Drafting Technology, Intellectual Property Or Related Commercial Agreements

Wednesday, July 2, 2014 - 10:50

This panel discussion, held on May 8, 2014, was the second of three seminars that Weil held this spring at its New York headquarters on science, technology, intellectual property and the media.

The current summary of the discussion deals with drafting contracts for transactions in these related fields. Panel participants include: Michael A. Epstein, a partner located in Weil, Gotshal & Manges LLP’s New York City office, is a recognized expert in intellectual property law. His practice involves transactions, litigation and counseling in all areas of intellectual property. His transactional work involves structuring and negotiating technology and intellectual property acquisitions, technology transfer and licensing arrangements, outsourcing transactions, and joint ventures and other targeted alliances. He has extensive intellectual property litigation experience, including handling technology-related disputes and litigation involving non-compete agreements.  Jeffrey D. Osterman, a partner in the Technology and IP Transactions practice located in the New York City office, concentrates on matters with deep commercial or technical complexity. He has had extensive experience with patent licensing, technology transfer, outsourcing, technology integration, content licensing and merchandising. Charan J. Sandhu, a partner in the Technology and IP Transactions practice also in the New York City office, concentrates her practice in the areas of complex technology transactions and intellectual property. She represents clients in matters relating to patent licensing, cross-border licensing, technology transfer, manufacturing, outsourcing, research and development, as well as the acquisition and commercial exploitation of technology and intellectual property.  

Epstein: What are the main concepts to keep in mind when drafting documents? There are two overarching concepts to keep in mind. One is to know the relevant law. For example, how does a provision in a contract limiting liability cover damages resulting from lost profits, or what are the legal ramifications of the words “indemnify, defend, and hold harmless” and what is the legal consequence of not including all three terms. The second component – in addition to knowing the relevant law - is to draft the provision so that the courts and all parties to the contract understand what the words mean. Do the words convey the intended meaning? One may know what the law is, but the provision could be drafted in an ambiguous manner so that it: (1) conveys more than one meaning; (2) is stated with undue generality; (3) is inconsistent with other provisions in the contract; (4) contains redundant terms, or (5) uses words in a conflicting manner. For example, consider a provision that states:  “Company A shall sell to Distributor the alpha assets excluding the beta assets, the gamma assets and the delta assets.”  What gets excluded from the alpha assets? Is it just the beta assets or do the gamma and delta assets get excluded as well? This ambiguity could easily be remedied. The provision could have been written: “Company A shall sell to Distributor (1) the alpha assets excluding the beta assets, (2) the gamma assets, and (3) the delta assets.” This redrafted sentence makes clear that only the beta assets are excluded from the alpha assets.

Another example of unclear drafting is the case of an inventor who entered into an agreement with Stanford University stating that he “agreed to assign” his right, title and interest in any invention to the university. He then went to work at Cetus Corp., and Cetus asked him to sign its form agreement which stated that inventor “will assign and does hereby assign” his inventions to Cetus. Stanford sued Cetus, claiming that Stanford had the earlier assignment and therefore owned the relevant invention. The Supreme Court disagreed. All Stanford received was a promise of a future assignment. That future assignment was never made and was cut off by the present tense assignment provision to Cetus, which was self-executing. Cetus prevailed because the Stanford agreement contained assignment language using the future tense whereas the Cetus agreement contained present tense assignment language.

Sandhu: I will be discussing indemnification and how it arises in the context of technology and IP agreements. There are three components of indemnity clauses: (1) The indemnity itself. Black’s Law Dictionary defines indemnity as “to reimburse for a loss suffered” or “to promise to reimburse” for a loss. (2) Black’s also treats “holds harmless” as a synonym for an indemnity, but under New York law that may not be the case. Others suggest that it has a broader meaning in covering inter-party claims. (3) Finally, we’ll review defense obligations, which are distinct obligations that are not necessarily covered in indemnities unless one actually builds them in. They can be indirectly addressed through procedures for third-party claims. Indemnity clauses are never boilerplate, are often narrow in scope (i.e. in not covering all acts or omissions of a party, but covering particular categories of actions such as infringement or product liability), are typically limited to third-party claims, and are often not the sole remedy for breaches. The seminal Hooper Associates, Ltd. v. AGS Computers, Inc. (74 N.Y.2d 487, 548 N.E.2d 903 (1989)) case illustrates that broad indemnification and hold harmless clauses under New York law are not necessarily sufficient to cover inter-party claims, such as attorneys’ fees, unless the language is unmistakably clear. Note that in New York, courts will strictly construe these indemnities. Courts will look to whether the scenarios in an indemnification clause are “typical of those which contemplate reimbursement when the indemnitee is required to pay damages on a third-party claim.” When intending to include inter-party claims in an indemnity, one must be very clear about their coverage. In fact, what is typically recommended is having separate clauses covering inter-party claims apart from third-party claims.

License agreements, for instance, may be narrowly worded:

Licensor shall defend at its own expense any action against Licensee brought by a third party to the extent that the action is based upon a claim that the Licensed Software [directly] infringes any U.S. copyrights or misappropriates any trade secrets recognized as such under the Uniform Trade Secrets Act, and Licensor shall pay those costs and damages finally awarded (after exhaustion of all appeals) against Licensee in any such action or those costs and damages agreed to in a monetary settlement of such action, in each case that are specifically attributable to such claim.

This one clause is just a defense obligation narrowly construed to be only against third-party infringement claims of U.S copyrights or trade secrets. Another related clause that would be common is conditioning this defense obligation on the licensee conducting certain actions, such as giving prompt notice of a claim, allowing the licensor to assume and control the defense, and cooperating with the licensor.

On the broader side of indemnification clauses, you will see clauses such as “defend, indemnify and hold harmless obligation of Licensee and its Affiliates and their officers, directors, employees and agents from and against any claims, losses, suits, damages, liabilities, costs and expenses (including reasonable attorneys’ fees and litigation costs) arising from or relating to claims of . . .”

The final topic on infringement indemnities is what I call “mitigation provisions.” From the licensee perspective, even if you are receiving an indemnity for infringement, it is useful to have a right to require the licensor to fix any infringement separate and apart from the indemnity. From the licensor side in considering these provisions, there is a potential moral hazard unless you have a provision that the licensee, who is indemnified, cannot continue the infringing behavior and simply be covered under the indemnification clause. These mitigation provisions are often negotiated and cover items such as whether the licensor has the right or obligation in the event of infringements to procure a license to continue to use the relevant software, replace or modify the software, or terminate the license and rebate any fees.

Osterman: My subject is the limitation of liability provisions in agreements. These provisions are not merely boilerplate but represent real business points. First, there are two conceptually different kinds of clauses that limit contractual liability – a consequential damages waiver, which is in fact a waiver of one or more classes of damages; this says, “if a damage falls in a particular kind of category, it is simply not recoverable.” The other is a liability cap, which stands for the proposition that the parties who are entering into a contract should be able to limit liability in the event of a breach.

There are several elements to look at when you review a provision disclaiming consequential damages. Often the disclaimer is in all capital letters and disclaims damages in contract, tort or otherwise. A typical provision might read: “To the maximum extent permitted by applicable law, in no event shall Seller be liable, in contract, tort (including negligence and strict liability), or otherwise, for any consequential, special, incidental, indirect, exemplary or punitive damages or lost profits, whether or not Seller has been advised of the possibility of such damages.”  A provision like this has some issues, as we will discuss.

Definitions of consequential damages vary: “Such damage, loss, or injury as does not flow directly and immediately from the act of the party, but only from the consequences or results of such act” is one definition. Another is: “Damages which arise from special circumstances that make them probable, although they would be unusual apart from such circumstances.”

It is often difficult to discern the line between consequential damages and direct damages. In a recent case before the New York Court of Appeals, seven members could not all agree as to whether damages suffered by the distributor of a medical device were direct or consequential damages. If the seven members of the Court of Appeals cannot speak with one voice, then how do you determine how to advise your client? The answer is to drill down to the particular category of damages that is at stake under a particular fact pattern and address them as specifically as possible.

Another pitfall in reviewing consequential damages disclaimers arises when “lost profits” are specifically disclaimed as a category of damages. There can be times when lost profits would be consequential damages, such as where a seller fails to deliver goods under a contract and the buyer loses his profits from resale; other times, lost profits would usually be considered direct damages, such as when a buyer fails to pay under a contract and the seller wants to recover not just its out-of-pocket costs, but the profit it would have earned if the buyer had performed.

Another area where disclaimers of consequential damages can be problematic would be with respect to confidentiality obligations. When a party breaches a confidentiality obligation, considerable harm can befall the person whose information was improperly disclosed – perhaps, increased competition or reduced ability to sell product because competitors have access to the confidential information. These types of damages would classically be considered consequential damages, and if disclaimed, could eliminate a party’s ability to be compensated for the most likely class of damages.

Finally, an area where disclaiming consequential damages causes problems could be in a distribution arrangement with a single supplier. In these cases, the buyer could face major disruption if the supplier fails to perform (because it has no backup source of supply), which might not be fully compensated by direct damages. One thing you can do in such a circumstance is to provide for liquidated damages. For example, you could provide that the seller is liable for 20 percent or more of the purchase price if it has a severe enough disruption in supply; or the supplier could agree that consequential damages are available for supply disruption, but only up to a cap of a certain percentage of the purchase price.

Incidental damages are basically your direct out-of-pocket cash costs associated with switching to another contract party.  They’re actually a category of direct damages under most laws. Punitive damages are generally not available for contract breach claims, unless the act giving rise to the breach is also a tort (e.g., fraud).

Sometimes limitation of liability provisions indicate that the limitations do not apply to liability arising from the other party’s gross negligence or willful misconduct. Under New York law and the law of a variety of other jurisdictions, intentional breach of contract is not, standing alone, willful misconduct, meaning that if you have a supply arrangement and your seller willfully decides not to sell it to you, that would not typically be willful misconduct. Willful misconduct is basically a tort-like claim.

Epstein: Many contracts contain a provision where one party performs services for another party, and the issue that arises is how to draft the standard governing the quality level at which the services must be performed. The best provision is a flat obligation such as:  “Party A shall sell at least 5000 widgets per month.” This is a direct obligation to sell at least a fixed amount per month. When a flat obligation is not possible, the parties often resort to standards such as “best efforts”, “reasonable efforts”, “commercially reasonable efforts”, “good faith efforts”,  or some other variation. One New York court has stated that the term “reasonable efforts” means the same as “best efforts.” In part, this conclusion arises from the fact that “best efforts” typically does not mean that a party must employ unreasonable efforts to perform the stated service. The standard of “commercially reasonable efforts” has been criticized as being redundant – the word “commercially” is unnecessary in the context of an agreement between two business entities. The term “good faith efforts” has been criticized as having little meaning since an obligation to act in good faith is implied into most contracts.

There are alternative drafting strategies to consider regarding these types of provisions. One is to use the terms “reasonable efforts” or “best efforts” but provide a definition for the term so the parties (and the courts) know what the term was intended to mean. Another alternative would be to state what is not included within the meaning of “reasonable efforts” or “best efforts.” Sample carve-outs could include not incurring a monetary expense above a stated amount, not incurring a material adverse change, not requiring the disposal of a material asset, not requiring the institution of a litigation, or not requiring a change in business strategy.

Sandhu: I will cover the treatment of business transfers in technology and IP agreements. What happens when a party such as ABC Company is granting a license to another entity such as Licensee Co. and one of the two parties either gets acquired by a third party or acquires a third party? 

Three licensee-side issues that arise are: (1) What if the licensee acquires a third party? Should the license extend to that acquired entity? What happens if there is already a preexisting license between ABC Co. and licensee and that acquired entity? What if ABC Co. has litigation with that acquired entity? (2) What if the licensee gets acquired? (3) What if the licensee divests an affiliate, does the license terminate as to the divested entity?

Imagine we are representing the licensor ABC Co. We granted a license to a small website company with a discrete amount of traffic so we have agreed to a prepaid, up-front royalty payment of $2 million. The license runs to the licensee and its affiliates. What if that website company acquires over a period of years 10 more companies and gradually grows to a larger company? Does the $2 million really reflect that new traffic? The other question is what if one of the companies that gets acquired also has a separate license with you under which that acquired entity has a $10 million royalty payment due? Do you mean to extinguish the $10 million receivable under that other agreement? On this issue of licensee acquiring a third party, our agreement language actually breaks out between the two scenarios: is there a preexisting license between the licensor and the acquired entity or not?

Moving to the second licensee-side issue of what happens if the licensee is acquired, some of the same concepts are applicable.  Additionally, there is the issue of whether the license will even continue, or will continue only on licensor consent and/or only as to the products and services of the acquired entity and not the third-party acquirer.

Moving now to the licensor-side issues: (1) What if the licensor is acquired? Is the acquirer’s IP meant to be covered? (2) What happens if the licensor sells its IP? (3) Will licenses and covenants run with any IP sold by the licensor?

If you are an early-stage company looking eventually to be acquired, it may not be in your interest that your license automatically extends to your acquirer. Think about three buckets of IP: (1) Is the IP at the time of acquisition meant to continue to be licensed? (2) Is IP of the acquirer meant to be licensed? (3) And finally, consider whether IP that arises from the licensee’s continued business operations is meant to be licensed.

The final issue from the licensor side is what happens if the licensor sells its IP? Often, licensees will require that the licensor have a contractual obligation to require that all acquirers of the licensed IP agree to comply with the relevant licenses, covenants and releases granted to the licensee.

Osterman: My next topic deals with allocation of intellectual property ownership and enforcement rights relating to IP. It’s not unusual to have agreements where there’s an expectation that certain intellectual property is going to be developed by one party, the other party or both parties. Figuring out who owns the resulting intellectual property and what the rights are to enforce it can pose challenges. You need to have a very good understanding of the circumstances under which there is going to be custom development or joint development, of the intentions of the parties, and of the joint development activity. 

There are at least three fairly typical ways of allocating ownership of intellectual property: one is the typical default case – if one party invents the property, then he or she owns it. If the parties jointly invent intellectual property, they jointly own it. This can cause problems if your counterparty winds up with technology that relates to the core of your own product. Such a conflict can occur where two parties work jointly on a project but a critical development in the process winds up either being jointly owned or owned solely by your counterparty.

Another problem that can arise using this typical allocation of ownership derives from the use of the terms “invented” (which can have different meanings in different countries) or in its stead, “conceived” or “reduced to practice.” If you use the latter construct to allocate intellectual property ownership, you could find yourself in a circumstance where the party on one side conceives of an invention and the other party mechanically helps reduce it to an operational form. Using a “conceives or reduces to practice” construct, this counterparty winds up being the joint owner of an invention to which it made only mechanical contributions. One way of potentially solving this problem is to state that U.S. law will apply when determining inventorship.

A second way of allocating intellectual property ownership is on the basis of subject matter, where any invention related to a certain subject matter will be owned by one party, regardless of whether that party was the inventor.

Finally, a third possible allocation is that intellectual property remains owned by the party that brings it to the relationship and, if either party invents an improvement to the other party’s intellectual property, the party whose IP is being improved will also own the improvement. The problem there is how to draw the line between an improvement to a piece of intellectual property and a new freestanding invention.

Another problem that can arise is how to allocate enforcement of intellectual property rights. Sometimes a party wishes to monetize its patents by giving them over to an enforcement entity, or the counterparty to an exclusive license agreement may wish to have full enforcement rights. Determining the likelihood that a particular arrangement works to give the licensee full enforcement rights without naming the patent owner as a party involves a fact-specific inquiry.

In order to assess standing of a licensee or assignee to sue under a patent, there are two issues: constitutional standing and prudential standing. “Constitutional standing” means that the party enforcing the patent has to have exclusive rights to the patent and have been injured in some way by the infringer’s activity. Constitutional standing will allow a party to bring an action but not necessarily without the patent owner’s participation. “Prudential standing” deals with the question of whether it is fair to expect the defendant to deal only with this plaintiff or whether the original patent owner should be brought into this action for some reason. The test for whether the recipient has prudential standing is whether he or she has been granted all substantial exclusionary rights to the patent. It is important to note that title to the patent is not dispositive as to whether you have prudential standing. You can transfer all substantial rights to the patent, even if you’ve retained certain rights with respect to the patent.

If you want to give counterparties prudential standing to enforce a patent in their own name, you must grant them exclusionary rights – the right to sue, mostly unfettered rights to transfer the patent if it has been transferred to them and to control enforcement actions.

One thing to note which is sometimes a bit surprising: a revenue stream associated with enforcement or licensing the patent retained by the original owner is not a bar to a finding that all substantial rights have been transferred. There are plenty of cases where a right to retain a percentage of patent licensing revenue or a percentage of recoveries was not found to defeat prudential standing. The courts in general look to who is in control and who is the right party to be dealing with in litigation.

Sandhu: What are some alternatives to licensing? Previously, when two companies with IP relevant to one another entered into a dispute, they would often seek to cross-license each other in some manner. That is not always the case anymore. With the complexity of modern commercial transactions and as a result of a heightened focus on the doctrine of “exhaustion,” companies in certain cases seek alternative structures to licensing. 

The doctrine of patent exhaustion announced in the Supreme Court case, Quanta Computer, Inc. v. LG Electronics, Inc. in 2008, basically provides that an authorized sale of a patented item exhausts a patentee’s rights and frees the initial buyer and all subsequent transferees from patent claims and “post-sale restrictions” and that exhaustion applies to both apparatus and method claims if the “reasonable and intended use” of the component is to practice the claimed invention and the component embodies the “essential features” of the invention. A key concern is if you incorrectly structure your license grants with component vendors, you may actually be licensing various downstream systems.

To avoid this problem, practitioners consider “defensive suspension” and “defensive termination” provisions in lieu of license grants. In the case of defensive suspension (DS) and defensive termination (DT), no actual grant of rights are involved so exhaustion is not at issue. The operation of DT or DS is to either terminate or suspend a grant of a license if the licensee brings a certain type of claim against licensor – this acts to discourage the licensee from bringing these covered claims against the licensor. DT and DS provisions often are negotiated in two areas: One is the process requirements, i.e., will licensee have an opportunity to check with the licensor as to whether a particular claim it is seeking to bring is indeed a covered claim that would trigger DT or DS? Will there be a cure period or allowance for licensee to undertake dispute resolution before the license rights are cut off? Once license rights are cut off, a key issue becomes whether the license (either whole or in part) is terminated prospectively only or also retrospectively? The second area that gets negotiated is what are the covered claims and exclusions to those covered claims (for instance, counter-claims may be excluded)?  

Two other potential alternative structures to licensing are standstill provisions (whereby no rights are granted but there is a tolling of rights and a delay of assertion), and covenants to sue last (whereby grantor agrees to sue the grantee after suing other relevant parties).

Osterman: It is not unusual in license agreements to anticipate that the licensor/service provider might go bankrupt and become unavailable. IP licenses may be viewed as executory contracts, which may be either assumed or rejected under Section 365 of the Bankruptcy Code. If your licensor does go bankrupt, Section 365 allows you to elect to retain your license as those rights existed on the date of the bankruptcy filing. You have to continue to pay royalties, which raises an issue in agreements that also require the licensor to provide services such as maintenance and support because you won’t be getting those services anymore. You can continue to use your license rights for the duration of the license plus any extension that you can elect as of right. Because the Bankruptcy Code only protects rights as they exist on the date of the licensor’s bankruptcy filing, it is important that these rights be drafted as present grants of a license right, not a promise to provide a license in the future.

To provide additional protection, it can be appropriate to include a provision that allows the customer to provide maintenance and support itself for a particular product. The Bankruptcy Code does respect a right under a license agreement to require the licensor to deliver materials following the commencement of a bankruptcy case, but there are still advantages to having materials placed in escrow with a third party. Sometimes when negotiating a license like this, a licensor or supplier will ask that the licensee/customer covenant not to exercise its license until a trigger event occurs. There is risk associated with agreeing to such a restriction and restrictions drafted like this should be resisted.

 

Please email the participants at michael.epstein@weil.com, jeffrey.osterman@weil.com or charan.sandhu@weil.com with questions about this report.