The Supreme Court of British Columbia recently considered a dispute over a software agreement where a licensor refused to indemnify a licensee for the licensee’s settlement of an intellectual property claim brought against the licensee by a third party. The licensor pointed to the licensee’s failure to give prompt notice of the third party claim and failure to take the dispute between them to arbitration as required in their agreement (cross-claiming against the licensor in the IP lawsuit instead).

Elastic Path was a software company that licensed its online shopping cart software to Coastal Contacts (“Coastal”), an online retailer of glasses and contact lenses. The license agreement contained two relevant clauses. First, Elastic Path agreed to defend or settle any claim or suit made by third parties against Coastal based on an allegation that the software infringed intellectual property, provided that Coastal would promptly notify Elastic Path of any such claim, and Coastal would have sole authority to defend or settle the claim. Second, all disputes under the agreement were to be resolved by arbitration.

In October 2009, Charles E Hill & Associates (“Hill”) sued Coastal in Texas for infringement of their patents by their use of online catalogue/shopping cart software. In January 2010, Coastal filed an answer, defence, and counterclaim to the Hill claim. In late January 2010 (more than 3 months after becoming aware of the claim), Coastal notified Elastic Path about the action, claiming the indemnity under the licence agreement. Elastic Path denied it was required to defend the Hill action. In March 2010, Coastal joined Elastic Path as a third party to the Hill proceedings.

Elastic Path argued they did not need to indemnify Coastal or defend the claims because Coastal had breached the licence agreement, first by failing to give prompt notice and second by commencing third party proceedings instead of going to arbitration. Furthermore, Elastic Path argued their software was not implicated in the Hill action and therefore nothing triggered the indemnity clause in the agreement. Elastic Path commenced arbitration proceedings on these bases.

In September 2010, Coastal settled with Hill for US$200,000 on legal advice. Coastal defended the arbitration with a claim for relief from forfeiture. The arbitrator concluded that:

  • On analysis of the Hill patents, the claims all contain an element involving a remote computer, and since Elastic Path’s software does not involve remote computers, “it is highly unlikely that the software infringes the patents on its own”.
  • By failing to give prompt notice, Coastal had deprived Elastic Path of the right to defend the Hill action from the outset and denied Elastic Path preparation time, which is the purpose of the requirement of prompt notification.
  • The conduct of Coastal in failing to give prompt notice and in breaching the arbitration clause disentitled Coastal from relief from forfeiture, under the clean hands rule.
  • Elastic Path was entitled to the fees and costs of the arbitration, with interest.

Coastal sought leave to appeal this decision to the Supreme Court of British Columbia. Justice Armstrong reviewed the test for leave to appeal from arbitration under British Columbia’s Commercial Arbitration Act. His Honour held that on the basis of the authorities, leave to appeal can be granted only in respect of an error of law (not fact, or mixed fact and law), where the correction to the error of law must be capable of leading to a different outcome, and the result of the arbitration must be sufficiently important to the parties to justify the expense and court time.

Justice Armstrong held that the arbitrator in this case had made an error of law by applying an incorrect test to the question of whether Elastic Path was liable to indemnify Coastal. By performing a summary trial on the claim on the merits in the patent dispute, analysing the patent to determine likelihood of infringement, the arbitrator had asked whether it was likely that the software infringed. The test he should have applied was whether there was a “mere possibility”. Contrary to Elastic Path’s submissions, this was not simply a finding of fact by the arbitrator that the patents were not infringed (implying Coastal could not appeal them), but the application of the wrong legal methodology (for which leave to appeal was granted).

Coastal also argued that the arbitrator had applied the wrong test in applying the clean hands rule; the proper test would be to weigh up the respective prejudices to each party, taking into account only the behaviour connected to the breach of the contract and no other unrelated misconduct. Coastal also argued that by denying they owed the indemnity, Elastic Path could not then claim prejudice for the late notice because even if the notice had been timely, there was no evidence that Elastic Path would have used the additional time to defend the claim. Elastic Path counter-argued that the grant of the remedy was the exercise of discretion based on the arbitrators finding of fact and could not be appealed on this basis.

Justice Armstrong agreed with Coastal; the arbitrator had not weighed up the respective prejudices to the parties, and Coastal’s prejudice (in not getting a defence/indemnity) was significantly greater than Elastic Path’s prejudice due to late notice, since Elastic Path would not have provided an indemnity or defence even if it had received timely notice. Furthermore, since Coastal’s breach of the arbitration clause had only occurred after Elastic Path refused to indemnify or defend, that conduct was not a relevant consideration for the decision to deny relief from forfeiture. The arbitrator had therefore applied the incorrect legal test.

Justice Armstrong overturned the arbitrator’s award, granting Coastal an award of damages for the settlement amount plus legal costs for the Hill proceedings. However, the costs of the arbitration remained in favour of Elastic Path, as those costs had only been engaged due to Coastal’s breach of the arbitration clause.

Although this case is under Canadian law, there are still several issues that should be familiar to Australian licensees and licensors. Any term of a license agreement creating an indemnity in favour of the licensee for third-party IP claims against the licensor’s software should clearly state what will trigger the indemnity, e.g. a mere accusation of infringement, institution of court proceedings against the licensee, a prima facie case, or judgment against the licensee. It should also be clear whether the licensee’s obligations (e.g. prompt notice of the claim) are preconditions of the indemnity, or whether noncompliance merely breaches the agreement and gives rise to damages.

But the critical lesson to be drawn from this case, from an Australian perspective, is the interaction of an arbitration clause with an indemnity for third-party IP claims. Cross-border software licenses are very common in the Australian market (indeed, throughout most of Asia). So is the use of arbitration – typically international arbitration under the New York Convention – as the method of resolving disputes arising out of the software licence. In that scenario, if a licensee is the target of a third-party IP infringement claim, and the licensor refuses to indemnify under an indemnity (or defend-and-settle) clause of the license agreement, the licensee should be wary of starting proceedings in court or cross-claiming against the licensor in the infringement proceedings if the agreement requires licensee/licensor disputes to go to arbitration or mediation. Failure to follow the correct dispute resolution procedure, even if the licensee subsequently wins the dispute against the licensor, may lead to an award of damages (reducing the amount received under the indemnity) or to a costs award against the licensee.