A software licence, alleged patent infringement, obligations to defend and indemnify, arbitration and an appeal to a court were all dealt with by a Canadian court in Coastal Contacts Inc. v. Elastic Path Software Inc.
On a motion for leave to appeal an arbitration decision, the British Columbia Supreme Court (the Court) addressed the claim of a software licensee against its licensor for breach of the licensor's duty to defend and indemnify the licensee in a suit by a third party alleging patent infringement by the licensee's use of the software.
The decision discusses the requirements to appeal an arbitration award and teaches several lessons to both licensors and licensees.
Coastal Contacts Inc. (Coastal) is an online retailer of eyewear. Elastic Path Software Inc. (Elastic) is a software developer that licenses software for the operation of e-commerce websites. Elastic and Coastal entered a licence agreement (the Agreement) that permitted Coastal to use Elastic's software.
The Agreement required Elastic to "defend or settle any claim made or any suit or proceeding brought against [Coastal] insofar as such claim, suit or proceeding is based on an allegation that any of the software...infringes (directly or indirectly) any patent...of any third party, provided that [Coastal] shall notify [Elastic] in writing promptly after the claim, suit or proceeding is known to [Coastal] and shall give [Elastic] information and such assistance as is reasonable in the circumstances, at [Elastic's] expense. [Elastic] shall have sole authority to defend or settle the same at [Elastic's] expense."
The Agreement also obliged Elastic to "indemnify and hold [Coastal] harmless from and against any and all such claims and...pay all damages and costs finally awarded...to be paid in the settlement of such claim, suit or proceeding...".
The Agreement further provided that "all disputes under, arising from, in relation to, or connected with [the] Agreement, [if not resolved]...will be [referred to and finally] resolved by arbitration...".
In 2009, Coastal was among several parties sued in the U.S. for patent infringement (the Patent Action) on the basis of its use of the licensed software. Three months later, Coastal filed a defence and counterclaim in the Patent Action and, several days after, requested Elastic to defend Coastal in the Patent Action. When Elastic refused, Coastal sued Elastic as a third party in the Patent Action.
Elastic then submitted a notice to arbitrate, denying any obligation to defend or indemnify Coastal on the basis that: (1) there was no liability for any intellectual property claim that would trigger either obligation; (2) Coastal breached the Agreement and prejudiced Elastic's rights by failing to give prompt notice of the Patent Action; and (3) Coastal breached the arbitration provision by suing Elastic in the Patent Action.
Coastal settled the Patent Action with a payment and the parties arbitrated Coastal's claim against Elastic.
The arbitrator's award (the Award) found that it was unlikely that the use of the software infringed any of the patents in the Patent Action. The Award concluded that Coastal failed to give prompt notice of the Patent Action to Elastic and breached the duty to defend provision because Elastic was deprived of the sole right to defend the Patent Action. The Award also held that Coastal breached the arbitration provision by suing Elastic in the Patent Action.
Therefore, the Award held that Elastic was not liable to Coastal for the settlement amount or any of its costs, and that Elastic was entitled to its costs of defending Coastal's suit and the costs of the arbitration.
Leave to Appeal
Coastal sought leave of the Court to appeal the Award. The British Columbia Commercial Arbitration Act (the Act) permits an appeal of an award only with leave on a question of law and in limited circumstances.
If a question of law is established, an applicant for leave must also qualify under one of the enumerated circumstances set out in the Act: (1) the importance of the result of the arbitration to the parties must justify the intervention of the court and the determination of the point of law may prevent a miscarriage of justice, (2) the point of law must be of importance to some class or body of persons of which the applicant is a member; or (3) the point of law must be of general or public importance.
Similar, but not identical, requirements apply in other provinces. For example, the Ontario Arbitration Act, 1991 provides that, if the arbitration agreement does not deal with appeals on questions of law, a party may appeal an award to a court on a question of law with leave only if the court is satisfied that: (1) the importance to the parties of the matters at stake in the arbitration justifies an appeal; and (2) determination of the question of law at issue will significantly affect the rights of the parties.
In Coastal, the Court said that courts are obligated to maintain the integrity of the arbitration system. Where parties have chosen arbitration to resolve disputes, public policy requires a court to give deference to an award. The requirement for leave to appeal an award safeguards the parties' choice to arbitrate.
An appeal is not available on a question of fact or of mixed fact and law. The onus is on the applicant for leave to establish that the question at issue is one of law that is apparent on the face of an award. An alleged error of law must be one that, if corrected, could result in a different outcome of the proceeding. The error must be part of the reasoning on which the award is based.
In exercising discretion to grant leave, a court considers: (1) the apparent merits of the appeal; (2) the significance of the issue to the parties, third parties and the community at large; (3) the circumstances surrounding the dispute and adjudication, including the urgency of a final answer; (4) other temporal considerations, including the opportunity for either party to address the result through other avenues; (5) the conduct of the parties; and (6) the stage of the process at which the decision at issue was made.
Errors of Law
The Court held that the Agreement required Elastic to defend Coastal where the pleadings raised a claim that would be covered by the defence provision. To trigger the duty to defend, it was not necessary that Coastal be held liable. The test is whether there was a mere possibility that the allegation of infringement might apply to the use of the software by Coastal.
The conclusion in the Award ought to have been confined to the question of whether there was a mere possibility that use of the software would attract liability in the Patent Action. The Award's finding that it was unlikely that use of the software infringed went beyond a review of the allegation in the Patent Action. The arbitrator's analysis constituted an error of law.
Coastal's failure to give timely notice of the Patent Action was a breach of the Agreement and denied Elastic any opportunity to defend the Patent Action. Coastal also breached the Agreement by filing the defence and counterclaim in the Patent Action and suing Elastic.
The Award did not assess the relative prejudice to the parties by their respective breaches. The Court found that the prejudice to Coastal outweighed any prejudice suffered by Elastic.
The Court held that there was not a sufficient nexus between Coastal's failure to give prompt notice and its suit against Elastic to deny relief to Coastal with respect to the breach by Elastic of its obligations to defend and indemnify. The arbitrator's treatment of this issue therefore constituted another error of law.
The Court concluded that Coastal satisfied the statutory criteria for leave. The amount was substantial and sufficiently important to warrant a review of the Award. The errors of law were important to the conclusions in the Award and may have resulted in a miscarriage of justice. The Court granted leave to appeal.
The parties agreed that, if leave to appeal were granted, it would be appropriate for the Court to decide the merits, and the Court did so. For the reasons discussed in the leave analysis, the Court held that, applying the correct test to the findings of fact made by the arbitrator, it was appropriate to grant Coastal relief.
Coastal was entitled to recover the amount expended to achieve a reasonable settlement of the Patent Action plus its costs. However, the Court did not disturb the award of costs incurred by Elastic in defending the suit by Coastal because of Coastal's breach of the arbitration clause.
Lessons to be Learned
This case illustrates the importance of the negotiation of, and timely compliance with, the duty to defend, indemnification and arbitration provisions in licence agreements in the face of the potential for alleged infringement by the licensee of a third-party's intellectual property rights. A number of specific lessons may be learned from the decision:
- It is advantageous for a licensee of intellectual property to negotiate strong and clear obligations of its licensor to both defend and indemnify the licensee from claims of infringement of third-party intellectual property rights resulting from use of the licensed intellectual property.
- A licensee should seek to provide that the obligations to both defend and indemnify will be triggered by allegations made by a third party and not by the merits of the third-party's claim.
- When a licensee becomes aware of such a third-party claim, it should promptly review the duty to defend and indemnification provisions to determine its own obligations, such as to give notice to the licensor to activate the licensor's obligations, and comply with them.
- If properly requested by a licensee, a licensor should assess, and if required, comply with, any obligations it may have to defend and indemnify the licensee.
- If the parties disagree on the obligations of defence or indemnification, and the agreement includes an arbitration provision, a party contesting the position of the other party should consider whether the arbitration provision precludes a court action against the other party.