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A QUESTION OF LIABILITY: WHO’S TO BLAME WHEN PRODUCTS DEVELOPED BY LICENSEES CAUSE UNFORESEEN…?

By: William A. Dreier

Are technology owners or patent or trademark holders potentially liable for injuries sustained from products developed by a licensee or assignee?

Consider the following scenario: A client holds a patent or trademark or trade secrets concerning a process or product, but has no plans to develop any physical products using the intellectual property. The client, however, wishes to retain a sufficient interest in the property so that if its assignee or licensee has no commercial success, the property could be re-licensed to another party or even donated to a tax-exempt organization with the resulting tax benefits.

Further assume that (1) the client has no knowledge of nor can reasonably foresee any particular dangers in the eventual uses of this concept, and (2) if a product has already been developed, the product itself is not somehow defective.

If there is a known design flaw in the material itself, or if the owner could foresee such a defect and has not given reasonable warning, then the owner might be liable on the same basis as the manufacturer of any defective component part of an eventual assembled product, and could be held liable for harm relating to the defective component for failure to give a reasonable warning of a foreseeable danger.

There is protection for a manufacturer of a component part that is not itself defective where it is not reasonably foreseeable that the product will be misused by being combined with other elements to form a dangerous product. See Port Authority of New York and New Jersey v. Arcadian Corp., 189 F.3d 305 (3d Cir. 1999) (manufacturer of ammonium nitrate that was possibly defective for failure to add anti-explosive properties held not liable for the unforeseen use of the fertilizer as a bomb component).

This article will analyze two issues: (1) Whether the owner of the intellectual property is liable for products incorporating the technology that are manufactured by an assignee or licensee, where the danger in the resulting product is not reasonably foreseen and warned about by the owner; and (2) How the owner can provide for recapture of the assigned or licensed material if the assignee/licensee fails to perform.

Product Liability

Product liability against one who is neither a manufacturer nor seller (or other distributor) of a product has never been predicated upon the mere ownership, license or assignment of patented technology. Although there are no cases directly answering the questions posed, there are various similar situations that indicate, subject to the predilections of a wayward judge, that the intellectual property owner should have no liability for injuries caused by products developed by a licensee or assignee if the owner had no input into or knowledge of the nature, development, testing or manufacturing of the end product.

This conclusion should be sound whether decided under the defendant-oriented views of the courts of Texas or the plaintiff-friendly courts in California, New Jersey, Connecticut or Illinois.

With the exception of the New Jersey cases discussed later, most decisions around the country have centered on trademark rather than patent concepts. For example, in Torres v. Goodyear Tire and Rubber Co., 786 P.2d 939 (Ariz. 1990), Goodyear, as a trademark licensor, was held responsible for tires manufactured by its licensee because it had significantly participated in the overall process by which the products reached the consumer.

The court determined that this participation qualified for common law liability, and furthermore that liability could be predicated under the Arizona product liability statute which encompassed one who “designs, assembles, fabricates, produces, constructs or otherwise prepares a product or component part of a product.”

The “otherwise prepares” standard was deemed to encompass “the entity that dictates and controls the design, specifications or formulation, technique for production, quality of production, marketing, advertising, sale and warranty of a product,” as Goodyear did in that case. Id. at 947. By virtue of its statute, Arizona is one of the more liberal products liability jurisdictions.

Arizona has not, however, fully endorsed the liberal “consumer expectation” standard as a basis for manufacturers’ product liability, Dart v. Wiebe Mfg. Corp., 709 P.2d 876,878-79 (Ariz. 1985), as have a few otherwise more conservative states such as Alaska, Arkansas, Nebraska, Oklahoma and Wisconsin. See .e.g., Woods v. Fruehauf Trailer Corp., 765 P.2d 770,775 (Okla. 1988).

None of the elements that caused Goodyear to be liable in Torres are present in the situation posed in the hypothetical. In a companion Torres case, the Ninth U.S. Circuit Court of Appeals endorsed the “enterprise theory” of liability against a trademark licensor that significantly participates in the process through which tires reach the public. See 901 F.2d 750 (9th Cir. 1990).

In City of Hartford v. Associated Construction Co., 384 A.2d 390 (Conn. 1978) the Connecticut Supreme Court similarly determined that strict liability could be imposed against a trademark licensor that had set the specifications for the product’s composition and the instructions for its use, and where the product was made available only through those licensed by the owner of the trademark. Again none of those factors are present in the hypothetical situation.

The Case For and Against Liability

Perhaps the strongest case favoring liability is Kasel v. Remington Arms Co., 101 Cal. Rptr. 314 (App. Ct. 1972) where Remington Arms was held liable for injuries from the explosion of a shotgun shell manufactured by a trademark licensee in Mexico.

Remington caused the licensee to be created, owned 40 percent of its stock and had interlocking or common directors and officers with the licensee. Remington had licensed the trademark, contracted for the sale of technical information and entered into a technical services contract, retaining the right to inspect and control the quality of all ammunition of which its trademarks were used.

The court held Remington liable under an enterprise theory and rejected the trial court’s decision that would have limited the application of strict liability and tort to cases of actual manufacture or proof of an agency. Again, none of these liability factors are present in our case.

On the other side of the ledger are cases arising in Texas such as Firestone Steel Products Co. v. Barajas, 927 SW.2d 608 (Tex. 1996), where the court applied a simple test. There, the preparation and transfer by a designer of a system or prototype transferred to another who constructed the product was found not enough to impose strict liability. Furthermore, the court determined that the mere licensing of a product does not subject the licensor to strict liability, unless there is some purposeful activity with respect to the design that caused the injury. “Mere preparation of drawings or a prototype, does not constitute designing the eventual product from which liability does lie.” Id. at 613, citing numerous authorities.

In A.G. Nelson v. International Paint Co., 734 F.2d 1084 (5th Cir. 1984), the Fifth Circuit, also applying Texas law, refused to hold a parent company responsible for a subsidiary’s acts but implied that, had the plaintiff been able to prove that the parent developed the formula for the defective product, summary judgment might not have been proper. Id. at 1087. This broad statement must be read, however, against the facts of this case, and the penchant of the Texas courts to recognize the protection afforded by the use of separate corporations.

On an alternative theory that the subsidiary held out the product as being manufactured by the parent, the Court held that without more this would not be a sufficient basis for liability, rejecting the application of Sec. 400 of the Restatement (Second) of Torts (now Sec. 14 of the Restatement (Third) of Torts: Products Liability.)

According to Sec. 14: “One engaged in the business of selling or otherwise distributing products who sells or distributes as its own a product manufactured by another is subject to the same liability as though the seller or distributor were the product’s manufacturer.”

The court recognized that the Illinois and Connecticut courts interpreted Sec. 400 more broadly, and the court further recognized that earlier Fifth Circuit decisions had found liability when the licensor exercised its authority to control the product of licensee. The Texas Supreme Court’s Firestone decision – decided 12 years later – demonstrates that the Fifth Circuit had correctly interpreted Texas law.

The Comments and Reporters’ Notes to Secs. 1 and 20 of the Restatement (Third) of Torts: Products Liability indicate clearly that the prevailing law protects a mere trademark licensor who does not actively control the manufacture of a product by the licensee. “[Licensors of trademarks are not held strictly liable when they do not participate in the design, manufacture, or distribution of the licensee’s product.” Reporters’ Note to Sec. 20(f). Section 14 continues the prior law, placing liability on a nonmanufacturer who holds out another’s product as its own.

The liberal California rule in this area is best seen in Rawlings v. D.M. Oliver Inc., 159 Cal. Rptr. 119 (Ct. App. 1979), leaving relatively open-ended the factors that will engender successor liability. There is little reason to suppose that the California courts would establish a less plaintiff-friendly rule concerning a predecessor’s liability than it applies to successors. But even according to Rawlings, the defendant must be shown to have engaged in a manufacturing business. An earlier holder of intellectual property would probably not qualify.

New Jersey Courts Weigh In

New Jersey has one trial court opinion concerning an injury caused by a defect in an unperfected machine. The machine was in the process of development and did not yet have a patent. In a pre-Products Liability Act setting, the court determined that the actions of the inventor provided no basis for a product liability claim, although there might be some claim of negligence concerning the inventor’s conduct. See Wood v. Luertzing Corp., 167 N.J. Super. 756 (Law. Div. 1979).

Also, in Saez v. S & S Corrugated Paper Mach. Co., 302 N.J. Super. 545 (App. Div. 1997), a selling corporation sold its manufacturing operation to one purchaser and its technology to a different purchaser. The buyer of the technology also purchased the seller’s parts inventory, which it sold as part of its service contract for existing machinery. A plaintiff injured by a pre-sale machine brought claims against both of the purchasers.

The manufacturer that had bought the equipment and continued to trade on the design and name of the seller was held responsible under New Jersey’s “product line” liability doctrine. This minority “product line” exception is soundly criticized in the 1997 Restatement. See Comment b to Sec. 12. (This position “would, in the judgment of most courts, be unfair and socially wasteful.”) As explained by the Reporters’ Notes to Sec. 12, New Jersey is one of only six states in the country (including California, New Mexico, Michigan, Pennsylvania, and Washington) extending such liability beyond the four traditional theories of business continuation. Of these, Michigan follows a broad “continuity of enterprise” theory, see Turner v. Bituminous Casualty Co., 244 N.W.2d 873 (Mich. 1976), and Pennsylvania’s position may be in doubt.

However, in Saez v. S & S, the court found that the technology and parts purchaser was not liable, applying the principles of Sec. 12 of the Restatement (Third) of Torts: Products Liability. This view was concurred in by the reporters of the Restatement who had in earlier drafts cited a trial court opinion relying upon California authority, extending New Jersey’s product liability beyond that apparently contemplated by the Supreme Court.

Most recently, in Potwora ex rel. Gray v. Grip, 319 N.J. Super. 386, 395-401 (App. Div.), certif. den. sub nom. Potwora v. Land Tool Inc., 161 N.J. 151 (1999), the Appellate Division considered the liability of the successor to a designer of a motorcycle helmet. The court distinguished this liability from New Jersey’s successor liability rule, because the original company was only a designer, and neither it nor its successor manufactured the helmet. Mere design, without more, was held to be an insufficient basis for liability.

If an intellectual property owner exercises some but not a complete measure of control over the eventual design, manufacture and distribution of the product, the holder must be wary of a claim that the placing of the defective product into the stream of commerce is, in effect, a joint venture, or that the distributor is acting as part of a joint enterprise, or that the distributor is the holder’s agent. Any agreement, therefore, should specifically state to the contrary, although such an agreement would not bind an injured claimant if the facts show an actual agency or joint venture.

Unfortunately, manufacturers who distribute their products nationally must tailor their actions to meet the law of the most liberal jurisdiction in which their products might be distributed or used. Today, this would encompass Arizona, California, Illinois or New Jersey. For example, as noted earlier, the Arizona Products Liability Act imposes liability on one who “designs, assembles, fabricates, produces, constructs, or otherwise prepares a product or component part of a product.”

The “otherwise prepares” standard was deemed in Torres v. Goodyear Tire & Rubber Co., supra, to encompass “the entity that dictates and controls the design, specifications or formulation, technique for production, quality of production, marketing, advertising, sale and warranty of a product.” 786 P.2d at 96.

As oppressive as this standard is for a manufacturer or distributor, it provides guideposts for governing a licensor’s conduct. If none of these factors are present, there is little chance of liability. If all are present, liability is likely. To minimize liability, the intellectual property owner should insulate itself from product development decisions that would satisfy the categories of the statute, and, most importantly, it must document this fact against later claims which may be made to the contrary.

Nothing in these authorities nor in the various articles discussing them remotely suggest that the licensing or assigning of a patent, trademark, or trade secrets, without more, could hold the licensor or assignor liable for a licensee’s or assignee’s defectively designed products which incorporate the technology. The common thread running through all of the cases is the participation of the assignor or licensor in the development and marketing of the eventual product.

Securing the Return of the Technology

Another issue is presented by the hypothetical: Whether the retention of a right to reclaim the intellectual property in the event of the failure of the assignor or licensor to develop a sellable product would engender any liability. The simple answer is “no.”

Insofar as the transaction is only a security transaction, or if the sale price has been adjusted to reflect the retention by assignor of a reversionary right, the transfer should be treated as nothing more than a financing arrangement that should not affect product liability. See e.g., A-Leet Leasing Corp. v. Kingshead Corp., 150 N.J. Super. 384 (App. Div.) certif. den. 75 N.J. 528 (1977); Reporters’ Notes to Sec. 20 of the 1997 Restatement.

If there is a security aspect to the transaction, the agreement should be structured so that the retention of the security interest is spelled out in an explicit agreement and the assignor/licensor’s interest is properly perfected. If however there is no security transaction, or if the rights are granted conditioned upon a defined commercial development within a fixed period of time after which the patent shall revert to the former owner, it should be clear that there is no secured transaction.

The problem with this arrangement is that there are at this time two versions of the Uniform Commercial Code that have been adopted in various jurisdictions because recent amendments are gradually being considered on a state-by-state basis. For example, New Jersey has passed the amendments, but they are not effective until July 1, 2001, and the older Art. 9 of the U.C.C., with some initial revisions, is still in effect.

The assignor/licensor must be sure that the definition sections of the applicable state’s U.C.C. are examined and complied with, because the transfer of or security interest in a “general intangible” such as a patent or trademark right or in trade secrets (see U.C.C. Comment to N.J.S.A. 12A:9-106) may be governed by unexpected filing requirements. If this is a purely New Jersey transaction there should be no problems. The filing would be with the Secretary of State. N.J.S.A. 12A:9-401.

Of course, the owner should also duly file any security instrument required by the patent or trademark laws. There is some question whether the state filing is sufficient in itself, but a group of cases over the last decade in the copyright field indicates that dual perfections, federal and state, are required. See National Perigrine Inc. (In re Peregrine Entertainment, Ltd.) v. Capital Federal Savings and Loan Ass’n, 116 B.R. 194, 197-99 (C.D. Cal. 1990); Official Unsecured Creditors Committee v. Zenith Prvducts Ltd. (In re AEG Acquisition Corp.), 161 B.R. 50 (BAP 9th Cir. 1993); In re Avalon Software Inc., 209 B.R. 517, 520 (Bankr. D. Ariz. 1997). See also Alice Halmmerli, “Insecurity Interests: Where Intellectual Property and Commercial Law Collide,” 96 Columbia L. Rev. 1645, 1675 (1996); Joel R. Glucksmann, “Pre-empting the Uniform Commercial Code,” 159 N.J.L.J. 482 (Feb. 7, 2000).

A similar rule should apply to patent or trademark cases. But there are two recent cases that apparently provide greater protection to a holder of a security interest in patents. See Aerocon Engineering Inc. v Silicon Valley Bank (In re World Auxiliary Power Co.), 1999 WL 1400 131 (Bankr. N.D. Cal. 1999), relying solely on local copyright filing and noting similarly to patent security interests); Moldo, Trustee v. Matsco Inc. (In re Cybernetic Services Inc.), 239 B. R. 917 (BAP 9th Cir. 1999) (state perfection sufficient for securing interest in patent).

Notwithstanding these recent cases, caution dictates that the owner file a conditional assignment of the patent or trademark with the Patent and Trademark Office, as well as perfecting the security interests under the U.C.C.

This article is reprinted with permission from the April 3, 2000 issue of the New Jersey Law Journal. © 2000 NLP IP Company.