Tag Archives: Leslie Marell

Contracts

Part One: Understanding the Indemnity Clause

Most business people assume that the Indemnity clause is a legal issue to be resolved only by their lawyer.

Black’s Law Dictionary (the Webster’s dictionary for lawyers) defines Indemnify – in part- as follows:  “To make good; to compensate; to make reimbursement to one of a loss already incurred by him.”

Read that carefully. Doesn’t that say to indemnify means to pay money?

And if indemnify means to pay…….can you really characterize the indemnity clause only as a “legal” issue?

Since many indemnity clauses contain unfamiliar legal jargon (not to mention long run-on sentences!), even business people experienced in contracting throw up their hands in frustration. They often turn the clause over to their lawyer without reading it. If the lawyer is unable to obtain the desired outcome, he/ she usually throws the ultimate decision back to the business person by saying “It’s a business decision….it’s up to you!” And the parties remain in a stalemate.

If this situation sounds all too familiar and you want to “break the mold”, I’d like to provide you insight into the meaning of the indemnity clause.

It’s not all that complicated. But, be forewarned:  You’ll need to devote 5-10 minutes of uninterrupted time to understand this. If you do, I promise you’ll have new insight into indemnity clauses.

THE PURPOSE OF THE INDEMNITY CLAUSE

In an indemnity clause, one party agrees to defend the other and pay for all costs of the lawsuit if it is sued by a third party for specified reasons and to pay any damages and judgment resulting from the lawsuit. The indemnity clause shifts “third party” risks from one contracting party to the other. In effect, the indemnifying party is acting as an insurer.

Examples give insight into a concept…so let me provide you with one:

Assume that you retain a contractor to perform construction work on your premises, and in the course of that work, the contractor injures the UPS driver and damages his vehicle. The UPS driver (third party) will likely bring a lawsuit against not only the contractor, but against your company on whose premises the injury occurred. Further assume that the case goes to trial and your company is found not to be liable and the contractor is found to be 100% responsible. Your company will have spent a significant amount of money defending itself in the lawsuit.

Your company would be entitled to reimbursement from the contractor of all moneys it incurred in defending itself only if the contract between your company and the contractor contained an indemnity clause.

In other words, each party to the contract is on their own when a third party claims injuries or damages unless the contract contains an INDEMNITY clause which shifts “third party” claims from one contracting party to the other.

THE (UNFORTUNATELY) TYPICAL PROBLEM

Before talking further about indemnity clauses, I’d like you to assume the following situation:

Seller sells a valve to its customer, a tractor company. Customer integrates the valve into the tractor. The tractor is sold to an end-user. The tractor malfunctions and causes injury to end-user. Injured user sues both the customer company and the seller (valve company).

The matter goes to court. The jury concludes that the malfunction was caused by the combined negligence of tractor company and valve seller: 25% of the malfunction was attributable to the seller’s minor manufacturing defects in the valve and 75% of the malfunction was due to faulty installation by the customer.

Assume further that the following indemnity clause is in the contract between tractor company customer and seller. You’ll note that I’ve underlined the key words to help you understand the “essence” of the clause. (This is a technique a very experienced lawyer shared with me many years ago and I found extremely useful):

Seller shall defend, indemnify and hold harmless Customer, its officers, directors, agents and representatives from and against any and all claims, suits, losses, penalties, damages (whether actual, punitive, consequential or otherwise) and associated costs and expenses (including attorney’s fees, expert’s fees, and costs of investigation) and all liabilities that are caused in whole or in part by: (a) any breach by Seller of this Agreement or (b) any negligent, or intentional act, or omission by Seller, its employees, officers, or agents in the performance of this Agreement.

Looking only to the underlined words,  what is the seller’s responsibility in the hypothetical situation?

HINT:  Look at the underlined words on lines 4 and 5 which read: “caused in whole or in part by…”

MAJOR PROBLEM:

SHIFTING ALL RISK TO SELLER

The above clause says that if the seller breaches or is found to be negligent in any percent, the seller will be 100% financially responsible for all damages caused by both the seller’s and customer’s negligence.

Going back to the hypothetical situation, even though the jury determined that the tractor customer is 75% negligent, as long as the seller is negligent in part, the seller’s financial responsibility will be 100%.

IMPORTANT NOTE:  The indemnity clause does not relieve the customer tractor company (in legalese the “indemnitee”) from responsibility to pay damages to the injured end-user. Tractor company will be liable to pay the end user for bodily injuries and property damage.

But, the indemnity clause gives the tractor company a legal right to go back to the valve seller (the “indemnitor”) to collect for all the damages paid to the end-user. Additionally, the tractor company has the right to be reimbursed for all costs and attorney’s fees incurred in its trial with the end-user.

Even if the clause doesn’t seem fair, generally speaking (of course there are always exceptions!) the courts will enforce it.

Fairness is rarely relevant in the B2B (business to business) contracting world. Of course, there are exceptions, but courts typically say that the parties to the contract are free to allocate (legalese for shift) the risks whichever way they determine. That means that if the seller is willing to assume responsibility for not only what the seller does but also for the actions – or negligence – of the buyer or a third party, the courts will enforce the seller’s decision to accept that risk.

Indemnity is a broad financial obligation. If a seller is required to provide indemnity, the prudent seller will want to limit that indemnity to behavior over which it has control.

The above example of overly broad language is the # 1 problem sellers have with buyer indemnity clauses.

Contracts

Time is of the Essence: Overused Phrases…Say What You Mean

Too frequently, contract drafters (both lawyers and business people) regurgitate phrases and clauses in their contracts because that’s what they’ve always read and that’s what they’ve always done.

The problem with using “standard” phrases is that while the courts have conferred upon them certain import, their overuse sometimes renders them meaningless.  If you use a “standard” clause understand its implications and give thought to what you’re trying to accomplish.

“TIME IS OF THE ESSENCE”

One example of such a standard phrase is “Time is of the essence.”  You’ll find this clause in many business contracts. In discussions with numerous buyers and sellers, I find that many don’t understand its legal significance.

In this article, I will discuss the interpretation and reason for the use of Time is of the essence in non-goods contracts and contracts for the sale of goods. Its use can be important in a contract. Just make sure you understand its purpose, use it for that purpose and specifically state your remedies if the time of performance is not met.

CONTRACTS FOR NON-GOODS

The general rule in contract law dealing with non-goods is that a party may cancel the contract if the other party is in material breach of the contract.

When it comes to non-goods contracts — for example, services, development, construction, real estate, loans — courts often don’t consider on time performance to be “material”. The general rule is that time is not of the essence unless the contract expressly so provides. While the buyer may be entitled to damages as a result of a “partial breach”, the buyer may not cancel the contract.

For that reason, lawyers began to use “time is of the essence” provisions in contracts. When a buyer wants to make sure that performance is completed on time, the contract will include a clause that specifically states: “Time is of the essence with respect to deliveries under this Agreement.” This clause changes the remedies available to the buyer. If the supplier fails to deliver on time in this situation, the buyer would have the right to terminate the contract immediately without notice and claim damages.

WILL “TIME IS OF THE ESSENCE” PROVISIONS BE ENFORCED?   MAYBE

The modern view held by most courts is that a party’s failure to meet the conditions of a “time is of the essence” provision amounts to a material breach of the contract. And, alternatively, most courts will not consider the timing to be crucial if this language is left out.

THE DANGER OF USING A “STANDARD” PHRASE

However, when a contract uses the overly broad phrase “Time is of the essence of this Agreement” without being specific to the specific performance that is critical (as many contracts do), courts might consider this clause to be too vague since: “A contract may contain many promises for sundry performances, varying in amount and importance. A general provision that ‘time is of the essence’ should not apply to all of the promises for performance.” 8-37 Corbin on Contracts § 37.3.

And even if it happens to be clear what particular performance the phrase applies to, the phrase is silent as to the exact consequences of untimely performance.

So, it’s not surprising that courts have been willing to ignore “time is of the essence” clauses on the grounds that you can’t assume that the parties to a contract understood and agreed on the perceived meaning of the phrase.

AGAIN: SAY WHAT YOU MEAN AND STATE THE CONSEQUENCES

In other words, if a buyer considers on time performance/ delivery to be essential to the deal, the buyer should expressly state that in the contract.

Of equal importance, the contract should be clear regarding the remedies (consequences) for late performance/ delivery.  The buyer may desire the right to terminate the contract as a result of such breach. If that’s the case, the contract should explicitly state so.

However, the parties should also discuss and agree upon alternate remedies and back up plans. During contract negotiations, the buyer will generally expect the right to terminate if the seller is late. In reality, when the time comes, many buyers won’t exercise that right. From a practical perspective, the buyer’s accepting later performance often makes more sense than termination simply because of the cost and time impact in contracting with an alternate supplier.

Alternate forms of remedies should be considered such as: reduced price, no-charge extensions of maintenance, and credits against future purchases, all of which are forms of “liquidated damages”.

Contracts

Guidelines in “Fighting” the Battle of the Forms

I consistently receive questions from my clients and seminar attendees relating to the Battle of the Forms. In this age of e-contracting, one might assume that this issue is no longer relevant.

However, unless both the buyer and seller sign (or click their assent to) a single agreement under which they agree to do business, the parties will be operating in the uncertain realm of the Battle of the Forms.

Below are some basic guidelines to keep in mind in “fighting” the battle and answers to often asked questions.

BASIC GUIDELINES

  1. If you don’t provide the other side with your terms and conditions (of either purchase or sale), you are not engaging in the Battle of the Forms…..and you will lose. That is to say, you may have inadvertently agreed to the other side’s terms even if you never signed their form.
  1. If you sign the other side’s form, you will have lost the battle….even if you provide the other side with your terms – previously or after the fact.
  1. One of the most important clauses to include in your terms is a clause which objects to those terms in the other side’s form that differ from or are in addition to your terms.  (See example language in answer to Question 2 below)
  1. Bad news for Sellers:  Sellers will almost always lose the battle regarding limitations of liabilities if the customer provides the seller with its terms of purchase. The only effective way to limit your liabilities with your customer is to negotiate and sign a master agreement.
  1. While every business person involved with the exchange of RFP’s, proposals, POs, acknowledgement forms, and the like should be familiar with the Battle of the Forms, the most efficient use of time and productive approach is to focus on the major issues and ensure agreement in those areas.

BATTLE OF THE FORMS QUESTIONS

QUESTION #1:    We include in our Bid package our terms and conditions of purchase and we state that any terms and conditions contained in the supplier’s proposal will not apply. In those cases where the supplier includes its terms of sale, whose Ts and Cs have superiority?

A:         This is a classic example of the “Battle of the Forms”. If you have included a set of terms and conditions of purchase in your RFP and the supplier responds with their terms and conditions of sale, neither document would supersede the other. The outcome would be as follows: In those areas where your terms are in agreement with the seller’s, those terms would apply. However, most terms will be in conflict with one another, in which case, neither clause would apply. In the event of a dispute regarding a clause with which there has been no agreement, the courts would look to the Uniform Commercial Code (if the contract involved the sale of goods) or General Contract Law (for service and other contracts) for resolution.

QUESTION #2:    What is a good example of language that should be on the buyer’s form that takes exception to the terms in the seller’s forms?

A:         The following language mirrors section 2-207 of the Uniform Commercial Code which addresses the battle of the forms issue:

“This purchase order is limited to the terms and conditions contained on the face and the reverse. Any additional or different terms proposed by Seller in any quotation, acknowledgment or other document are hereby deemed to be material alterations and notice of objection to them is hereby given. Any such proposed terms shall be void”.

          (NOTE TO SELLERS:  Change “purchase order” on line 1 to “proposal”. Change “Seller” on line 2 to “Buyer”. Change “quotation, acknowledgment” on line 2 to “request for proposal, purchase order”.)

QUESTION #3:    We have a Master Agreement with a supplier. After we issue our P.O. release document, our supplier provides its acknowledgment form (with terms on the back) and it also submits an invoice with terms on the back. Are these binding and do they supersede the negotiated terms of the Master Agreement?

A:         While terms on the back of the supplier’s form will not supersede a provision of the Master Agreement, they might ADD TO the Master Agreement. Let’s say, for instance, your Master Agreement did not address the right to cancel an order. If your supplier’s acknowledgment form has a clause that assesses a 25% restocking fee if you do cancel, that term might be considered part of the overall agreement between the companies.

The way to avoid this from occurring is to include language in your Master Agreement similar to the following:

“This Master Agreement shall apply to all proposals, purchase orders and other documents issued by either party in connection with the purchase and sale of Products (referred to as “releases”). No inconsistent or additional term or condition in any release shall be applicable to a transaction within the scope of this Master Agreement”.

NOTE TO SELLERS: The above clause also protects the seller from additional terms contained in a buyer’s P.O. or other document.

Buyer, Contracts, Seller

The Pesky Auto-Renewal Clause

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We’re all familiar with the automatic renewal (evergreen) clause that appears in many supplier proposed agreements. The following is a typical example:

This Agreement shall be for a term of one year beginning on January 1, 2013 and expiring in December 31, 2013 and shall automatically renew for one year periods unless terminated by either party by giving the other written notice of termination at least sixty (60) days prior to the expiration of any one year period.

Under this clause, the customer must notify the supplier no later than November 1st if it doesn’t want the contract to automatically renew. If the customer fails to provide timely notice, the contract will automatically renew for another one year period.

Too often, our internal clients sign a supplier proposed document which contains an evergreen clause. Frequently, the window of opportunity to terminate the agreement passes, and the company finds itself on contract for another year.

In the context of commercial business-to-business contracts, courts often strictly construe these provisions where the contract language is clear and unambiguous. In those cases, if the contract language is not followed and notice is not given within the required time to terminate, the contract extends automatically for another term.

A NEW TWIST:  SELLER BEWARE

A few states have passed laws that may make it difficult for suppliers to enforce automatic renewal clauses. Most of these laws apply only to contracts between businesses and consumers.  However, two states, New York and Wisconsin, have enacted statutes applicable to business to business contracts.

BUSINESS-TO-BUSINESS CONTRACTS

New York General Obligation Law Section 5-903

In 2006, New York passed a statute which provides that automatic renewal provisions in contracts for service, maintenance or repair are unenforceable unless “the person furnishing the service, maintenance or repair, at least fifteen days and not more than thirty days previous to the time specified for serving such notice upon him, shall give to the person receiving the service, maintenance or repair written notice, served personally or by certified mail, calling the attention of that person to the existence of such provision in the contract.”

Wisconsin Statute Section 134.49

In 2011, Wisconsin passed a statute that affects the enforceability of automatic renewal clauses in certain business-to-business contracts. Generally, the law applies to business to business contracts for the lease of business equipment or for providing business services, with some exceptions.

Under the statute, an automatic renewal provision in a business contract is void unless the supplier (i.e., service provider/ lessor) gives the customer proper notice, and the customer has initialed the evergreen clause in a specific location in the contract, as described in the statute. A supplier who attempts to enforce an automatic renewal provision that violates Section 134.49 may be liable for damages.

BUSINESS-TO-CONSUMER CONTRACTS

If you’re selling services/ products to consumers, you should be aware of statutes in a number of states which create requirements applicable to automatic renewal in a wide range of contracts. Failure to abide by statutory requirements governing automatic renewal clauses may make these clauses unenforceable.

The following states have laws pertaining to automatic renewal clauses that generally fall into three categories:

  • Auto-renewal laws that apply to contracts with consumers, not businesses, that require only clear and conspicuous disclosure of auto-renewal terms. The following states have such laws:  California,  North Carolina, Louisiana, Oregon;
  • Auto-renewal laws that apply to contracts with consumers, not businesses, that require clear and conspicuous disclosure of auto-renewal terms and require a service provider to notify its customer of the auto-renewal within a certain period of time before the cancellation deadline. The following states have such laws: Connecticut, Florida, Illinois, Hawaii and Utah;
  • Auto-renewal laws that impose similar requirements as those described above, but only with respect to specific types of contracts, such as, contracts for health club memberships, home security services, leases of certain types of personal property, retail telecommunications service subscriptions. The following states have such laws: Arkansas, Maryland, South Carolina, South Dakota, Tennessee and Wisconsin.

TIPS FOR BUYERS AND SELLERS

BUYERS:

Many companies have been unpleasantly surprised by an auto-renewal clause and have paid the price by being economically obligated for a renewal term. As a result, many companies have internal policies against including evergreen clauses in their contracts.

However, If correctly written, these clauses can be beneficial to the buyer. This requires two additional considerations and clauses: i) A mechanism to cap any price increase in the renewal term; and ii) An additional clause giving the buyer the right to terminate the contract at any time on XX days advance notice to the seller.

SELLERS:

Check your state’s statute before inserting an auto-renewal clause in your contract. There may be requirements regarding conspicuous disclosure of the clause, notice to your customer and the types of contracts that must meet these requirements.

Contracts

If It’s Not Part of the Contract It’s Not Part of the Deal!

A frequent source of contract disputes revolves around this simple statement. Business people often think that once they’ve discussed and agreed upon the deal, the written contract is mere formality. Many people tell me that the contract is for worst case scenarios and the relationship is key.

I don’t disagree with the importance of the relationship. In fact, my own experience demonstrates that a well written contract will not repair a bad relationship. And, more frequently, I have found that the converse is true. We’ve all experienced business relationships where the contract documents were either minimal or non-existent but all went well.

Before I address the issue of why you want to include all the deal points in your contract, I want to make mention of a typical boilerplate or “standard” clause that you find in many contracts.

It’s often entitled “Entire Agreement”, “Merger” or “Integration” and reads similar to the following:

This Agreement constitutes the entire agreement between the parties with respect to the subject matter hereof and supersedes all prior and contemporaneous agreements, negotiations, promises, representations and warranties, whether oral or written, of each party.

Let me tell you about a client of mine “Jim” and the importance of this clause.

A TRUE (AND SAD) STORY 

Jim, an independent sales representative, was approached by a manufacturer who asked Jim to represent its products on the west coast. The manufacturer had no presence in that region and had heard that Jim was very successful in pioneering new products into a territory.

The parties agreed that Jim would be paid a higher commission than other sales reps as a result of the effort and expense involved in pioneering a product. After their discussions, the manufacturer presented its standard contract to Jim which included the higher commission rate.

There was two clauses in the contract I’ll tell you about: One was a “Termination” clause that read:  “Either party has the right to terminate this agreement at any time on giving 30 days written notice to the other”.  The other was an Entire Agreement clause similar to the one above.

Jim read the contract, called the Executive Vice President and said he had a problem with the 30 day termination clause. Jim said: “Here’s my concern: It will take me much effort, time and money to introduce your products and get sales up and running. My concern is that after sales start coming in, you’ll terminate me and I won’t have the opportunity to reap the benefits of my work.”

EVP responded:  “You know, I agree with you. We won’t terminate you, Jim, so long as you meet your annual quotas”.

Jim – a very astute business person – asked the EVP to put that in writing.  The EVP did. He wrote Jim a letter saying that as long as Jim met his annual sales quota, the principal would not exercise its right to terminate the contract on 30 days’ notice.

So far….so good.

But, let me continue.

For discussion purposes, I’ll tell you that the EVP dated and signed the letter March 1st. About 10 days later, on March 11th, the parties signed the contract as originally written.

Five years went by. Jim was doing a fantastic job. He was consistently meeting and exceeding his quotas. He was awarded “Best Sales Rep of the Year” award several times…..when….

The Manufacturer’s CEO retired. A senior management shakeup ensued. EVP resigned and a new Sales VP was brought in. New VP reviewed Jim’s contract, saw that Jim was getting a much higher commission than all the other sales representatives and sent Jim a termination notice.

Jim tried unsuccessfully to negotiate a resolution with the Manufacturer before and after the notice of termination.

Jim brought suit claiming that the Manufacturer did not have the right to terminate the contract on 30 days’ notice. Jim argued that the EVP’s letter reflected the actual agreement between the parties relating to termination.

I’ll spare you the sad details but ultimately, the case was dismissed by the judge via a motion brought by the Manufacturer. Why?

The judge said that the termination clause was clear and unambiguous. The judge pointed to the entire agreement clause which clearly indicated that the parties intended the contract as the final statement of their agreement. As a result, the judge could not admit into evidence a document that came before (or even at the time!) the contract was signed.

MORAL OF THE STORY

What should Jim have done?

He should have ensured that the language in the signed contract corresponded to his agreement with the EVP.

(I should tell you that Jim became a client of mine during his trial, when he asked me to review several other proposed principal contracts!)

BOTTOM LINE:

  • All understandings should be included in the contract, and any term that is unacceptable or not consistent with the verbal and written agreements should be removed or changed. If any agreements have been reached in side letters or other writings, they should be specifically included in the language of the contract or attached to the contract as Exhibits.
  • The “Entire Agreement’ clause may look innocuous, but its impact is critical!  It signifies that it may not be possible to enforce any prior promises.
  • If it’s not in the contract, it’s not part of the deal!
Contracts

Indemnity, Lions and Tigers….OH MY!: Has the Pendulum Swung Too Far?

I recently went on safari to the Serengeti in Tanzania. It was an amazing adventure and quite remarkable being 10 feet from giraffes, elephants, lions and wildebeests!  During our trip we stayed at lodges which were (truly) in the middle of the bush (actually, Africa).  In some places, Masai warrior guides armed with guns or a bow and arrows (!) would accompany us from our tents to the dinner tent …in order to stave off hungry lions or cheetahs looking for dinner. Fortunately, we all successfully avoided becoming appetizers and eluded dangerous skirmishes (except for a baboon who stole one of our lunch boxes).

Such close encounters are rare (mostly due to the skill and training of the guides) but likely must happen since the purpose of the trip is to “commune” with (or at least get a good look at) wild animals over whom humans have no control because, after all, they are wild.

At one camp site in the midst of a vast expanse of land with no civilization in sight for miles, there was an informational sheet in our tent.  It contained the following paragraph:

Our camp offers guided nature walks, game drives, and similar activities. In order to participate in any of these activities, you must sign an indemnity form which indemnifies the camp from any injuries, damage or distress that may occur while participating in the activities. You will not be permitted to participate in any of the activities if you do not sign the form.

HOW DO YOU SAY INDEMNITY IN SWAHILI?

I couldn’t believe it!  Indemnity had come to the Serengeti!

Is it me or have our concerns about risk, its management, and its allocation gone a bit too far?

Does it say something about our society that an indemnity clause should appear on an informational sheet in the middle of the Serengeti?

Has the pendulum swung too far?

I think so.  At least that’s my conclusion based on my 25+ years business contracting experience as well as some recent data from the International Association for Contract and Commercial Management (IACCM).

WHAT THE DATA SUGGESTS

For the past 10 years, IACCM has conducted surveys relating to the most frequently negotiated contract terms.  Surveys since 2007 have consistently shown that the two most highly negotiated terms each year were…………..Limitations of Liabilities and Indemnity.

In the 2011 IACCM survey of 8,000 negotiators from 1,123 worldwide organizations, the Scope and Changes clauses appeared as numbers 16 and 18, respectively on the list of most frequently negotiated.

By contrast, when asked about the most frequent source of actual dispute during contract implementation, the same respondents listed the following areas:

Delivery/ Acceptance:   41%;

Price/ Price Changes:   38%;

Change Management:  32%.

It is important to note that actual disputes relating to Limitations of Liability and Indemnity came in at 16% and 14%, respectively.

This data confirms my experience:  Far too much time is being spent in negotiations dealing with the more theoretical “what if” issues at the expense of dealing with the real world issues. The origins of the contract disputes I have been involved with over the years most frequently revolve around the parties differing interpretation (or inadequate description) of the scope of work (service or product),  changes to the work, and the impact of changes on pricing. I think many contracting people share the same observation.

LET’S BE MORE CENTRIST

(I’M NOT TALKING POLITICS)

That’s not to undermine the significance of the risk management (“legal”) clauses. For years to come, lawyers will be analyzing and litigating the Limitation of Liabilities and Indemnity clauses in the BP Gulf of Mexico disaster and Toyota supplier/ customer contracts in light of the ultimate tragic loss of life and economic loss.  Worst case scenarios happen.

I’m just advocating that we do a better job of putting these issues into perspective and balancing them with those issues calculated to ensure greater contracting success. Let’s spend more time on crafting a more detailed and well thought out statement of work and method to manage changes.  Let’s be more mindful of when it makes sense to emphasize indemnity and when it makes less sense.

In other words, let’s get that pendulum back a bit more to the middle.

ANY SUGGESTIONS OR FEEDBACK?

It takes courage to “buck the trend” and many of us are concerned that our jobs would be in jeopardy if we don’t always insist upon the one sided risk management clauses many of our companies proffer.

My experience, however, demonstrates that engaging in this balancing exercise yields more respect and cooperation internally, from our client, and from the organization with whom we’re negotiating.

I welcome and am interested in your experiences, suggestions, and feedback.

Intellectual Property

Part Two: Intellectual Property Copyright Ownership

As I discussed in a previous blog, under copyright law, the author who creates an “original work of authorship” owns the copyright to that work.  An “original work of authorship” includes designs, specifications, software, documentation, photographs, website development, artwork, or multimedia work.

This means that when your company outsources the design or development of any work, your company will not automatically own the copyright to the work created by the supplier/ independent contractor/ customer even when you’ve paid them for it. In order to acquire ownership, your company must obtain a written assignment (transfer) of copyright ownership signed by the author of the work.

The “Works for Hire” doctrine is an exception to the above general rule. However, those items considered “works for hire” are very limited and likely do not cover many of the projects companies typically outsource.

THE BUYER’S POSITION

Buyers assume that if they pay for the development of the work, design, software, services they should own the intellectual property rights to such development. At first blush, that position seems logical:  The Buyer pays for it, the Buyer should own it. The Buyer may also want the ability to be able to incorporate the work into other products, or modify the original work.  Additionally, the Buyer is concerned that the Supplier might sell or license the work to the Buyer’s competitors.

THE SUPPLIER’S POSITION

 Most frequently, the Supplier’s pre-existing intellectual property will be used in the development of the deliverable. The Supplier has likely spent many years and significant money developing its IP. If the Supplier transfers ownership to the Buyer of the entire work, the Supplier will end up giving up far more than it actually realized or intended:  The Supplier may lose its rights to its pre-existing/ background technology and, therefore, the assets to its business.

ISSUES TO CONSIDER

Many Buyer proposed IP assignment clauses are very broadly written to say that the Supplier will assign to the Buyer ownership to all IP contained in the entire deliverable/ work product. The problem with these clauses is that the Buyer is requesting ownership to IP not only for which it paid but for the Supplier’s pre-existing IP as well.

  • CARVE OUT SUPPLIER’S PRE-EXISTING TECHNOLOGY

A key step to resolution is to take the Supplier’s pre-existing technology “off the table” in terms of ownership. The Supplier will want to retain all ownership rights to its background IP and that’s certainly not unreasonable since the Buyer typically has not paid for the development of that background IP.

Supplier should prepare a separate exhibit to the contract that identifies in as much detail as possible the pre-existing technology to be included as part of the deliverable. It often is not possible to identify all the items of the Supplier’s background technology that will be used, so the contract should allow for additional items to be added later.

  • DETERMINE YOUR GOAL

If the Buyer is having the Supplier semi-customize a standard product or software, the Buyer often insists on ownership rights to the customized portion without giving thought to the underlying reasons. Generally speaking, the ownership of the code or design applicable to the customization will not be of much value.

Perhaps the Buyer is concerned that the Supplier will use the customized portion (paid for the Buyer) in product the Supplier sells to the Buyer’s competitors. If that were the case, a narrowly written restriction against performing the same sort of customization for Buyer’s direct competitors would be more to the point. (CAVEAT: Work with your lawyer in writing these “restrictive covenant” clauses because they must be carefully worded.)

Perhaps the Buyer wishes to include the technology in other products. In this case, the Buyer will want to discuss the possibility of acquiring a nonexclusive license to use the pre-existing technology with an exclusive license for the IP developed.

SEVERAL APPROACHES TO RESOLUTION

ALTERNATIVE 1:   Ownership by Supplier with Exclusive License to Buyer

One option is for the Supplier to retain ownership of the work (defined to exclude pre-existing technology) but give the Buyer the exclusive license to use it. If an exclusive license gives the Buyer the right to use the work in every possible context at every possible location, it would be the functional equivalent of ownership. In practice, however, the parties usually agree to limit the Buyer’s use rights. For example, the Buyer’s right to use the work may be limited as to duration, area (worldwide or domestic), or market. The Supplier has the exclusive right to modify the work and may sell or license it to others outside the Buyer’s area of exclusivity.

This arrangement often benefits both the Buyer and Supplier. The Buyer is assured that the Supplier will not sell or license the work to competitors during the term of the exclusive license. At the same time, the Supplier retains control over the work and will have the opportunity to earn income by licensing/ selling to others outside the area of the Buyer’s exclusivity and/ or after the exclusive license expires.

ALTERNATIVE 2:   Ownership by Supplier with Non-Exclusive License to Buyer

The most favorable ownership arrangement for the Supplier may be for the Buyer to be given only a nonexclusive license to use the work (defined to exclude pre-existing technology). This means that the Supplier is free to license/ sell the work to anyone else; including the Buyer’s competitors. This type of ownership arrangement should result in the lowest possible price to the Buyer, because the Supplier may earn additional income by licensing the work to others.

In nonexclusive license arrangements, it is not uncommon for the Supplier to agree to pay the Buyer a royalty for each license it sells to third parties. This often seems fair because the Buyer paid to have the work created in the first place. The total cumulative royalty is usually limited to the total price the Buyer paid the Supplier for the work. The royalty can be a percentage of the total price paid for each license or a set dollar amount. While this is a common solution, there are no industry guidelines for the amount of such royalties.

The Buyer may object to licensing of custom modifications for which it has paid to competing companies. One solution is hybrid:  the Supplier agrees to a one or two year exclusive license to the Buyer for the particular modifications before those modifications are made available to other users.

ALTERNATIVE 3:   Joint Ownership

Yet another option is for the Buyer and Supplier to jointly own the work. Under a joint ownership arrangement, each party is free to use the work or grant nonexclusive licenses to third parties without the other’s consent (unless they agree to restrict this right). Normally, joint owners must account for and share with each other any monies they earn from granting such licenses. However, in most circumstances, it is not practical or desirable in the Buyer/ Supplier situation.