Indemnity Exclusions for Goods Made According to Specification or Industry Standard

This article describes the default rule set found in the Uniform Commercial Code relating to goods made according to customer specifications, and reviews some of the open issues associated with application of that rule set. This article then discusses some of the issues associated with drafting around the default rule set to attribute liability between commercial parties for infringement claims relating to goods made pursuant to specification or industry standard.

I. Default Exclusion Under U.C.C. § 2-312(3)

The Uniform Commercial Code creates a default indemnity exclusion where the purchaser of goods has furnished specifications for the good to the supplier of the goods. Section 2-312(3) of the Uniform Commercial Code provides that:

Unless otherwise agreed a seller who is a merchant regularly dealing in goods of the kind warrants that the goods shall be delivered free of the rightful claim of any third person by way of infringement or the like but a buyer who furnishes specifications to the seller must hold the seller harmless against any such claim which arises out of compliance with the specifications.

U.C.C. § 2-312(3) (2005) (emphasis added). The issues associated with how this exclusion applies include: what suppliers are subject to this provision, which goods are covered, what types of patent infringement claims are covered, what it means to have a “rightful claim” of infringement, what the scope of damages is for the breach of warranty, and where claims for breach of this warranty must be litigated. Each is discussed in turn below.

A. Nature of Goods Sold

First, the U.C.C. default indemnity provision only applies where the seller is a merchant “regularly dealing in goods of the kind.” U.C.C. § 2-312 (3). There is little caselaw on this provision in 2-312(3). However, comment 4 to subsection (2) of 2-312 states that the default warranty against infringement found in 2-312 of the U.C.C. “is limited to sellers that are merchants that ‘regularly deal in goods of the kind sold.’ When the goods are part of the seller’s normal stock and are sold in the normal course of business it is the seller’s duty to see that no claim of infringement of a patent…by a third party will impair the buyer’s title.” Comment 4 to U.C.C. § 312(2). Accordingly, given that similar language is used as in the underlying warranty against infringement, it appears that the default exclusion may only apply to goods that are part of a supplier’s regular stock.

B. Provision of Specification

Second, the caselaw on what constitutes a “claim which arises out of compliance with the specifications” furnished by the seller is still developing. Section 2-312(3) provides that “a buyer who furnishes specifications to the seller must hold the seller harmless against any such claim which arises out of compliance with the specifications.” U.C.C. § 2-312(3).

In Jack Frost Laboratories, Inc. v. Physicians & Nurses Mfg. Corp., 92 Civ. 9264, 1995 U.S. Dist LEXIS 6413 (S.D.N.Y. May 12, 1995), the district court delineated the issue that courts continue to face in determining what is a claim that “arises out of compliance” with customer specifications, noting that at that time, “No state or federal court has addressed the issue what degree of ‘specification’ by a buyer is necessary to trigger a buyer’s indemnity against a claim of infringement. “ In Jack Frost, the district court held that where the purchaser had specified product characteristics that did not directly relate to the infringement claim, liability did not shift to the purchaser. 1995 U.S. Dist LEXIS at *7. Thus, where the infringement claim related to the material used on the exterior of a gel pack, the fact that the customer had specified the gel pack size and microwavability did not result in shifting liability to the purchaser. The district court rejected the argument that specifying microwavability meant specifying the materials from which the packs were made, where the record showed that the seller chose the actual exterior material for the packs. Id. at *7-8.

C. “Rightful” Nature of Infringement Claim

Third, caselaw on what constitutes a “rightful” infringement claim by a third party is still developing. U.C.C. § 2-312(3) applies only where the goods were subject to a “rightful claim” of infringement.

The Federal Circuit has addressed the “rightful claim” provision only once, in Cover v. Hydramatic Packing Co., Inc., 83 F.3d 1390, 1393 (Fed. Cir. 1996). There, it was called upon to determine whether there was a conflict between the federal patent laws and the Uniform Commercial Code. The court held that there was no conflict, noting that once a case has settled “the patentee and the patent code are no longer in the picture” and thus there can be no conflict. The Federal Circuit has not otherwise addressed the question of what constitutes a “rightful claim.”

A couple of other courts have squarely addressed the “rightful claim” provision. In Pacific Sunwear of Cal., Inc. v. Olaes Enterprises, Inc., 167 Cal. App. 4th 466 (2008), the California Court of Appeal held that “A rightful claim under section 2312(3) is not synonymous with a claim that ultimately will prove successful in litigation. Rather, as we will define for the first time under California law, a rightful claim under section 2312(3) is a nonfrivolous claim of infringement that has any significant and adverse effect on the buyer’s ability to make use of the purchased goods.” 167 Cal. App.4th at 470. The court cited Comment 3 to section 2 312(3), which explained that this provision was intended to “’reject[] caselaw that had required a buyer to be ‘expressly prevented from using the goods’ by an infringement claim prior to obtaining relief.’” Id. at 475. The court also noted caselaw on the 2-312(1) warranty against infringement, construing the warranty that title transfer be “rightful,” as not requiring an adjudication of the merits of the underlying claim. Id. at 476. The court thus rejected a harsher standard of requiring proof the infringement claim was likely to prevail in favor of a more lenient standard of “a warranty against all nonfrivolous claims of infringement.” Id. at 478-79. It then held that there were triable issues of fact on whether the claim was rightful, noting that at least one other court has held that a settlement is presumptive evidence that the claim was not frivolous. Id. at 483.

The Pacific Sunwear decision has been applied in at least one subsequent case. In Phoenix Solutions, 637 F. Supp. 2d at 696, the court also took into account the fact that the parties had entered into a settlement and held there were triable issues of fact on this point.

Given the limited authority on the question of what constitutes a “rightful” claim of infringement, further disputes on this point are likely. However, the trend appears to be to reject the notion that the validity of the underlying claim has to either be admitted or should be tried on its merits before a seller can shift liability for supply of goods to its purchaser. Whether the California standard of non-frivolousness will be adopted elsewhere remains to be seen.

D. Knowledge of Infringement Claim

While not in the statute, a couple of cases have taken into account whether the purchaser of goods knew of the potential infringement claim prior to ordering the goods. This appears to be a weighing of the facts to determine which party had superior knowledge and thus the superior opportunity to avoid an infringement claim. First, in Phoenix Solutions, 637 F. Supp. 2d at 696, in finding a triable issue of fact on whether a claim was rightful, the court noted both that the purchaser had known of the potential infringement claim, and that the parties had settled the underlying matter.

Second, in Pyramid Plastics, LLC v. Roundhouse Products, Inc., 130 Fed. Appx. 162, 163 (9th Cir. 2005) (unpublished), the court affirmed the refusal to apportion liability between a seller of goods and a purchaser, where both had knowledge of the patentee’s infringement claim prior to purchasing the goods at issue. The Court of Appeals affirmed a district court decision that it would inequitable to require one party to indemnify the other, “where the parties were each capable to avoiding the litigation but chose, instead, to take the risk.” In that case, the seller had designed the accused feature while at a prior employer, and the purchaser had knowledge of the risk when it placed the order.

These cases emphasize the potentially unpredictable nature of relying on the default provision rather than custom-drafting a provision to suit a given project.

E. Limited Nature of Default Coverage

Next, U.C.C. § 2-312(3) may not permit contribution either for some claims of infringement of patented apparatuses or methods or for some claims of indirect infringement. U.C.C. § 2-312(3) only applies to “goods,” which are defined in the U.C.C. as “all things (including specifically manufactured goods) which are movable at the time of identification to the contract for sale.” Id. at § 2-105.

First, courts have held that the warranty extends only to goods transferred from the supplier to the buyer and does not regulate conduct after purchase. See, e.g., Motorola, Inc. v. Varo, Inc., 656 F. Supp. 716, 718-19 (N.D. Tex. 1986); Chemtron, Inc. v. Aqua Products, Inc., 830 F. Supp. 314, 315 (E.D. Va. 1993). If the goods as sold do not infringe, section 2-312(3) does not apply. Id. Thus, where the infringement claim arises out of the combination by the purchaser of the seller’s goods with devices from another, the default warranty provision does not apply. Id.

In addition, infringement of a method claim usually occurs not as a result of the sale of goods, but usually of their subsequent use. As the Federal Circuit explained in Joy Techs., Inc. v. Flakt, Inc., 6 F.3d 770, 775 (Fed. Cir. 1993), “a method claim is not directly infringed by the sale of an apparatus even though it is capable of performing only the patented method. The sale of the apparatus is not a sale of the method. A method claim is directly infringed only by one practicing the patented method.”

However, one still may be liable for contributory infringement for provision of a good used to practice a method if the good “has no use except through practice of the patented method.” C.R. Bard, Inc. v. Advanced Cardiovascular Systems, Inc., 911 F. 2d 670, 670 (Fed. Cir. 1990) (quotation omitted).

Similarly, the sale of a device may induce infringement of a method claim, provided the requisite intent is present. E.g., Hilgraeve Corp. v. Symantec Corp., 265 1336, 1344 (Fed. Cir. 2001).

Accordingly, where more than one type of patent claim or infringement theory is asserted, reliance on the default indemnity provision may result in liability for any given infringement claim being split between the contracting parties in a somewhat arbitrary fashion, based on the nature of the claims asserted by the plaintiff, rather than being primarily apportioned to one party or the other.

F. Agreement to Alter Default Coverage

Next, the parties must not have formed another agreement. The warranty created by section 2-312(3) can be disclaimed by express agreement, for example by stating in the sales contract that all warranties are disclaimed. It is also possible that the warranty can be disclaimed by industry practice or a course of dealing. See U.C.C. §§ 1-205, 2-316(3)(c).

Somewhat surprisingly, there is inconsistent caselaw on what constitutes an agreement to alter default coverage. First, there is at least one case that holds that if the language used in an express written agreement on indemnity is not sufficiently different from the statutory language found in the U.C.C., the U.C.C. standards will be applied to the dispute. In Bonneau Co., 116 F.3d 155, the court applied U.C.C. section 2-312(3) even though the parties had entered into a written agreement on indemnity. In that agreement, the parties included a provision that “Purchaser assumes liability for patent and copyright infringement when goods are made to Purchaser's specifications.” Id. at 157. The court held that the provision did not constitute an “otherwise” agreement under the section 2-312(3). Id. The court reasoned that because the provision tracked the language of section 2-312(3), it did not “rise to the level of the parties having ‘otherwise agreed.’” Id.

Another court has held, on the other end of the spectrum, that "[e]ven if it is unclear what, precisely, was 'otherwise agreed,' the statute only applies if nothing was said as to liability, and the other conditions are fulfilled." MAS Corp. v. Thompson, 62 N.C. App. 31, 302 S.E.2d 271, 275 (1983).

Given this divergence in authority, contracting parties may wish to explicitly detail their intent to either incorporate or diverge from the default rule set found in the Uniform Commercial Code.

G. Recovery Under Section 2-312(3)

Where a purchaser is able to invoke section 2-312(3), it is permitted to recover from the seller any incidental and consequential damages. See U.C.C. § 2-714(3). These damages likely include attorneys’ fees and expenses and the cost of settlement or judgment. See, e.g., Pacific Sunwear, 167 Cal. App. 4th at 483-484; Chere Amie, Inc. v. Windstar Apparel, Corp., No. 01 Civ. 0040, 2003 U.S. Dist. LEXIS 15261 (S.D.N.Y. Sept. 3, 2003).

Additionally, while not explicitly applicable to U.C.C. § 2-312(3), section 2778 of the California Civil Code contains express rules regarding “the interpretation of a contract of indemnity.” The rules include the following:

    1. Upon an indemnity against claims, or demands, or damages, or costs, expressly, or in other equivalent terms, the person indemnified is not entitled to recover without payment thereof;
    2. An indemnity against claims, or demands, or liability, expressly, or in other equivalent terms, embraces the costs of defense against such claims, demands, or liability incurred in good faith, and in the exercise of a reasonable discretion.

Cal. Civ. Code § 2778(2), (3). In addition, under California Civil Code section 2778(5) and (6), the indemnitor has the obligation of providing a defense, but only assuming that it is provided reasonable notice of the claim. Although no case was found construing Cal. Civ. Code section 2778 in the context of U.C.C. section 2-312(3), reading these two statutes together leads to the conclusion (assuming that the section 2-312(3) obligation is subject to section 2778’s indemnity “contract” rules of interpretation) that the indemnity obligation under section 2-312(3) includes a duty to defend on the part of the seller provided that reasonable notice of the claim is provided to the distributor. Other similar state statutes may be of useful reference in understanding the scope of and defense or indemnity obligation subject to the law of other states.

H. Venue for Litigation under U.C.C. Section 2-312(3)

Finally, another issue on which case law is developing, but which may arise depending on how the provision regarding a “rightful claim of infringement” is construed, is whether reliance on the U.C.C. default provision will mandate any resulting disputes being litigated in federal court. Historically, indemnity disputes have been resolved in state court unless (1) the parties are diverse and the amount in dispute exceeds the jurisdictional minimum for state court actions, or (2) the claim is pled as an interpleader claim in existing federal court patent litigation and the court exercises pendent jurisdiction over it. 28 U.S.C. § 1332 (federal district court has jurisdiction over disputes exceeding the sum of $ 75,000 and between citizens of different states, or of a state and a foreign state); 28 U.S.C. § 1367(a) (federal district court may exercise supplemental jurisdiction over state law claims that “form part of the same case or controversy under Article III of the United States Constitution.”).

In Christianson v. Colt Indus. Operating Co., 486 U.S. 800 (1988), the U.S. Supreme Court held that whether a claim arises under the patent laws, and has to be brought in federal court, depends not just on whether federal patent law creates the cause of action but also on whether “the plaintiff’s right to relief necessarily depends on resolution of a substantial question of federal patent law.” 486 U.S. at 808. Thus, unless there are alternate theories for recovery, there will be exclusive federal court jurisdiction over a contract cause of action that rests on the resolution of a patent law issue. E.g., University of West Virginia, Board of Trustees v. Vanvoorhies, 278 F.3d 1288, 1295 (Fed. Cir. 2002) (federal court jurisdiction over licensing dispute over obligation to assign continuations-in-part); U.S. Valves, Inc. v. Dray, 212 F.3d 1368, 1372 (Fed. Cir. 2000) (federal court jurisdiction over licensing dispute requiring proof of infringement).

Accordingly, if the existence of a rightful claim of infringement is to be determined with reference to federal patent law, associated disputes that turn solely on that issue may need to be brought in federal district court. Thus, in 84 Lumber Co. v. MRK Technologies, Ltd., 145 F. Supp. 2d 675 (W.D. Pa. 2001), the district court determined that removal to federal court was proper because the inquiry into what represents a “rightful claim” of infringement presented questions of federal patent law. The district court, while declining to decide “precisely what constitutes a rightful claim of patent infringement,” concluded that whatever standard is applied, “we cannot analyze the reasonableness of such a belief without comparing the scope of the patents at issue with the allegedly infringing products.” 145 F. Supp. 2d at 680.

Under this rationale, indemnity disputes based on the default exclusion found in U.C.C. § 2.312(3) could need to be litigated in federal court unless there were also other theories of recovery asserted that did not depend upon a substantial question of federal patent law. Christianson, 486 U.S. at 808.

However, if a court concludes that it can resolve the merits of an indemnity provision without resort to federal patent law, the case may remain in state court. Cf. Linear Tech. v. Applied Materials, Inc., 152 Cal. App. 4th 115 (2007) (specially drafted contract provision did not incorporate federal patent law standards). Thus, decisions on the standard for determining whether a “rightful claim” of infringement existed may impact the location in which indemnity claims may be brought.

II. Right of Contribution of Indemnity Under Express Agreement

A. Drafting Considerations for Express Agreements

As discussed above, there are numerous limitations and uncertainties on the right to contribution under section 2-312(3). To avoid many of the limitations and uncertainties, it may be preferable to contractually create clearly defined rights to contribution and indemnity. For example, parties may wish to:

    • Clearly contract around the default indemnity provision;
    • Attribute responsibility in advance for the different types of infringement claims that may arise, whether for direct or indirect infringement, or infringement of design, apparatus or method claims;
    • Delineate whether the provision of a specification should be the measure of responsibility for infringement claims;
    • Provide for shared responsibility in some circumstances;
    • Avoid disputes over the underlying merits of infringement claims;
    • Provide clear rules for defense of tendered claims;
    • Clearly define recoverable and non-recoverable costs; and/or
    • Establish exclusive federal court jurisdiction over resulting disputes.

Given the myriad of possibilities, sample provisions have not been provided, other than on the basic issue of design to specification.

B. Sample Specially-Drafted Provisions

As noted above, there is a risk as to goods covered by the U.C.C. of specially crafting indemnity provisions that hew too closely to the default language of section 2-312(3). However, in instances where the U.C.C. does not apply or the parties wish to vary from the default coverage, a variety of provisions may be agreed to that attribute responsibility for compliance with customer specifications. Examples include:

Manufacturer shall not have any obligation to indemnify Customer if such claim would not have arisen but for Manufacturer’s manufacture, assembly or test of the Product in accordance with the Specifications.

Manufacturer will have no obligation under this subsection to the extent any such claim is due solely to Manufacturer’s compliance with any Customer unique designs or specifications that Customer expressly requires Manufacturer to use hereunder.

Manufacturer has no obligation to indemnify if claim arises solely and directly from Manufacturer’s compliance with Customer Specification, provided that all implementations of that Specification constitute an unauthorized use or infringement of the third party’s Intellectual Property Right.

In drafting such provisions, however, parties need to understand the risk that how the dispute is ultimately decided will depend in large part on the details of a particular infringement claim. For example, in Branch Banking & Trust Co. v. Syntellect, Inc., No. 2:08 Cv 955-MHT, 2010 U.S. Dist. LEXIS 74837 (M.D. Ala. July 22, 2010), a bank contracted with a developer to supply an interactive voice response telephone system. After the bank was sued for patent infringement and settled with the patentee, the bank brought an action against the developer for indemnity based on a contractual provision that obligated the developer to indemnify for any claim that the system infringed a patent. The provision included an exclusion that the developer “shall not be liable for any losses, costs, or damages … resulting from any suit or proceeding based upon a claim arising from … compliance with Customer designs, specifications, or instructions.” Id. at *21. The supplier brought a motion for summary judgment arguing that the infringement allegations arose from the bank’s customer service function which were designed and specified by the bank. Id. at *22. The bank argued that the bank’s instructions related only to the call flow and the script of the text that would be spoken. The Court held that because the infringement allegations related to the automation of the system and not the flow, the allegations did not arise from the bank’s instructions. Id. Additionally, there was evidence the developer assisted the bank in developing the functional specifications. Id. at *22-23. On these facts, the court denied the developer’s motion for summary judgment holding that there was a genuine issue as to whether the exclusion applied. Id. at *23.

However, it may be possible to use contract language to firmly affix liability on one of the parties in a transaction. In In re Visi-Trak, Inc., 266 B.R. 372 (Bankr. N.D. Ohio Aug. 4, 2001), the purchase agreement provided that supplier would be held harmless on any product it manufactured for the buyer upon the buyer’s specifications. Id. at 374. In dicta, the court stated that the evidence clearly demonstrated that the product manufactured by the supplier was made pursuant to buyer’s specifications reasoning that the buyer’s own conditions of purchase state: “By accepting this order you hereby warrant that the material to be furnished hereunder will be in full conformity with the specification, drawing or sample.” Id. at 374.

III. Compliance with Industry Standards

A. Absence of U.C.C. Provisions

There are no U.C.C. indemnity provisions that expressly cover infringement claims arising out of a supplier’s compliance with an industry standard. However, to the extent that a buyer includes in its specifications compliance with an industry standard, the default provisions found in section 2-312(3) discussed above, will apply.

B. Specially-Drafted Provisions

A contracting party that does not want to rely on, or cannot rely on, the default indemnity provisions associated with purchaser specifications found in U.C.C. § 2-312(3) may draft provisions to attribute responsibility for infringement claims arising out of the fact that a good complies with an industry standard.

There are, of course, numerous instances where a party holding a patent has contended that all entities that are in compliance with a given industry standard infringe that patent. Accordingly, it is not uncommon to either assign liability to a provider of goods offered in compliance with an industry standard, or to shift liability to a purchaser who specified compliance with an industry standard. An example of each is set forth below:

Manufacturer shall not have any liability to Customer if the infringement or other violation of a third party right is based in any way upon compliance with an industry standard or communication protocol.

Manufacturer shall have no liability to Customer if the claim of infringement is caused by Manufacturer’s compliance with Customer’s unique written specifications if the infringement would not have occurred but for such unique written specifications (excepting any such specifications arising from compliance with a standard adopted by any standards setting organization).

One wrinkle that may arise in drafting is what, exactly, constitutes compliance with an industry standard. In many standards, there is a distinction between features that are necessary in order to be in compliance with the standards, and features that are optional in practicing the standard. For example, the MPEG-1 standard for video and audio defines data decoding, but not encoding, which can be performed according to an optional reference implementation. See ISO/IEC 1172-5:1998 Information Technology – Coding of Moving Pictures and Associated Audio or Digital Storage Media. Accordingly, the drafter may want to provide or exclude coverage for optional aspects of practicing an industry standard.

Caselaw arising in the context of challenging the failure of a member of a standards organization to disclosure the existence of an arguably relevant patent may provide further useful context for this drafting exercise. In Qualcomm Inc. v. Broadcom Corp., 548 F.3d 1004 (Fed. Cir. 2008), the court held that the patents were reasonably necessary to practice the H.264 standard where the claims of the patent mapped onto the standard such that devices that practice the standard actually practice the claims of the patent. Id. at 1018. Additionally, Qualcomm accused Broadcom's products of infringement solely because they practiced the standard and Qualcomm employees described the patent as a "core patent relevant to H.264." Id. In contrast, in Rambus Inc. v. Infineon Technologies AG, 318 F.3d 1081 (Fed. Cir. 2003), the court examined whether claims of patents would be necessary to practice a standard. See id. at 1103-04. The court held that there was no evidence that the patent claims "reasonably would be needed to practice the SDRAM standard." Id. In one patent application, the claims recited a multiplexed bus and a device identifier feature, neither of which were present in the SDRAM standard. Id. at 1103. In another patent application, the claims required voltage swings less than a certain value. Because the voltage swing specified by the SDRAM standard was greater than the value required by the claims, the standard was not covered by the claims. Id.

Accordingly, contracting parties may wish to clearly delineate responsibility for claims arising out of compliance with industry standard, and/or apportion responsibility for such claims based on whether a particular design was necessary or optional for compliance.

Originally published October 21, 2010 in the American Intellectual Property Law Association.