Indemnity and Limitation of Liability Provisions in Software Product Licensing Contracts

February 24, 2014

1.         Indemnity 

Indemnity and limitation of liability provisions consume the majority of the time that is spent negotiating software licensing contracts. Indemnity is a promise by one party to save the other party from loss or damage. On the other hand, limitation of liability provision limits a party’s liability for loss or damages that arise from the software licensing contract. References to software licensing contracts made in this article are to software licensing contracts that are entered into by the original design manufacturers and original equipment manufacturers.    

The indemnification obligations of the parties in a software licensing contract are mutual but vary in degree and scope.            

1.1       Indemnification of Licensor  

Indemnification of a Licensor would normally cover all liabilities or claims arising from the Licensee’s use of the licensed technology (excluding claims alleging infringement of third-party intellectual property rights by the licensed technology).

1.2       Indemnification of Licensee

Indemnification of a Licensee is typically limited to third-party claims that the licensed technology infringes the intellectual property rights of that third party. The Licensee would also be joined in any such legal proceedings since the Licensee’s products would incorporate the licensed technology. 

Generally, the Licensor will agree to indemnify the Licensee for any claims that the licensed technology breaches third-party intellectual property rights. The Licensee will however be required to notify the Licensor of any such third-party claims promptly and cede control of the defence and any settlement related negotiations.

If the use of licensed technology is held to constitute infringement and its use is restrained by the court, the Licensor will be required to:


·       procure for the Licensee the right to use the licensed technology on same terms as contained in the software licence contract;

·       modify the licensed technology so as to make it non-infringing while retaining substantially equivalent performance;

·       replace the licensed technology with non-infringing substantially equivalent licensed technology; and

·       refund all amounts paid under the contract.  

An indemnification right of the Licensee for third-party claims usually contains several qualifiers that will require careful examination. Licensors are averse to making any revisions to the original indemnification language. It is common to hear Licensors say that any changes to the indemnification terms would require escalation to senior management and that may delay the contract closure. Further, Licensors also commonly say that the costing provided to the Licensee is based on the standard indemnification provision and any revisions would result in a price increase.

A Licensee generally has little room for negotiation in any contract, particularly if the Licensor is a market leader, is an effective monopoly, is licensing an established technology or a technology standard or the licensed technology has not been subject to any infringement action since it was first marketed. The bargaining position of the Licensee will however be enhanced if the Licensee commits to provide large volumes of business. Nevertheless, it may be worthwhile to the Licensee, notwithstanding the delays that result from escalations, to pursue revisions to the original indemnification language. At least, the Licensee could use the issues arising on the indemnification provision, or any concessions it makes on them, as bargaining chips to negotiate a more favorable or reasonable position on other terms of the software licensing contract.

Here are a few commonly arising factors affecting the indemnification: 

(a)       The Licensor’s obligation to indemnify is generally excluded if the liability or claims result from unauthorized modifications to the licensed technology and where the licensed technology on a stand-alone basis without modifications could not have infringed third-party intellectual property rights. Additionally, if the licensed technology involves standard essential patents (eg chipset licensing) and the Licensor has no right to sub-licence the use of the licensed technology, the Licensee would be required to obtain rights to the use of licensed technology from its owners. In such cases, the Licensor will not be liable to indemnify the Licensee against any third-party claims that the licensed technology or the product breaches third-party intellectual property rights.

 (b)       In certain cases, the scope of Licensor indemnification against claims that the licensed technology breaches third-party intellectual property rights is limited to intellectual property rights that are issued or registered in certain specified areas (such as the USA or Europe) as on the date of the software licensing contract.  

There are two problems that arise from such language.

Firstly, third-party claims covering intellectual property rights issued or registered after the date of the software licensing contract do not fall within the scope of indemnification. Patents may be issued after the date of the contract but carry a priority date much before the effective date of the contract. If such a patent forms the basis of any infringement action covering the licensed technology, it is excluded from the indemnification obligation of the Licensor. Such a restriction should be rejected outright since it will dilute the indemnification right of the Licensee.  

Secondly, if the Licensee is distributing products incorporating the licensed technology in a country that is not covered within the scope of indemnification, the Licensor will have no obligation to indemnify the Licensee against any claims that the licensed technology breaches third-party intellectual property rights. If the Licensor is not prepared to alter the above limitation and the Licensee is certain about its countries of distribution, the Licensee should propose to the Licensor that the contract should at least include in the scope of indemnification the countries in which the products incorporating the licensed technology would be distributed. A Licensee may also negotiate a reduced royalty or exclude applicability of royalty in countries to which Licensor indemnification is not extended or where the licensed technology is not registered as a patent.     

(c)       Normally, the Licensor indemnification is not limited by time and survives expiry or termination of the software licensing contract. In rare cases though, the contract provides indemnification only during the term of the licence. This provision may appear harmless on the face of it, but if the Licensee wishes to replace the licensed technology with an alternative application and thereby terminates the licence, the Licensee will have no indemnification rights with respect to previous versions of the Licensee’s product that incorporate licensed technology provided under the terminated licence.  

(d)       If the use of licensed technology is restrained by a court order and the Licensor fails to provide the Licensee with alternate software containing similar functional features or modify the licensed technology to make it non-infringing, it appears reasonable for the Licensor to be required to refund to the Licensee all monies paid under the software licensing contract. It is very rare for the Licensor to agree to refund full monies paid under the software licensing contract.  

What is more commonly refunded is advance royalties (if any) and/or support fees that remain unused on the date of infringement action or the date the Licensee is restrained from producing products incorporating licensed technology. The Licensee may however incur costs in finding a replacement and losses due to stoppage of production, changing the architecture or customization efforts to suit alternate application. These costs may sometimes be regarded as consequential damages, speculative in nature and difficult to measure. Sometimes the software licensing contract may also provide for refund of all monies paid to the Licensor under the software licensing contract as depreciated for the term of the software licensing contract on a straight-line basis.      

(e)       The Licensor agrees to indemnify the Licensee against all costs, damages and legal fees as finally awarded in a third-party claim. Usage of the term ‘final’ complicates the indemnity right of the Licensee. It could mean that the Licensee is not entitled to invoke the indemnity right until a third party has obtained a judgment compelling the Licensee to pay damages. It could also mean that the Licensee is not entitled to sue on indemnity until the judgment of the highest court is pronounced. An indemnity may not be effective if the Licensee is not entitled to sue until a judgment is pronounced. A Licensee should be entitled to call upon the Licensor to indemnify as soon as a third-party action is threatened against the Licensee.                  

2.         Limitation of Liability  

2.1       Limitation to Indemnification of Licensor   

Licensees prefer that liability for ‘direct damages’ should be limited to: (i) the amounts that are paid under the contract; or (ii) a certain sum of money (such as  $100,000); and prefer that their liability for ‘indirect damages’ be absolutely excluded. 

A Licensor would generally require that the obligation of the Licensee to indemnify be either of the following:   

(a)         unlimited liability for ‘direct’ and ‘indirect’ damages arising from breach of any provision of the contract; or 

(b)         limited liability for ‘direct’ and ‘indirect’ damages, except where the liability arises from breach of confidentiality obligations, intellectual property rights or the grant of a licence.

Any proposal from the Licensee to limit its liability is generally faced with outright rejection for a number of reasons. In the event of breach of certain provisions (confidentiality, IPR, license grant), the amounts specified under the software licensing contract would not be sufficient to compensate the losses that the Licensor would suffer. Further, providing for such lower threshold (in terms of liability of the Licensee) may potentially act as an incentive for the Licensee to breach the material provisions. If the Licensee proposes any amounts to cover any breach under the software licensing contract, the Licensor will normally seek the basis for such determination. A Licensee’s proposal is normally based on the maximum liability that the Licensee is willing to take on with respect to a specific transaction. The damages that arise from intellectual property rights breaches are ‘consequential damages’ and if ‘indirect damages’ are excluded the indemnification provision would be too weak.

In most cases, limitation of liability provision remains an open issue with no meaningful negotiations with the Licensor until the contract is overdue for closure. The Licensee usually ends up agreeing to unlimited ‘direct’ and ‘indirect’ damages for losses arising from breach of confidentiality and intellectual property rights and the Licensor agrees for unlimited ‘direct’ and ‘indirect’ damages for losses arising from third-party intellectual property rights breach. 

2.2       Limitation to Indemnification of Licensee

Licensors prefer to limit their liability for ‘direct damages’ to the amounts paid under the software licensing contract (in certain cases, amounts paid in the 12 months preceding the date of claim). Licensors prefer to exclude all liability for any ‘indirect damages’. Normally the Licensors succeed in such demand. However, the Licensor’s liability to indemnify Licensee for ‘direct damages’ and/or ‘indirect damages’ arising from third-party actions should be unqualified. In a third-party action where the licensed technology infringes third-party intellectual property, the Licensee may be required to pay damages exceeding the maximum liability of the Licensor under the software licensing contract.

However, it is important to note that, if the Licensee’s liability for ‘direct damages’ is limited and/or liability for ‘indirect damages’ is excluded, the same will naturally become applicable to the Licensors. So, if the Licensee at a future time incurs loss pursuant to a third-party claim that the licensed technology infringes third-party intellectual property rights, the Licensee’s claim for damages or indemnification from the Licensor would be limited to ‘direct damages’ cap and if any ‘indirect damages’ flow from the breach they may not be covered under indemnification.

3.         Conclusion

Licensors are normally reluctant to allow any form of modifications to the indemnification and limitation of liability provisions. Licensees are concerned about the potential unlimited liability that may flow from the software licensing contract. Solutions to these problems are never easily achieved.

While Licensors may agree to minimal modifications that are normally deviations from the standard licensing contracts, they rarely agree to any modifications that would diminish their indemnification rights or enhance their indemnification obligations.

Whatever indemnification and limitation of liability provision finally applies, it is extremely important that the business and technical teams understand the key terms and conditions of the licence and what actions and omissions will give rise to an indemnity claim by the Licensor.

Raghunath Ananthapur is a lawyer at Tatva Legal. Raghunath’s special areas of interest are: commercial contracts, intellectual property rights, information technology, software licensing.