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A decision issued last month by the 2nd U.S. Circuit Court of Appeals clarified when a customer “owns” a copy of a computer program, as opposed to merely licensing it. In Krause v. Titleserv, Inc., [FOOTNOTE 1] the 2nd Circuit affirmed a grant of summary judgment dismissing plaintiff’s claims for software copyright infringement. The court held that the defendant owned the software copy at issue and had broad rights under the Copyright Act to modify the software to fit its needs. This decision has important implications for software licensing, but is unlikely to apply to common mass-market software — like Windows or Photoshop. BACKGROUND Plaintiff William Krause was a computer programming consultant who wrote software for Titleserv Inc., a title service agency. Between 1986 and 1996, Krause wrote over 35 programs for Titleserv — eight of which were at issue in this suit — and was paid over $350,000. The eight disputed programs constituted part of Titleserv’s operating system, enabling it to manage client requests and other aspects of its business operations. In July 1996, before Krause and Titleserv could reach an agreement addressing the assignment of the copyright for these programs, Krause terminated his relationship with the company. The works-made-for-hire doctrine [FOOTNOTE 2] did not apply to Krause, as an independent contractor, and he retained ownership of the copyrights. When Krause left the company, he took the only copies of the source code for two of the programs, but left the source code for the other six programs on Titleserv’s file servers and backup tapes. Source code allows other programmers to understand and modify a program; the source code must be compiled into executable object code to be used. Krause left copies of executable code for all eight programs and told Titleserv that it could continue using the executable code but not modify the source code. He also put lock commands on the executable code, preventing Titleserv from decompiling it to reveal the source code. Titleserv believed this limitation crippled the software’s value, since it could no longer fix bugs or even perform routine operations like changing a client’s address without modifying the source code. In response, on July 16, 1996, Titleserv filed a misappropriation suit in state court against Krause. However, Titleserv was subsequently able to circumvent the “locks” and reverse engineer the programs back to their source code. Titleserv then modified the source code by fixing bugs, updating client information and adding new features such as check printing and providing for direct client access to the system. Titleserv also allegedly updated the programs to function on Titleserv’s new Windows-based system, although Titleserv claims it stopped using Krause’s programs when it switched to its new system by early 1998. Krause brought a copyright infringement action against Titleserv in the U.S. District Court for the Eastern District of New York, alleging that Titleserv’s source-code modification constituted unauthorized copying and creation of derivative works. Titleserv moved for summary judgment. The district court granted Titleserv’s motion for summary judgment after accepting the recommendations of Magistrate Judge William Wall, who found that Titleserv’s use and modification of Krause’s programs were protected under 17 USC �117. [FOOTNOTE 3] THE DISTRICT COURT’S FINDINGS Section 117(a) of the Copyright Act provides an affirmative defense against copyright infringement when the owner of a copy of a computer program makes a new copy or adaptation that “is created as an essential step in the utilization of the computer program in conjunction with a machine and that it is used in no other manner.” [FOOTNOTE 4] Parsing the statutory text, the district court first determined that Titleserv “owned” a copy of the program, having paid over $350,000 for Krause’s programming services. The court disregarded his claim of an “oral licensing agreement, as opposed to an ownership agreement” regarding the programs, noting that even if such an oral agreement existed, it would be “invalid under the Copyright Act’s statute of frauds.” [FOOTNOTE 5] The court next addressed whether Titleserv’s modification was an “essential step” to using the programs in conjunction with Titleserv’s machines. Relying on the 2nd Circuit’s interpretation of �117 in Aymes v. Bonelli, [FOOTNOTE 6] where the Court of Appeals held that �117 protected the modification of programs for compatibility with a successive generation of computer systems, the district court found that �117 protected source code modifications for fixing bugs and updating business records. Finally, the district court concluded that Titleserv’s modifications were “used in no other manner” as required by �117. The district court granted summary judgment in favor of Titleserv, concluding that its modifications were protected under �117. Krause appealed to the 2nd Circuit. Perhaps the most interesting aspect of the 2nd Circuit’s opinion is the court’s discussion of what it means to “own” a copy of software, as opposed to licensing it. Typically, an author owns the copyright of a book, while each purchaser of a copy of the book owns that copy. By contrast, software purchasers are typically bound by an End User License Agreement, so that they license the software rather than own it. Because the affirmative defense in �117 applies only to “the owner of a copy of a computer program,” the 2nd Circuit needed to determine at the outset of its opinion whether Titleserv qualified as such an “owner.” Krause argued that Titleserv never owned title to the program copies, but merely possessed the copies as a licensee pursuant to an oral agreement. Rather than follow the district court’s approach and dismiss the alleged oral license agreement as violating the statute of frauds, the 2nd Circuit looked more closely at whether Titleserv “exercises sufficient incidents of ownership over a copy of the program to be sensibly considered the owner of the copy for purposes of �117(a).” [FOOTNOTE 7] Applying this nuanced approach, the court rejected Krause’s argument that ownership should be limited to formal title owners, thus overruling Applied Info. Mgmt v. Icart [FOOTNOTE 8] and resolving a split within the 2nd Circuit. The court noted that the legislative history of �117(a) did not support limiting ownership to formal title and, since formal title is determined by state law, permitting state law interpretation to control would undermine the national uniformity sought by the Copyright Act. Additionally, the court cited as support a Federal Circuit case that looked to “incidents of ownership” rather than formal title. [FOOTNOTE 9] ‘INCIDENTS OF OWNERSHIP’ Applying the “incidents of ownership” standard, the court determined that Titleserv was an “owner” because: (i) it had paid Krause substantial sums to develop the programs for its sole benefit; (ii) Krause customized the software for Titleserv’s operations; (iii) copies were stored on Titleserv’s servers; (iv) Krause never reserved the right to repossess the copies and agreed that Titleserv could possess them forever; and (v) Titleserv was free to discard or destroy the copies. The 2nd Circuit’s framework makes it far easier to be considered an owner of a program. Being an owner rather than a licensee has other implications under the Copyright Act, such as being entitled to limited “first sale” rights. [FOOTNOTE 10] BROAD RIGHTS TO MODIFY Having determined the question of ownership, the 2nd Circuit next found that owners had broad rights to modify their software under �117. Titleserv’s modifications fell into four main categories: (i) bug fixes, (ii) updating client information, (iii) compatibility with the new Windows-based system, and (iv) adding new capabilities such as printing checks. The court found that each of these modifications was an “essential step” for using the computer program with Titleserv’s machines. The first three categories were deemed to be straightforward applications of the 2nd Circuit’s earlier Aymes opinion, which allowed modifications designed to keep the software in step with changes in the defendant’s business. The court grappled with the fourth category, which consisted of changes that were not strictly necessary, but which improved the functionality for which the program was created. The court discussed at great length the definition of “essential,” ultimately rejecting Krause’s cramped interpretation. The court instead read “essential” in conjunction with “utilization” in the statute. Since “utilization” might refer more broadly to “making the program useful” to its owner, adding new functionality might qualify as an “essential step” in making the program useful. More relevantly, the “CONTU Report” referred to in the legislative history of �117 specifically contemplated adding new program features. [FOOTNOTE 11] Between the textual ambiguity and the legislative history, the 2nd Circuit concluded that modifications adding new features could be “essential steps in the utilization of the computer program” within the meaning of �117. Finally, the 2nd Circuit addressed Krause’s objection that the modifications failed to be “used in no other manner” because Titleserv shared copies of the modified program with its subsidiaries, and granted two clients dial-up access to the program. The court deemed use by Titleserv’s subsidiaries as merely a “continuation” of the original intended use — not use “in another manner.” The court acknowledged that Krause’s argument was “slightly stronger” regarding the dial-up access to the programs, but noted that Krause’s programs were designed to aid Titleserv in managing transactions with client banks. Thus, the modifications merely improved the versatility of the programs by allowing client banks to access the programs’ data directly, rather than having Titleserv’s personnel access it at the request of the client. While the court read this as “use in the same manner,” this logic seems questionable in light of commercial reality, where many programs on the market — including Microsoft Windows — are sold either as stand-alone or as more expensive remote-access versions. CONCLUSION The 2nd Circuit thus concluded that Titleserv was entitled to summary judgment since it owned copies of Krause’s software and satisfied the other requirements of the �117(a) affirmative defense. The court’s articulation of software “ownership” and the resulting broad modification rights have important implications for software licensing. Sophisticated purchasers/licensees will construct their contracts to convey “incidents of ownership” to maximize their rights to modify and update the purchased software. Licensors, of course, will press the opposite position in negotiations. However, since mass-market software, such as Windows XP, is nearly always sold with a EULA that restricts the end user’s rights, this decision likely will not enable people to reverse engineer and modify Windows. Martin Flumenbaum and Brad S. Karp are litigation partners, specializing in complex commercial litigation and white collar criminal defense matters, at Paul, Weiss, Rifkind, Wharton & Garrison. Drew L. Harris, a litigation associate at the firm, assisted in the preparation of this column. ::::FOOTNOTES:::: FN1 402 F3d 119 (2d Cir. March 21, 2005). FN2 In the case of a work made for hire, the employer owns the copyright. 17 USC �201(b). FN3 Krause v. Titleserv, Inc., 289 FSupp2d 316 (EDNY 2003). FN4 17 USC �117(a)(1). FN5 Krause, 289 FSupp2d at 318 n.2. FN6 47 F3d 23 (2d Cir. 1995). FN7 Krause, 402 F3d at 124. FN8 976 FSupp 149 (EDNY 1997) (holding erroneously that �117 applied only to title owners of a copy of a computer program). FN9 DSC Communications Corp. v. Pulse Communications, Inc., 170 F3d 1354 (Fed. Cir. 1999). FN10 17 USC �109 (providing limited first-sale rights for copies of computer programs). FN11 Final Report of the National Commission on New Technological Uses of Copyrighted Works 13 (1978) (commonly referred to as the CONTU Report).

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