contract. Once you select the applicable law, the second issue is jurisdiction, meaning the country or other governmental unit such as State or Province where the case must be brought. The third issue is forum, which means which specific court you want the case to be heard. For example even if you specified New York State as the jurisdiction, a case could be brought in either the state court or a federal district court located in New York State. For example if you wanted New York Law to apply, and have the case heard in New York and wanted it to be heard by the Federal District Court of lower New York based in the borough of Manhattan in New York City you would need to specify that.

If all you specified was the applicable law, a case could be heard in any court that feels that it has “jurisdiction”. Jurisdiction is usually found when the work is there. It can be found where one of the parties is legally located in that jurisdiction. It also can be found where there is mutual agreement by the parties that a specific jurisdiction and/or forum will be used. If there is agreement by the parties on law, jurisdiction or forum, courts will normally honor that. For example, you could have New York law apply, but have the jurisdiction and forum be located somewhere else and that court would need to interpret the contract according to New York law, but the parties would need to follow the procedural rules of that court.

So how does this work? Let me give you an example:

An English Company could hire a German contractor to manage building a manufacturing facility in Singapore.
As between them, they might agree upon English Law, German Law, the Laws of Singapore or some other country’s law that has specific expertise in dealing with the subject matter. They could also agree that the Jurisdiction or forum be in England, Germany, Singapore or another country that has specific expertise with the subject matter. If there were multiple legal forums in the jurisdiction they select, they can agree to select the forum. The parties could agree the applicable law is English Law. They could also agree that the jurisdiction and forum be in Singapore. In that case the court in Singapore would hear the case, but would apply English law rather than Singapore law in interpreting the contract.

The same applies between contractors and subcontractors. There is no hard set rule as to what law, forum or jurisdiction. There is only the requirement that the court must feel they have jurisdiction over the matter. When a contract is specialized the Prime Contractor and Subcontractor may agree upon a jurisdiction and forum that has experience, and knowledge in the specific area of the law involved. If it isn’t specialized there should be a connection with one of the parties to the contract so the courts feel they have jurisdiction over the matter. For example:

The German contractor may hire local subcontractors. They also have equipment suppliers from a number of other countries. In those subcontracts they need to decide what law, jurisdiction and forum should apply to each. For local subcontractors it would probably be local law. For foreign equipment suppliers it probably would be either that supplier's country law or Singapore, but it could be any location that has a relationship with the parties. A major influence in making those decisions may be where the parties have assets. If you get judgment in one jurisdiction where a party does not have substantial assets, to collect damages or monies due you would still need to go to court in the jurisdiction where the assets exist to get an order to enforce the other court’s judgment.

In making applicable law decisions, the parties should know if there are major differences between those applicable laws and the laws they use most often for interpreting contracts to make sure there aren't any gaps in coverage / protection. For jurisdiction and forum you would normally want:
1. A jurisdiction that can hear the case quickly.
2. A jurisdiction that shows impartiality in its decisions.
3. If there is potential complexity you may also want applicable law and jurisdiction to be a location that is familiar with and hears a number of similar cases.

Why suppliers may be unwilling to agree to DDP delivery terms.

A reader that is involved in having aircraft engines repaired thought that it was “unfair” as the supplier required them to ship the item to be repaired on DDP terms (delivered, duty paid) to their repair location. The supplier insisted upon shipping the repaired item under CPT (cost paid to) deliver terms. Since others may run into a similar situation with returning Items for repair, I thought I would share my response.

If you understand the reasons why they want to do it that way, it may not be "unfair", it may be just good business for both parties and it may in the end be saving you money.

There are many reasons why a supplier may not want to deliver product or service on a DDP basis. The first is duties, usually when there is export, duties are not charged. When a product is imported back into the country where it was made, there usually are no import duties provided that it is shipped out. When it is returned to the buyer, there could be import duties although some countries will allow free import if it can be proved that it was previously imported and duties paid. Since the supplier didn't import it, they can't prove it was previously delivered and duties paid, so with their delivery term they are looking for the buyer to prove it with their export documentation for the return of the product.

A second and usually more important reason is when a company sells a good or service under delivered terms, that sale is becomes a local sale within the importing country. This is normally the major reason why they will not want to sell under DDP terms. Being a local sale would make them subject to needing to be registered to do business locally. That can be an expensive, time consuming process. It would subject them to local law. Their profit they make on the repair would be subject to local taxes. That can change their selling margins and profits. In many countries, local transactions must also be paid for in local currency. That can also create potential issues with repatriating the profit. Then there can currency exchange issues and potential losses. If a supplier were to accomodate the request for DDP terms on the return shipment, my guess is they would need significantly increase their price to cover the additional costs and risks associated with that DDP term.

Since the supplier was shipping under a CPT terms I also commented on that. CPT (cost paid to) is not a good term for Buyer's as the risk of loss is transferred to the Buyer upon delivery to the carrier. As in his case engines are very expensive so rather than pursue DDP terms (that you are unlikely to get because of the above reasons), I suggested that he might want to focus on two things. One is to have them deliver on CIP terms so that it is insured by them. If it is damaged, it will cost them less to repair it than it would cost you. This is especially important if the supplier is selecting the carrier and the freight lanes as either of those can also increase your risk loss or damage. The other thing I recommended is more of a cost of quality issue. I would want the supplier to reimburse you for the costs you incur with the shipment of the repaired item if the repair is defective and needs to be returned again. The simple argument that I always use is you paid for a quality repair, so you should only have to bear those costs once.