Back to Basics: Intellectual Property Warranties in Commercial Contracts

In the latest article in our Back to Basics series, Christoff Pienaar looks at IP warranties and some of the issues that go with the transfer of IP rights.

The strained economic climate has increased the pressure on lawyers to negotiate appropriate contractual variations to the 'let the buyer beware' (caveat emptor) position of the common law. This pressure has coincided with a rising awareness of the value and importance of intellectual property rights to most commercial and corporate transactions. Almost every business uses and generates intellectual property rights in its day-to-day business activities.  

This article will focus on intellectual property warranties in commercial and corporate contracts and more specifically, intellectual property warranties in sale of assets agreements (including sale of business agreements), share purchase agreements, services agreements (including consulting services agreements), assignments and licenses.  

Intellectual property rights 

Intellectual property rights are valuable commercial assets which may be used and exploited in various ways. Intellectual property rights may be assigned (ownership in the whole or part of the right is transferred), licensed (on an exclusive or non-exclusive basis) and/or used as security for a loan (by way of mortgage or other charge). Some intellectual property rights arise automatically whilst others can only be acquired or ratified through registration. With most intellectual property rights there are certain formalities that must be adhered to in order to make a transaction effective at law. For example, an assignment of copyright or a registered trade mark must be in writing and be signed by or on behalf of the assignor and an assignment or mortgage of a patent is void unless it is in writing and signed by or on behalf of the assignor or mortgagor. The position in respect of the ownership and exploitation of unregistered intellectual property rights is sometimes more complex as there is no public register to consult in order to objectively assess and define such unregistered intellectual property rights. 

Warranties  

Corporate and commercial contracts often include warranties given by one or more parties. The content of the warranties will vary from contract to contract.   

A warranty is a contractual assurance from one party to another, confirming that a state of affairs exists. If these assurances turn out to be untrue, in principle the beneficiary of the warranty will have a claim against the warrantor for breach of contract (breach of warranty). A breach of warranty establishes a right to damages, but will only give rise to a successful claim in damages if the aggrieved party can show that the effect of the breach is to cause that party loss. However, this is subject to common-law restraints such as the principle of 'remoteness'. Loss which does not flow naturally from the breach of warranty, or which was not fairly and reasonably in the parties' contemplation when they made the contract, is in principle irrecoverable. The party who suffers loss must also use reasonable endeavours to minimise (or 'mitigate') its loss wherever possible.

In many contracts involving the licensing and the transfer of ownership of intellectual property rights, warranties and indemnities are incorporated into contracts to give some comfort to purchasers. The purpose of these clauses is to provide the purchaser with a legal right to commence proceedings against the licensor or vendor if it transpires that the licensor or vendor did not have sufficient rights to license or transfer ownership of the intellectual property rights concerned. In the case of licensing, warranties will be sought to guarantee the provision of the rights to be licensed from the licensor for the duration of the contract.

Are warranties worth having?

Warranties and indemnities are only as good as the business giving them. In the event that a party giving the warranty is insolvent or has no assets, unless resort may be had to an insurer, the warranty or indemnity has no value or benefit. If acting for a 'customer' (as opposed to a supplier) you should make enquiries in respect of the legal entity providing the warranties and whether such legal entity has sufficient assets and is of a financial standing that will allow it to satisfy breach of contract (breach of warranty) claims. Where a customer has concerns in this regard, the supplier can be requested to provide appropriate security or guarantees, such as a bank guarantee, performance bond or parent company guarantee. The provision of security and guarantees comes at a cost and a supplier might request that the customer be responsible for such cost.

The relationship between warranties and due diligence

It should be remembered that warranties are not a substitute for thorough due diligence. Due diligence is meant to ensure that the rights are in place prior to the licence being entered into, which allows informed decision-making on the existence of rights and the risks of entering into the transaction in the first instance. However, because some intellectual property rights are unregistered, warranties are normally required as well as there is no other means to verify the ownership, validity and status of such unregistered intellectual property rights.

Warranties and the sale of assets or shares 

Every business has intellectual property rights, even if it is only its name. Intellectual property rights may or may not be a key asset of a business, but it is advisable to consider the question carefully with a client because some assets, sent in the form of data or documents, are often overlooked. Intellectual property rights are often acquired as part of a transaction which includes other property such as the assets of a company, tangible property such as computer hardware and plant and equipment.  

In the specific context of intellectual property rights, the seller will usually be asked to make certain representations and warranties in connection with the intangible assets to be sold. The principal purpose of warranties in sale and purchase agreements is to override the common-law principle of caveat emptor. The second purpose for warranties is to elicit information relevant to whether or not to proceed with the proposed transaction. The third (and most important) purpose of warranties is to allocate risk between the contracting parties.   

Proper investigation of intellectual property rights is essential to the success of due diligence when buying a business or asset that includes intellectual property rights. Intellectual property rights can sometimes be overlooked in a due diligence exercise because they are not physical assets. Knowledge about intellectual property rights tends to be dispersed and held by different individuals within a business and for this reason it is important that IPR  warranties in asset purchase or sale of business contracts is 'comprehensible'. For example, a warranty such as "all intellectual property rights are valid" is unlikely to elicit information that might affect validity of intellectual property rights unless specific examples are given. Broadly worded warranties should be replaced by short and specific warranties which are more easily digestible (for example, "all renewal and application fees have been paid up-to-date"). Intellectual property warranties should be drafted with the potential problems affecting the value of intellectual property rights being acquired or sold and potential dependence on third parties in mind. Beware of any intellectual property rights shared within the target's group of companies. Carefully review any research and development or collaboration agreements and sale and leaseback arrangements. Investigate intellectual property rights licensed by the business. Review existing arrangements for their profitability and potential competition law issues. Investigate infringements. Beware of litigation already underway which may be expensive and time-consuming. Ensure warranties are appropriately drafted to induce information and maximise the chances of success of any eventual claim.  

The person or organisation acquiring the assets and/or property will typically have the following questions in respect of intellectual property rights: 

·        what intellectual property rights are there?

·        are the intellectual property rights actually owned by the seller?

·        Are the intellectual property rights owned outright or jointly?

·        is the seller using any intellectual property rights under a licence granted by a third party?

·        if the seller is using any intellectual property rights under a licence, what is the scope of the relevant licence?

·        has the seller granted any licences in respect of the intellectual property rights to third parties (for example, manufacturing licences)?

·        were all previous transactions in respect of the intellectual property rights registered with the appropriate registries?

·        have all renewal fees in respect of registered intellectual property rights been paid?

·        have any of the intellectual property rights been infringed by a third party?

 

In addition to the above, the following should also be considered: 

·        whether all registered trade marks have been used by the seller within the last five years (since a period of more than five years' 'non-use' could make the relevant registered trade marks liable to be revoked); and

·        whether there are any patent licences which oblige the seller to purchase unrelated products (since this contravenes the Patents Act 1977, s 44 and renders the patent in question entirely unenforceable in infringement proceedings);

·        whether any current applications filed by a seller are in difficulty (whether by reason of third-party oppositions or because there are official actions in progress by the relevant registration authority);

·        whether there are restrictions on the use by the seller of intellectual property rights which are not contained in licences (eg restrictions contained in litigation settlement agreements or co-existence agreements);

·        when patents (or other intellectual property rights) are due to lapse. 

The majority of these questions can be answered by investigating the seller's intellectual property rights as part of a due diligence exercise, but appropriate warranties should be included in respect of the remainder. The inclusion of warranties may help, but is no substitute for actual knowledge of all the rights and interests that might affect the value or exploitation of the intellectual property rights. 

In corporate transactions it is common to specifically exclude from the warranties in a contract those matters that were formally disclosed to the other party. Such disclosures are often included in a 'disclosure letter' which is sent by the party giving the warranties at the time of signing the contract. A thorough due diligence is necessary to put such disclosures into the proper context.  

A search of the records maintained by the Intellectual Property Office in the UK of registered UK patents, registered designs and registered trade marks (and indeed international registered intellectual property rights) should be undertaken as part of the due diligence exercise. Appropriate searches in respect of Internet domain names should also be undertaken. In practice it often happens that changes of ownership of registered trade marks, designs or patents have not been recorded at the appropriate registry. Under such circumstances, the 'paper trail' has to be investigated and the sale and purchase agreement should contain appropriate warranties relating to the ownership of such registered trade marks, designs or patents.  

In order to transfer the legal ownership of intellectual property rights, an assignment is required and care should be taken to ensure that the assignment complies with the relevant statutory requirements for a valid assignment. Unless one acts as a duly authorised agent for an owner, it is never possible to transfer title if you do not own the relevant intellectual property rights. Sections 6(1) and 7(3A) of the Unfair Contract Terms Act 1977 provide that liability for breach of the obligations as to title and quiet possession implied by the Sale of Goods Act 1979 and the Sale of Goods and Services Act 1982 cannot be excluded or restricted in a contract where UCTA applies. This gives rise to special problems in the area of the supply of goods which infringe third-party intellectual property rights where UCTA applies. In Niblett v Confectioners' Materials [1921] 3 KB 387 it was held that the supply of goods which infringe third-party intellectual property rights amounts to a breach of these warranties. This being the case, it is not possible to exclude or restrict liability for the supply of goods which infringe third-party intellectual property rights. The one exception is where the infringement was caused by a design, specification or other instruction supplied by the buyer.   

On the other hand, a share purchase will transfer the entire rights in the intellectual property by operation of law. However, regardless of the nature of the transaction, asset schedules in the context of intellectual property play a key role in determining the representations and warranties to be included in the contract. The warranties to be incorporated into a typical purchase agreement tend to be one of the more heavily negotiated aspects of any purchase agreement. A seller will typically include warranties to the effect that the schedule of intangible assets is complete and accurate, it is the rightful owner of such intangible assets, no liens or encumbrances exist with respect to such intangible assets, the intellectual property does not infringe the intellectual property rights of a third party, the seller will assist the buyer in performing due diligence in connection with the intellectual property being transferred and other disclosures (such as existing licences, settlement agreements, consent agreements, ongoing litigation, opposition, interference or other actions which may affect the use of the scheduled intellectual property). 

In a share purchase the buyer will acquire all the assets and liabilities of the seller whereas in an asset purchase the buyer will only acquire those assets and liabilities which it agrees to take on. Buying assets offers some protection for a buyer in respect of unknown issues although warranties may still be required to address unregistered intellectual property rights.    

Although most sellers in the UK will offer title guarantees concerning the ownership of intellectual property rights under the Law of Property (Miscellaneous Provisions) Act 1994, express contractual warranties should also be given. The most important warranties are those relating to title and/or authority. A supplier of goods and/or services should be the owner of the goods (or should have the necessary rights to sell the goods in question) and the provider of services should have the necessary rights, licences and consents required for the provision of the services.

Specific issues relating to services agreements

In the majority of contracts for services a service provider will be using intellectual property rights in providing the services to the client. The output of the services (the deliverable) is also likely to contain both existing and newly created intellectual property rights. The most important intellectual property warranties from the client's point of view would be (i) that the service provider owns or has the necessary rights to the intellectual property rights to be used in the provision of the services, and (ii) that such intellectual property rights and any newly created intellectual property rights do not infringe the rights of third parties. The client is likely to provide material, data, information and specifications to the service provider in order to enable the service provider to provide the services. From the service provider's perspective the most important intellectual property warranty would be that such material, data, information and specifications do not infringe the intellectual property rights of any third party.      

The warranty in respect of third-party intellectual property rights infringement is often coupled with an indemnity in favour of the customer in the event that the services, deliverables resulting from the services and/or goods do infringe the intellectual property rights of a third party. An indemnity is a free-standing mechanism by which one party promises to reimburse another party in respect of a specific liability, should it arise. This warranty and indemnity often leads to heated negotiations between the contracting parties. The supplier may use individual contractors or subcontractors to provide the services and will argue that it has limited control over the potential infringing activities of such third parties, or the supplier may be a distributor or reseller of goods and did not receive a back-to-back warranty and/or indemnity from the manufacturer (or principal). The customer will argue that it has no control over the supplier's performance of the services and/or the manufacturing of the goods and that it expects the supplier to ensure that the services, deliverables and/or goods are not infringing the intellectual property rights of third parties.

Recent trends suggest that suppliers are becoming more reluctant to give intellectual property indemnities and warranties and are, at the very least, significantly qualifying or reducing their scope. There are several reasons for this. The increased use of open source software has made suppliers far less certain that they own all intellectual property rights in their products and therefore less confident about providing intellectual property warranties and indemnities. The amount of intellectual property infringement litigation taking place is increasing dramatically and the increasing number of software related patents that are being issued in the United States has made it more difficult for technology companies to warrant that they are not (albeit innocently) infringing a patent belonging to a third party.

It is normal for the licensor of a patent to resist providing a warranty that the relevant patent is valid and such a warranty will normally not be implied by the grant of a licence. The fact that a patent has been granted does not guarantee that it is valid. Similarly, it will not normally be implied into a patent licence that the granting of the licence and its exercise by the licensee will not infringe third-party patents, but it is normal for licensees to insist for such a warranty to be included in the licence. A similar position applies in respect of UK registered designs. 

The position often adopted by contracting parties is an indemnity in favour of the customer with either a 'cap' or 'limit' on such indemnity and/or specific conduct of claims provisions such as that the supplier will control the defence, the customer will not make any admissions or agree to any settlements without the consent of the supplier or reserving the right to replace the infringing goods or deliverables with non-infringing goods or deliverables. In contracts for the provision of services (such as software development contracts), it is not uncommon for a supplier to request a reciprocal indemnity from a customer in respect of material and data provided by the customer for purposes of the development of the software.

It is important to note that the exclusion of terms implied by statute is not absolute and is only valid to the extent that the exclusions are reasonable (UCTA 1977, s 2). 

Conclusion

As mentioned earlier, warranties are not a substitute for thorough due diligence and should be used to supplement the due diligence exercise not replace it. The types of warranties required will depend on the specific goods and/or services and the circumstances present. From a commercial perspective it is advisable for contracting parties to consider during the pre-contract stage which of them is in a better position to manage a particular risk or who has more control over a specific aspect of the goods and/or services.

An understanding of warranties and indemnities and how they operate is crucial in order to properly advise a client in respect of its commercial and IT contracts. 

Christoff Pienaar is a partner in the Intellectual Property and Commercial Department of Wedlake Bell LLP

Published: 2011-10-16T12:15:54

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