California Court Finds UCC Infringement Indemnification Does Not Require Underlying Infringement Claim to Succeed So Long As Underlying Claim Is Not Frivolous

In Pacific Sunwear of California v. Olaes Enterprises, Inc., 167 Cal. App. 4th 466; 84 Cal. Rptr. 3d 182; 2008 Cal. App. LEXIS 1573 (CA 4th Ct. App. Oct. 9, 2008), Pacific Sunwear of California, Inc. (PacSun) appealed a trial court order granting summary judgment in favor of Olaes Enterprises, Inc. (Olaes) in PacSun’s breach of warranty lawsuit.   As background, Olaes supplies PacSun with T-shirts for resale in PacSun stores. In 2004, PacSun purchased 16,000 T-shirts depicting a monkey drinking hot sauce, with the captions “Smile Now” and “Cry Later.” On January 12, 2005, clothing maker Smile Now Cry Later Inc. (SNCL) filed suit against PacSun alleging that the hot sauce monkey shirts violated SNCL’s trademark. SNCL filed a motion for a preliminary injunction barring further sales of the hot sauce monkey shirts, but the District Court denied this motion, finding that SNCL failed to carry its burden under an eight-factor test utilized by the Ninth Circuit to determine likelihood of confusion.

In May 2006 PacSun filed an action in superior court, alleging that Olaes breached the statutory warranty that the hot sauce monkey shirts were “free of the rightful claim of any third person by way of infringement or the like,” as contained in section 2312, subdivision (3) of the California Uniform Commercial Code (§ 2312(3)). Both parties filed cross-motions for summary judgment. The trial court denied PacSun’s summary judgment motion, but with respect to Olaes’ motion, the court ruled that “SNCL’s underlying claims of infringement were not ‘rightful claims’ under § 2312(3) and thus Olaes did not breach the warranty provided for under that section” and relied upon the fact that SNCL did not carry its burden to succeed on the motion for preliminary injunction in the underlying trademark suit.

On appeal, PacSun argued that the trial court erred in ruling, as a matter of law, that SNCL’s trademark infringement claim was not a rightful claim because “at the very least,” there is a disputed factual issue as to whether the claim is “rightful,” which precludes summary judgment. The issue before the Court of Appeal for the Fourth Appellate District of California was whether the trial court properly ruled on a motion for summary judgment that the § 2312(3) warranty did not apply because the trademark suit filed by SNCL was not a rightful claim of infringement. Olaes suggested that a rightful claim is a valid claim, meaning one that has proven, or will likely prove, meritorious in litigation. By contrast, PacSun argued that any claim “in the form of litigation” constitutes a rightful claim regardless of its underlying merits.

Citing 84 Lumber Co. v. MRK Technologies, Ltd. 145 F.Supp.2d 675 (W.D.Pa. 2001), the Court of Appeals noted that other courts have found that the phrase “rightful claim” under the UCC as being somewhere between these interpretations.  However, there were no California cases that discussed § 2312(3) and the definition of a rightful claim.  As such, the Court of Appeals applied the general rules of statutory interpretation.

First, looking to the text of the statute itself, the phrase “rightful claim” is not defined in the California Uniform Commercial Code, and due to the multitude of definitions of “rightful” in common usage that leave the term ambiguous, the court then turned to extrinsic aids. The court looked to the official commentary to the Uniform Commercial Code, as an especially helpful aid under California caselaw as done in AmerUS Life Ins. Co. v. Bank of America, N.A., 143 Cal.App.4th 631, 638 (2006); Wilson v. Brawn of California, Inc. 132 Cal.App.4th 549, 555 (2005); Cohen v. Disner 36 Cal.App.4th 855, 862 (1995).  This demonstrated that, contrary to Olaes’ position, the term “rightful claim” as used in the statute is intended to broadly encompass any nonfrivolous claim of infringement that significantly interferes with the buyer’s use of a purchased good. The court of appeals found that the comments, by stating that the seller warrants that there will be “no claim of infringement,” and by asserting that the buyer’s remedy arises immediately upon notice of infringement, strongly suggests that any significant claim of infringement – whether or not ultimately meritorious- triggers the § 2312(3) warranty. The court also noted public policy arguments that supported interpreting the warrant to encompass all nonfrivolous claims of infringement. For example, the seller’s incentive to reduce or eliminate prospective claims of infringement is undermined if the § 2312(3) warranty applies only to meritorious claims, leaving the risk of closely contested, but ultimately unsuccessful, infringement claims to be borne by unsuspecting purchasers, who are less familiar with the product than the seller.

Lastly, the Court of Appeals noted that this interpretation was consistent with another court’s decision on the same basic warranty provision: Sun Coast Merchandise Corp. v. Myron Corp. 393 N.J.Super. 55; 922 A.2d 782, 796–797 (App.Div. 2007), which held that a rightful claim is a claim that “cast[s] a ‘substantial shadow’ on the buyer’s  ability to make use of the goods in question.”  However, the Court of Appeals modified this standard to clarify that to cast a substantial shadow, the claim must be non-frivolous since whether a claim is frivolous is more consistent with terminology used in California law.  As such, the Court of Appeals settled on the following standard:

A rightful claim under section 2312(3) is a nonfrivolous claim of infringement that has any significant and adverse effect, through the prospect of litigation or otherwise, on the buyer’s ability to make use of the purchased goods.

Because the evidence presented on Olaes’ summary judgment motion demonstrated that there was at least a triable issue of material fact as to whether SNCL’s infringement claim was a rightful claim, the trial court erred in granting Olaes’ motion for summary judgment. The trial court could not properly resolve that question, as a matter of law, in favor of Olaes.

Olaes then contended that even if the court of appeals disagreed with the trial court’s interpretation of rightful claim, it could still affirm the summary judgment ruling on the alternate ground not ruled on by the trial court: that Olaes’ breach of the warranty was not the proximate cause of PacSun’s damages. Olaes argued that the warranty breach cannot be considered the proximate cause of the damages because PacSun knew of the purported defect in the hot sauce monkey shirt before it ordered them. The court of appeals, however, did not find that the evidence presented on Olaes’ summary judgment met the threshold for a ruling in Olaes’ favor.

The trial court’s interpretation of “rightful claim” was erroneous; a rightful claim under § 2312(3) is not synonymous with a claim that ultimately will prove successful in litigation. Under this standard, the trial court could not properly conclude on the evidence before it, as a matter of law, that the third party infringement claim against PacSun was not a rightful claim. The court of appeals reversed the judgment of the trial court.

Significance to Merchants and Sellers

Pacific Sunwear confirms what an ordinary review of the UCC reveals: warranties of non-infringement are to be broadly interpreted.  While few cases exist on the subject, sellers and distributors should be aware of the scope of this indemnification.  Moreover, Pacific Sunwear also highlights the need to disclaim these warranties in order to ensure that a seller are able to limit its liability, or at least control its liability and ensure its participation in the defense of an allegedly infringing article.


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