Perhaps the most interesting litigation to arise in the wake of the Internet bubble is the series of copyright infringement cases that started with A&M Records, Inc. v. Napster, Inc., continued with Katz v. Napster and Metro-Goldwyn-Mayer Studios, Inc. v. Grokster, Ltd., and have most recently continued with additional cases filed in the Central District of California Western Division (UMG Recordings, Inc. v. Hummer Winblad Venture Partners) and in United States District Court Southern District of New York (Leiber et al. v. Bertelsmann AG, UMG Recordings, Inc. et al. v. Bertelsmann AG et al., and Capital Records, Inc. et al. v. Bertelsmann AG et al.).
All of these cases involve the emerging technology of peer-to-peer file sharing and seek to apply in the world of cyberspace the established theories of contributory and vicarious liability for copyright infringement. These cases, and their precedents, represent important exceptions to the traditional axioms of limited stockholder and director liability, and merit the attention of founders, investors and strategic partners: First, they stand for the principle that the specifics of the underlying technology and business model can be critical when evaluating the potential for legal exposure. Second, they test the limits of liability for vicarious and contributory infringement. This line of cases explores under what circumstances (i) a corporation can be liable for the copyright infringement actions of its customers; (ii) an individual stockholder can be liable for the copyright infringement actions of a corporation; (iii) a parent corporation can be liable for the copyright infringement actions of its subsidiary; (iv) a corporate strategic partner can be liable for the copyright infringement activities of its partner; and (v) a venture capital investor in a corporation (and its employees who serve as officers or directors of the corporation) can be liable for the copyright infringement activities of the corporation. In particular, how proximate must the defendant be to the direct infringer to be contributorily or vicariously liable?
These cases have generated a great deal of attention in the popular press. They have caused understandable concern among venture capital and corporate investors. Directors have relied upon the limited liability provided under the Delaware Corporations Code and similar statutes in other states. Stockholders have relied upon the insulation from liability absent a basis for "piercing the corporate veil." Boards and venture investors have adopted appropriate precautions to secure disinterested director or disinterested stockholder approval of transactions in which they as directors or their respective funds have a material interest. Corporate investors have often further distanced themselves from potential claims of appearance of breach of fiduciary duty or duty of loyalty by holding only board "observer rights" rather than actually taking board seats, thereby enabling them to operate with greater freedom in structuring commercial arrangements with the issuer. Practitioners can expect client queries regarding potential exposure from investing in emerging technologies, especially companies with business models that raise unique questions of law in the area of copyright infringement. The following is an overview of the state of play.
The U.S. Copyright Act and Direct Copyright Infringement
To appreciate the issues presented in these cases, a brief review of basic copyright law may be helpful.
The 1976 U. S. Copyright Act, 17 U.S.C. §§101-810, prohibits the infringement, i.e., the unauthorized use, reproduction, distribution, performance, license, or display, of any work having copyright protection. Any such unauthorized use of a copyrighted material by an individual or other entity constitutes a direct copyright infringement. To establish a prima facie case of direct copyright infringement, a plaintiff must satisfy two basic elements: (i) plaintiff's copyright ownership of the allegedly infringed material; and (ii) defendant's unauthorized copying of the original work.
In addition to liability for direct infringement provided by statute, the courts have found that a party may be liable for "vicarious" or "contributory" infringement.
i. Vicarious Infringement
Long before Napster, the Second Circuit's decision in Shapiro, Bernstein & Co., Inc. v. H.L. Green Co., Inc., established a two-part test for determining when third parties can be liable for vicarious infringement. Shapiro and its progeny provide that once a plaintiff has proven a case of direct copyright infringement, parties other than the direct infringer may be liable for vicarious infringement if two conditions are met:
In Shapiro, plaintiffs were copyright owners of several musical compositions. Plaintiffs alleged copyright infringement against a manufacturer of pirated records containing the compositions, along with the retailer that sold the records. Though the district court imposed liability for direct infringement on the manufacturer, it did not impose any liability on the defendant retailer. The Second Circuit reversed as to the retailer, imputing knowledge of the infringements despite the retailer's lack of actual knowledge of the illegality of the records. The court explained that "[w]hen the right and ability to supervise coalesce with an obvious and direct financial interest in the exploitation of copyrighted materials—even in the absence of actual knowledge that the copyright monopoly is being impaired—the purposes of copyright law may be best effectuated by the imposition of liability upon the beneficiary of that exploitation."
ii. Individual Stockholder Liability for Vicarious Infringement
Notwithstanding the insulation from liability typically granted to shareholders for a company's debts or acts, courts have extended the vicarious liability provided for under Shapiro and its progeny to both individual and institutional shareholders of companies that are direct infringers. Where individual shareholders are involved, liability is almost uniformly limited to cases where the shareholder also serves as an officer or director of the infringing company, thereby combining the economic interest of the stockholder status with the control of the officer or director role.
iii. Vicarious Liability of Parent for Infringement by Subsidiary
In the case of parent-subsidiary relationships, the standard for determining vicarious liability most frequently used by the courts is the "substantial and continuing connection" test adopted by the Ninth Circuit in Frank Music Corp. v. MGM, Inc. Though corporations are typically protected from liability for the debts or acts of their subsidiaries, in Frank Music I the Ninth Circuit held that parent corporations can be held liable for the infringing actions of their subsidiaries where there is a "substantial and continuing connection between the two with respect to the infringing acts." In Frank Music II, the Ninth Circuit held that there was such a connection between the MGM parent and the MGM subsidiary based on the facts that (i) MGM Grand was a wholly-owned subsidiary of MGM, Inc.; (ii) MGM, Inc.'s counsel responded to the allegations of copyright infringement; (iii) MGM, Inc. hired the MGM Grand employee who committed the infringement; and (iv) the infringing employee had an office at MGM, Inc.
iv. Contributory Infringement
Even where a party does not direct or supervise the infringing activity or have a direct financial interest in the infringing activity, there is still potential exposure to liability for "contributory infringement" if the party knowingly provides assistance to direct infringers. To prevail on a contributory infringement claim, a plaintiff must demonstrate that the defendant induced, caused or materially contributed to another party's direct infringement. Two requirements for any successful contributory infringement case are thus
In order to satisfy the second prong of this test, the contributor must engage in "conduct that encourages or assists the infringement."
Generally, copyright holders whose works have been infringed upon may select one of two forms of damages: actual or statutory. Actual damages consist of any damages suffered by the copyright holder, plus any profits earned by the infringer not taken into account in computing the holder's actual damages. Statutory damages can range between $750 and $30,000 per copyright infringement. However, in cases of willful copyright infringement, statutory damages may reach up to $150,000 per infringement. Although the statute does not expressly provide for damages for contributory or vicarious infringement, the plaintiffs in UMG Recordings, Inc. v. Hummer Winblad Venture Partners, discussed below, seek the statutory maximum of $150,000 per vicarious or contributory infringement.
Napster and Its Fallout: UMG and the Bertelsmann Cases
A. Napster v. Grokster: Technology Matters (As It Turns Out)
In A&M Records, Inc. v. Napster, the plaintiff record companies alleged that the popular website committed contributory and vicarious copyright infringement by operating a file-sharing network through which users swapped MP3 files on a massive scale, thereby resulting in millions of direct copyright infringements. Though the district court did not decide the issue of liability, it concluded that the plaintiffs showed a reasonable likelihood of success on both claims and on July 26, 2000, ordered a preliminary injunction against further infringements. The court noted that Napster's contributory infringement stemmed from its knowing facilitation of wide-scale copyright infringement by millions of users. Napster's vicarious infringement resulted from its "right and ability to supervise" the file-swapping network, combined with its obvious financial interest in the millions of infringements occurring on the network. On appeal, the Ninth Circuit ordered the district court to modify the injunction, but the relevant holding remained the same: Napster faced contributory and vicarious liability unless it stopped operating its system in a way that led to copyright infringements. Napster shut down its service on July 2, 2001. On July 11, 2001, the district court ordered Napster remain shut down based on its determination that Napster has not sufficiently filtered copyrighted works and files from its system.
In contrast, in Metro-Goldwyn-Mayer Studios, Inc. v. Grokster, Ltd., a federal district court in the Central District of California considered whether a company that distributes free software enabling users to exchange digital media through independent peer-to-peer networks was contributorily or vicariously liable for the users' copyright infringements. Granting Grokster's summary judgment motion, the court reasoned that since Grokster merely provided a tool to access independent file-swapping networks and not the "site and facilities" where the file-swapping occurs, it did not exercise the requisite amount of control over infringing activities to be held contributorily or vicariously liable. The court distinguished Napster, noting that because Napster provided the entire network on which peer-to-peer MP3 exchanges occurred, and because Napster had the power to include or exclude participants from the network, it was vicariously and contributorily liable for the direct infringements its users committed.
It is interesting to observe how many precedents cited in the Napster and Grokster decisions related to brick-and-mortar businesses and principles of landlord-tenant law—determining whether the defendant went beyond merely leasing space to facilitating or controlling the activities of the direct infringers. A notable technology case exception cited in both Napster and Grokster is Religious Tech. Center v. Netcom OnLine Communications Servs., Inc., in which the court found that Netcom's services as an access provider, including storage and transmission of information necessary to facilitate the end user's postings to an internet newsgroup, and its control over the site to delete postings and suspend or preclude users, gave it a level of control greater than a mere landlord. Many would argue that even after Netcom the ultimate outcomes of the Napster and Grokster cases could not have been predicted with certainty.
B. The Hummer Winblad and Bertelsmann Cases
The Napster saga continues with a series of cases that have tested or are currently seeking to test the extent to which officers, directors and shareholders (including institutional investors and their employees who serve as officers or directors of the companies) and strategic partners can be vicariously or contributorily liable for copyright infringement. In Katz v. Napster, the court dismissed vicarious and contributory infringement claims asserted by music producer Mathew Katz against a number of Napster investors, including Hummer Winblad Venture Partners and Hank Barry, a Hummer Winblad partner who served for a period as Napster's CEO. The court characterized the plaintiff's claims as a "tertiary theory" of liability unsupported in the case law, noting that Napster was not alleged to be a direct infringer and that a claim for contributory infringement requires substantial participation in the specific act of direct infringement. However, two pending cases will test that decision.
In April 2003, UMG Recordings, Inc. v. Hummer Winblad Venture Partners was filed in the Central District of California. UMG alleges that Hummer Winblad, by way of its investments in and control over Napster, is liable for vicarious and contributory copyright infringements by users of the Napster system. Notably, Hank Barry and John Hummer, both partners of Hummer Winblad, are named as individual defendants, for their roles as directors and Barry's role as CEO of the company.
UMG's contributory infringement claim asserts that despite knowing of the infringements occurring on Napster's system, Hummer Winblad nevertheless acquired "significant control" over Napster in the following ways:
UMG's complaint stresses the allegation that Hummer Winblad deliberately acquired control over Napster despite thorough due diligence that revealed the infringing activity, and despite the fact that the infringement lawsuit against Napster had already been filed. The complaint further alleges that even after the District Court issued injunctions against any further contributory or vicarious infringement, Hummer Winblad continued to operate Napster. Thus, by acquiring control over Napster with knowledge of its customers' infringing activities, and by continuing to operate Napster with this knowledge, Hummer Winblad allegedly committed contributory copyright infringement.
UMG also asserted a vicarious infringement claim against Hummer Winblad. The vicarious infringement claim asserts that Hummer Winblad had a direct financial interest in the infringing conduct that occurred on Napster's system. UMG further asserts that by way of its investment in Napster and its members' seats on Napster's board, Hummer Winblad had the right and ability to control and/or supervise the infringing activities taking place on Napster's filesharing system. UMG alleges that Hummer is therefore liable for vicarious infringement due to its failure to exercise this control to bring to a stop the direct infringements.
UMG's complaint seeks substantial damages claims. Under both its contributory and vicarious infringement claims, UMG seeks the statutory maximum of $150,000 per infringement. Though UMG's complaint does not specify exactly how many infringements of its copyrighted works occurred on Napster's system, it alleges that Napster, and thus Hummer Winblad, facilitated "millions" of infringements. Should UMG's claims prove successful, and if UMG is awarded the statutory maximum per infringement, damages could reach hundreds of millions, or even billions, of dollars.
As of this writing, the complaint had only recently been filed and no answer had yet been filed to the complaint. The Bertelsmann cases, discussed below, are more developed in that answers and briefs have been filed by the parties.
In the Bertelsmann cases, the plaintiffs claim that through its control over Napster's management and $85 million of financial support in the form of loans when Napster was in dire financial straits, Bertelsmann (i) had knowledge of the infringing activity and materially contributed to infringing conduct (contributory infringement) and (ii) had the right and ability to supervise the infringing activity and had a financial interest in its continuation (vicarious infringement). The plaintiffs explicitly reject the defendant's characterization of their claims as based on a theory of "tertiary liability," arguing that the question of the degree of remoteness in Bertelsmann's relationship to the direct infringer was one of fact to be decided at trial, and that the plaintiff in Katz did a wholly inadequate job of pleading sufficient facts to support his claims.
The plaintiffs argue that Bertelsmann viewed itself as a "strategic partner," not a mere passive lender, and that, with full knowledge of the infringing activities, Bertelsmann elected to support Napster in the near term as a means to preserve Napster's user base until Bertelsmann could use the Napster platform to execute its own e-commerce business strategy. The crux of the plaintiffs' argument is that Bertelsmann had the ability to control and did in fact control Napster through its status as sole funding source, which influence it used to assure that the Napster service continued, and with it, the infringing activity. No direct nexus between Bertelsmann and the direct infringers (the users) is alleged. Unlike the Hummer Winblad case, the Bertelsmann representative joined the company as its new CEO after the shut down the service, a fact that the plaintiffs argue is further evidence of Bertelsmann's control before the shutdown. The parties also address the issue as to whether control must actually be exercised over the infringing activity in order to prove vicarious liability. The plaintiffs argue that Bertelsmann's decision to use its financial control over Napster to not force Napster to cease the infringing activity is in itself an exercise of control. Plaintiffs also cite authority for the principle that the exercise of actual control is not a legal requirement for vicarious infringement.
UMG's copyright claims are unique because they represent the first attempt to impose vicarious and contributory liability on the shareholders, officers, directors and lenders of a corporation that itself may be liable only for contributory and vicarious infringement, not direct infringement. The existing precedent has been limited to cases involving shareholder liability for corporations' direct infringements. In the Hummer Winblad and Bertelsmann cases, however, the direct infringers are the former users of Napster's system. Napster itself was, at most, guilty of vicarious and contributory infringement and the court in the Northern District of California specifically rejected claims brought against the officers and directors of Napster. The pending cases will challenge that decision and may create new theories of liability for officers, directors, strategic partners and others who contribute to or assist in the underlying direct infringement. Hopefully, the courts will adopt a consistent approach in deciding these cases, and provide some guidance for the future.
Among the unanswered questions are:
C. Implications of Hummer Winblad and Bertelsmann
The Hummer Winblad and Bertelsmann cases are far from over, and the unique circumstances they present may provide only limited guidance for structuring investments in the future. However, the plaintiffs' allegations suggest the following consequences for strategic partners and venture capitalists considering commercial agreements and/or investments in new technologies:
D. Strategies for Reducing Risk for the Client and the Lawyer
The following are suggested strategies for reducing risk of liability for copyright infringement:
Current Trends in Venture Capital Investments
There are some positive trends in the market. Venture funds are holding approximately $50 billion in unspent capital and blue chip funds are raising new funds. Venture investing in 2002 totaled $21 billion, tied to the fourth largest year ever. In terms of total number of venture deals being done, activity is at about 1997-1998 levels. Much of the investment activity is concentrated in Silicon Valley and New England. However, public and private valuations are down about 50% and the IPO market for venture-backed companies continues to be soft. In Silicon Valley, the total number of Series A deals [is as low as it has ever been, at least going back as far as 1995.] Overall dollar amounts invested are also very low. The greatest number of deals and most of the dollars are going to larger stage financings and expansion capital.
It is taking longer to get deals done; five to ten months is not uncommon. More deals are being syndicated to spread risk. And the write-downs are not over yet.
It takes more to get the first venture round. Entrepreneurs should expect to self-fund, seek government grants, do a friends-and-family round or find other seed financing to get started. Generally, venture investors are expecting to a lot see more progress before the first venture round—the amount and type of progress depending upon the industry. For example, a software company should expect to have completed product development and have a few customers. First round venture investors may require that all of the prior money be converted into common stock (including the bridge notes that by their terms are convertible into the next preferred round).
Investors commit, but fund slowly. More financings are being completed in tranches, with each capital infusion tied to achievement of milestones (without a step in valuation). These terms should be negotiated carefully, or the investors will essentially have an option to fund at the original valuation and the entrepreneurs may find themselves quickly back to the bargaining table.
Strategic corporate investors are still making investments. While some corporate funds have shut down or significantly retrenched, many companies are still making investments in early-stage companies. These funds vary widely in their approaches—some only invest in connection with a commercial agreement; others are completely independent of their corporate sponsor. Key areas of negotiation include confidentiality and nondisclosure agreements (in particular "non-use" provisions, which some strategic investors are reluctant to sign), board seats and in cases where commercial agreement is being negotiated, rights of first refusal or first negotiation or outright options to purchase the company.
Investors are watching the expenses. More aggressively cost sensitive, funds are executing nonbinding term sheets that provide for exclusive dealing or "no shop" clauses and provide that the investors' legal expenses will be paid whether or not the transaction closes. Expect some downward pressure on legal fees generally.
Investors are watching their backs. Many investors are routinely insisting on D&O coverage and founders are happy to comply (as long as they get it too!).
Companies are looking outside the U.S. for funding. Ex-U.S. funding sources are active in the U.S. startup market. Interestingly, inbound term sheets have been slower to return to the simple terms and may require significant negotiation/education regarding current trends. Some of those investments come with strings—some Canadian funds, for example, require that the company establish a significant presence in Canada and be majority-owned by Canadian stockholders.
Please see Section 5.3.3.a for the beginning of this article
[*]Deborah Marshall is a director at Howard Rice Nemerovski Canady Falk & Rabkin, A Professional Corporation, in San Francisco, California. She gratefully acknowledges the invaluable assistance in the preparation of this article provided by Sarah Good and Annette Hurst, directors, and David Tang, an associate, at Howard Rice, and David Prahl, a law student at the University of California at Davis.
239 F.3d 1004 (9th Cir. 2001).
259 F. Supp. 2d 1029 (C.D.Cal. 2003).
03 CV 1093 (TPG).
03 CV 3338 (TPG).
03 CV 4074 (TPG).
A & M Records, Inc. v. Napster, Inc., 239 F.3d 1004, 1013 (9th Cir. 2001) (citations omitted).
316 F.2d 304 (2d Cir. 1963).
Id. at 307; see also Fonovisa, Inc. v. Cherry Auction, Inc., 76 F.3d 259, 262 (9th Cir. 1996); Sony Corp. of America v. Universal City Studios, Inc., 464 U.S. 417, 435 (1984).
Shapiro, supra, n.19, at 305-6.
Id. at 307-10.
Id. at 307.
See 18A Am. Jur. 2d Corporations §166 (2003); 18 Am. Jur. 2d Corporations §43 (2003).
See Frank Music Corp. v. MGM, Inc., 886 F.2d 1545, 1553 (9th Cir. 1989); RCA/Ariola International, Inc. v. Thomas & Grayton Company, 845 F.2d 773, 782 (8th Cir. 1988) (holding individual shareholder liable for vicarious infringement); Broadcast Music, Inc. v. Hartmax Corp., 1988 U.S. Dist. LEXIS 13298 (N.D. Ill.1988) (holding defendant holding company vicariously liable for infringing music performances occurring at two stores owned by defendant's subsidiary).
886 F.2d at 1553.
See 18 Am. Jur. 2d Corporations §57 (2003); 18 Am. Jur. 2d Corporations §56 (2003).
Frank Music Corp. v. MGM, Inc., 772 F.2d 505, 519-20 (9th Cir. 1985).
886 F.2d at 1553.
Napster, supra, n.17, at 1019.
Adobe Systems Inc. v. Canus Prods., Inc., 173 F. Supp. 2d 1044, 1048 (C.D. Cal. 2001).
Napster, supra, n.17, at 1019.
17 U.S.C. §504(a).
17 U.S.C. §504(6).
17 U.S.C. §504(c)(1).
17 U.S.C. §504(c)(2).
114 F. Supp. 2d 896 (N.D. Cal. 2000).
Id. at 900.
Id. at 927.
Id. at 918-20.
Id. at 920-22.
Napster, supra, n.17 at 1027.
Id.; see also Napster, 114 F. Supp. 2d at 927.
259 F. Supp. 2d 1029 (C.D. Cal. 2003).
Id. at 1031-33.
Id. at 1041, 1043, 1045-46.
907 F Supp. 1361 (N.D. Cal. 1995).
C 00-4725, Mem. & Order (N.D. Cal. Jul. 9, 2001).
845 F.2d 773, 782 (8th Cir. 1988).
Two kinds of D&O insurance may be available to protect partners in venture funds who serve on the boards of directors of portfolio companies and are named as defendants in subsequent suits: (1) the portfolio company's D&O policy to the extent that the partner is being sued in her/his capacity as a member of the portfolio company's board of directors, and (2) the fund's D&O policy which operates as excess insurance over (1). In addition, the funds themselves that are named as defendants in subsequent suits concerning a portfolio company can be covered by the fund's D&O policy (which typically includes the fund and all related funds and entities, along with individual partners). In the past funds often elected not to purchase D&O insurance at all (relying entirely on the D&O insurance policy purchased by the portfolio company (which covers only individual partners of the fund who serve on the boards of portfolio companies and does not cover the fund or related entities themselves). In light of the increased frequency of such suits, funds today should consider purchasing their own insurance in sufficient amounts to protect themselves.
886 F.2d at 1553.
See 1988 U.S. Dist. LEXIS 13298 (N.D. Ill. 1988).
The author thanks PriceWaterhouseCoopers for sharing its "Shaking the MoneyTree—Q1 2003 Update" data for the venture investment statistics cited in this article.
These transactions often involve establishing a "sister" U.S. company and issuing stock in the Canadian company that is exchangeable for stock in the U.S. company in the event of an IPO. Corporate, intellectual property, employment and tax counsel in the U.S. and Canada is required; these investments can be quite complex (and expensive) to negotiate and maintain.