Young companies that license enterprise software or sell components to OEM customers (collectively, “Suppliers”) face a new and dire threat emanating from counter-claim-proof patent Non-Practicing Entities (“NPEs”), often called “patent trolls.” Because royalty claims by NPEs can be based upon the revenues and profits of the software licensees and OEM channel customers, rather than the revenues and profits of the Supplier, contractual clauses that require the Supplier to indemnify licensees and channel customers in full against patent damages threaten to drive the Supplier out of business. Potential patent indemnification liability is a time bomb for young Suppliers. This Alert explains this new threat and encourages every young Supplier to reexamine the indemnity clauses contained in their customer license and channel agreements.
It is customary in enterprise software license and OEM channel agreements for the licensor of the software or the manufacturer of the OEM component (collectively, “Suppliers”) to indemnify the licensee or channel partner against any patent claims arising from the licensed software or sold OEM component. Damages related to such patent claims are often excluded from any contractual limitations on liability, rendering the patent indemnification obligation unbounded. This unbounded exposure can be fatal to a young Supplier.
Such indemnity contract provisions have been standard practice for decades. But with the emergence of recent trends relating to NPEs, such provisions can threaten the continuing existence of the indemnifying Supplier.
In the past, patent litigation was largely driven by one operating company seeking marketplace leverage over another. The defendant’s strongest defense was often comprised of a counter-suit or threat of counter-suit based on the defendant’s own patent portfolio. Accordingly, many suits were settled through a combination of monetary payments and patent cross-licensing, where the cross-licensing arrangement often tended to reduce the amount of monetary payments.
Today, however, the patent litigation world is dramatically different, in large part due to the emergence of the NPE.
NPEs are Changing the Technology World
An NPE is an entity that owns patent rights but has no material business operations of its own. Many NPEs acquire patents for the sole purpose of generating license revenue through litigation or threat of litigation. The NPE has no operations that can give rise to any counterclaims, and therefore there is little to no business pressure the defendant can bring to bear to encourage settlement. Given that NPEs are counter-claim proof, it serves their interests to sue every company with business operations in a given sector, and they have little to no incentive to settle without extracting significant monetary value.
The acceleration of patent litigation activity at the hands of the NPEs has resulted in patent litigation and licensing costs rapidly becoming a basic cost of doing business. It is now a “Patent Tax” that must be paid and a Tax that must be financed. Technology companies are coming to realize that every product they offer likely infringes a large number of patents.
For example, take any smart phone device such as an Apple iPhone. The increasingly wide range of technology incorporated into any one of these devices probably operates against thousands of patents. Most of these patents are not owned or licensed by the manufacturer of the device. Large numbers of these patents are owned by NPEs.
In years past, the various device manufacturers and their suppliers would cross-license their patents and compete in the marketplace. Today, the dockets of these companies are filled with patent infringement lawsuits by NPEs. The costs of such lawsuits are staggering, starting from the typical legal expense of $3-5 million per case, to settlement and damage awards that can escalate into the tens or hundreds of millions of dollars per case.
Motivated by the emergence of this new patent battlefield, and forced in part by a need to fund the massive license fees payable to trolls NPEs and others, large technology companies are starting to go on the offensive as well. In the smartphone field, numerous high profile lawsuits have been filed, creating a spaghetti bowl of lawsuits among the major players. See http://www.ppcgeeks.com/2011/08/19/who-is-using-whom-with-graphic-chart/. At the same time, there have been several high profile acquisitions of relevant patent portfolios at staggering prices (e.g. Google acquiring Motorola for $12.5B; Apple et al acquiring Nortel patents for $4.5B; etc.). We expect other industry sectors to follow suit.
The patent wars are only going to escalate, throughout the technology world, and the Patent Tax on every company will continue to increase.
The Problem facing Suppliers
Given the emergent dynamics described above, the problem with unbounded patent indemnification liability becomes clear. Patent holders typically seek damages from an infringer based upon the total revenues and profits accrued to the infringer based on its patent infringement activity. When an NPE sues multiple operating companies who may have licensed technology or purchased components from one Supplier, the NPE seeks damages and royalties based upon the collective revenue of those multiple customers of the Supplier, not based upon the revenues or profits of the Supplier.
The total financial exposure is therefore significantly magnified relative to the revenue of the Supplier. The channel might have total revenues 20x, 50x, 100x the revenues of the Supplier. Accordingly, if the Supplier is indemnifying each channel partner for its full liability, the total exposure to the Supplier can be 20x, 50x, 100x the liability that would accrue to the Supplier based on the size of its business.
At a patent royalty rate of even 0.5%, a 50x multiplier results in a royalty rate to the Supplier of 25% of its revenues. This is a cost that no company can bear. That fact is immaterial to the NPE business. What the Supplier can’t pay, the channel legally must. In the absence of concessions from the channel, the Supplier very well could go out of business.
The above scenario of dire risk facing Suppliers is not fiction. It is happening right now for at least one unlucky Supplier that we know of. History says that this dynamic will only spread. How far? As far as the money will go.
In short, Suppliers are sitting on a time bomb. That time bomb is found in the patent indemnification clauses of their channel agreements. Prudence in defusing these bombs is required.
Because of the risks explained above, we recommend that every young Supplier review and, as appropriate, seek to modify the patent indemnity clauses in its existing agreements. The revised clauses could take any of the following forms (from most favorable to less favorable, within the perspective of the Supplier):
- Exclude indemnity for any suit brought by a non-practicing entity.
- Limit the amount of indemnity for patent claims to what would be a reasonable royalty on the amounts paid by the licensee or channel partner to the Supplier.
- Limit the amount of indemnity for patent claims to the total amounts paid by the licensee or channel partner to the Supplier.
We realize it will be very difficult to obtain any changes to indemnification provisions with very large customers and channel partners. Any single Supplier typically has little negotiating leverage against a big player. However, change can be brought about as more Suppliers seek such changes and as more Suppliers educate large customers on the rationale for the change.
The basic argument by Suppliers for this modification is that the patent world has changed and the proposed contract modifications are necessary as a result of this change.
Larger companies today are more focused than ever before on managing their financial exposure to patent risk. At the same time, however, we believe that they will become more sympathetic to the argument by a young Supplier that patent infringement risk has become a basic tax on operating a business, what we refer to as the Patent Tax, and is largely out of the control of the Supplier. At this point in time, parties need to accept that they will almost certainly be sued, and arguably that risk is largely independent of any “fault” on the part of one party or the other.
Accordingly, Suppliers and their customers need to determine how to allocate between them the cost of addressing that risk, on the basis of the relative benefits received by the two parties from the underlying product, rather than simply saying the risk lies fully with the Supplier. The benefit received by any Supplier is defined by the revenues received by the Supplier, not the revenues realized by its channel partners.