When the Limitation of Liability Is Not So Limiting

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Commercial agreements typically contain many provisions that extend beyond each party’s performance and payment obligations—addressing a myriad of other issues such as those involving tax, offshore and export rights, data rights, information security, insurance, premises liability, and intellectual property (IP) rights. Within a large company, a team of lawyers is often engaged in the negotiations, with each attorney having his or her own area of responsibility. By focusing on only certain sections of the agreement, these subject matter attorneys are proficient in their own areas of expertise and in managing specific legal risks. However, this divide and conquer approach could expose the company to unwanted risks if each attorney truly takes a myopic view of the overall agreement.

Pay Close Attention to Infringement Indemnity Terms!

The IP attorney working on a commercial agreement is not immune to this risk when negotiating infringement indemnity terms. Through no fault of their own, the attorney may only be provided the infringement indemnity terms of the agreement and may have no visibility into the rest of the agreement. Infringement indemnity terms are often contained in their own section of the agreement and, for convenience, the parties may ask their attorneys to have separate negotiations amongst themselves over these terms. The attorneys may therefore falsely believe that the stand-alone section contains all the relevant terms governing each party’s rights and obligations concerning infringement indemnity.

Because of the potentially large exposure to third-party infringement claims, especially patent claims, the infringement indemnity terms demand meticulous attention. Legal defense costs, alone, for a patent infringement lawsuit can easily exceed $10 million and courts routinely issue damage awards in the tens or even hundreds of millions of dollars. Thus, attorneys are entirely justified in scrutinizing every clause and staunchly debating the proper metes and bounds of the infringement indemnity obligations. These negotiations can be protracted, require the exchange of multiple drafts, escalation within each company to senior executives, and commonly are one of the last issues to be resolved. With so much time and effort being spent on infringement indemnity terms, when the parties finally come to terms on the infringement section they may be lulled into believing that all contract factors weighing on infringement liability have been fully vetted.

Wait—Any Limitations on Infringement Indemnity Obligations?

Before declaring the infringement indemnity liability as being fully vetted, the IP attorney should also check the remainder of the agreement for any limitations of liability provisions that may have a bearing on infringement indemnity. A limitation on infringement indemnity liability can potentially eviscerate the protection being sought by the indemnified party. Accordingly, the interplay between the infringement indemnity terms and any such limitation of liability provisions must be considered before truly understanding and assessing the company’s risk of a third-party infringement claim.

Limit on the Amount of Damages?

One way in which the indemnifying party may seek to limit its infringement indemnity liability is by limiting the amount of its liability. The most simple and common example of this type of limit is a cap which defines the maximum amount of liability for the indemnifying party. The indemnifying party may desire a cap to have some upper limit on its liability, arguing that its liability should not be unlimited. The indemnified party, on the other hand, may object to any cap—no matter its magnitude—since that may require them to assume incremental liability for infringement caused by the indemnifying party’s products. Each party will have to determine whether a cap is proper given the overall commercial deal and further they will need to get comfortable with the amount of the cap based, in part, on how they estimate their respective exposure to any future third party claims.

Limit on Indirect Damages?

A limit on the type of damages is another common way in which the indemnifying party may seek to contain their liability. Subject to certain carve-outs, commercial agreements commonly prohibit the recovery of any indirect, incidental, consequential, or special damages. In doing so, the parties intend to limit their liability only to direct damages, which are those damages that flow directly from the breach. In contrast to direct damages, indirect damages, roughly speaking, are losses that arise indirectly from the breach, such as from special or unique circumstances, and arguably may be less certain or foreseeable.

Normally, commercial agreements make an exception for infringement claims as to the ability to recover indirect damages.  A third-party claimant may be able to recover its lost profits—which is a type of indirect damage—for trade secret misappropriation or for infringement of its patent, trademark, or copyright.  With this exception, the indemnifying party remains responsible for all types of damages resulting from an infringement claim that may be suffered by a third-party claimant.

A distinction, of course, should be made between the damages suffered by the third-party claimant and the losses incurred by the indemnifying party due to that third-party claim. As discussed above, the third-party claiming misappropriation or infringement may be entitled to recover damages that are deemed to be indirect damages, like lost profits. From the vantage point of the indemnified party, however, their payment to the third-party claimant is a loss that flows directly from the infringement claim. This distinction between an indemnity obligation that pertains to damages; whether these damages are those suffered by the third-party claimant and/or the indemnified party; and an indemnity obligation that points to the losses suffered by the indemnified party—all must be considered.

What about Punitive or Exemplary Damages?

Along with indirect damages, commercial agreements may also seek to excuse the indemnifying party from any liability for punitive or enhanced damages. A third-party claimant may be able to recover punitive, exemplary, or enhanced damages when the misappropriation of the trade secret was willful and malicious or when the infringement of its trademark, copyright, or patent was willful. Courts may also impose sanctions, costs, or enhanced damages due to the infringer’s litigation misconduct. Often, infringement indemnity claims are excluded from any contractual prohibition on punitive, exemplary, and enhanced damages because the indemnifying party has sole control over the defense of both pre-litigation and litigation claims. By controlling the litigation, the indemnifying party is responsible for litigation misconduct and, by taking responsibility for pre-litigation claims, the indemnifying party is likewise responsible for failing to take proper steps to avoid a finding of willful infringement. Those assumptions are not always true and are premised on what is actually set forth in the indemnity terms. Considerations include: Does the indemnifying party have sole control over the defense or are there situations in which the indemnified party can jointly control or entirely control the defense? Does the indemnifying party have an obligation to defend the indemnified party for pre-litigation claims of infringement, and what is the remedy if the indemnified party fails to provide proper notice? The negotiation of any limitation on punitive or enhanced damages must therefore factor in the parties’ obligations as set forth in the infringement indemnity terms.

Imposing Limits on Infringement Indemnity Liability

The parties, of course, can be creative in how they define the limitations of liability to accommodate their respective risk tolerance. The following are non-exhaustive examples of how the limitation of liability provisions may be tailored:

• Rather than setting the cap as a fixed dollar amount, the cap may be defined to have a minimum floor and a maximum amount based on the amount of spend under the agreement or some multiplier of an average spend over multiple years.
• The total maximum liability may be specified on a yearly basis or for the term of the agreement.
• The limitation may specify a maximum amount of liability on a per claim basis or a per proceeding basis.
• The limitation may apply only to claims that involve a combination of the indemnifying party’s product with third party products.
• The limitation may be focused on a specific, identified claimant that poses a unique threat or an entire class of claimants, such as non-practicing entities; and/or
• The limitation may apply only to certain products or to technologies defined by industry standards.

When Should the Indemnifying Party Remain Liable?

Similarly, the parties may be creative in carving out exceptions to the limitations of liability. Some possible carve-outs are as follows:

• Exclusion of misappropriation of trade secrets claims and copyright and trademark infringement claims,
• Exclusion of patent claims known to the indemnifying party as of the date of the agreement,
• Exclusion of pre-litigation claims,
• Any enhanced damages for litigation misconduct or for willful infringement; and/or
• All defense costs, which remain the responsibility of the indemnifying party.

Reasonable Infringement Indemnity Terms in View of a Limitation on Liability

Neither the infringement indemnity terms, nor the limitation of liability terms should be negotiated in isolation from each other but, instead, they should be in close coordination. Because the indemnified party will necessarily assume more potential liability with a limitation on liability, this party may be less willing to cede total control of the defense over to the indemnifying party. For instance, the indemnified party may seek some type of joint defense of a claim and require their approval for any settlement. As another example, the indemnified party may require the indemnifying party, and not merely give them the option, to take efforts to design around or to provide substitute non-infringing products or services. With the aim of avoiding liability greater than a cap, the indemnified party may seek early termination rights so that they can obtain non-infringing products or services from another supplier. From the indemnifying party’s viewpoint, they may be willing to expand upon their infringement indemnity obligation provided this additional liability is subject to some limitation. Both the indemnified and the indemnifying parties will therefore need to reassess the infringement indemnity obligations in view of any limitation of liability provision.

Acceptable Proposed Risk of Overall Infringement Indemnity Liability

Negotiating and understanding infringement indemnity risk requires looking beyond the indemnity terms to consider any limitations on liability. Limitation of liability terms can profoundly alter the overall infringement risk for the parties. The indemnified party may refuse to sign a deal because of the mere existence of a limitation of liability which would require them to assume some liability. Taking an opposite view, the indemnifying party may insist on some limitation on liability since they cannot accept unlimited liability. When negotiating limitation of liability terms, attorneys must be mindful of the interrelationship with, and dependency upon, the infringement indemnity obligations: introduction of a limitation of liability may require revision to the indemnity terms and negotiations of indemnity terms may likewise be premised upon some limitation on liability.

By being creative in drafting limitation of liability provisions, attorneys can use the limitation of liability terms as a tool to adjust the overall indemnity liability to fit their company’s risk tolerance for the specific commercial agreement. It is only by taking a holistic view of both infringement indemnity and the limitation of liability terms that attorneys can accurately negotiate infringement indemnity liability and advise their clients of the entirety of infringement risk.

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