Napster Investment Keeps Haunting Hummer Winblad

Hummer Winblad Venture Partners moved one step closer to a courtroom on Tuesday, as a San Francisco judge refused to dismiss copyright infringement claims brought by Universal Music Group. Judge Marilyn Patel did not rule on the case’s merits, instead saying that the record company has the right to proceed through at least the discovery phase.

The case relates to Hummer Winblad’s May 2000 decision to invest $13.5 million into Napster Inc., a Mountain View, Calif.-based company that already was in legal hot water for its online file sharing software. Even though the deal only gave Hummer Winblad a 21% ownership stake (post-money valuation of $64.5 million), it received two board seats and the right to insert one of its own as interim CEO. Firm co-founder John Hummer took one board seat, while the other board seat and interim CEO role went to Hank Barry, a Hummer Winblad partner since July 1999, who previously had led the interactive new media law practice of Wilson Sonsini Goodrich & Rosati.

Barry’s participation was key to the investment, as the Recording Industry Association of America (RIAA) already had issued a copyright infringement lawsuit against Napster. Hummer Winblad and Barry believed that they were right on the law, and never gave serious thought to Hummer Winblad itself being sued. Maybe board members Hummer and Barry could be named as defendants alongside Napster, but not the firm itself.

A few months later, District Court Judge Patel (yes, the same Judge Patel) issued a preliminary injunction against Napster, but the company continued to operate thanks to a stay from the 9th Circuit Court of Appeals, pending its own ruling. In late 2000, German media conglomerate Bertelsmann AG dropped out of the RIAA suit, and instead teamed with Napster and provided a substantial investment.

The 9th Circuit ended its stay in early 2001, and which point Napster went offline. The company technically never was found liable of violating copyright infringement, but it also never was able to resume its free-for-all operations.

In mid-2001, Barry stepped down as CEO to make way for a Bertelsmann executive – Konrad Hibers — who planned to relaunch Napster as a subscription-based service. The plan was delayed, however, as Bertelsmann tried to acquire the entire company from its original shareholders and Hummer Winblad, who were feuding at the time. An initial offer of approximately $16 million was rejected, at which point Napster began considering bankruptcy protection. A subsequent offer of just $8 million was accepted, with the entire payment going to Napster creditors. Bertelsmann soon sold the company over to Roxio Inc., which since has launched a subscription-based file-sharing service branded as Napster. Hummer Winblad seemed to be left with nothing but sour memories.
Investment Bites Firm

On April 21, 2003, Universal Music Group filed civil charges or copyright infringement against Hummer Winblad, and also named John Hummer and Hank Barry as individual defendants. UMG also joined a larger lawsuit against Bertelsmann, which basically included the same charges.

The suit stunned both Hummer Winblad and the venture capital industry as a whole, particularly because it seemed to be implying tertiary liability for copyright infringement (end user being first-tier, Napster being second-tier, Hummer Winblad being third-tier). Such an accusation never had been successfully levied against a VC firm, and some VCs accused UMG of trying to intimidate other firms interested in making content-related investments. Even the National Venture Capital Association chimed in, arguing in a letter to members of the U.S. Senate Banking and Small Business Committee that the UMG lawsuit – and any copycat lawsuits – could prompt VCs to shy away from high-risk technology investments.

Earlier this year, Hummer Winblad issued two motions. The first was for the case to be moved from Los Angeles to San Francisco, so that it could be heard by Judge Patel. The second was for the entire case to be dismissed. Judge Fisher in Los Angeles approved the venue change, which had been requested because Patel had a demonstrated understanding of the issues in play, and also earlier had demonstrated that she did not completely buy “tertiary responsibility” claims in copyright cases involving file-sharing software.

Judge Patel last Tuesday ruled against the motion to dismiss, which even some of Hummer Winblad’s lawyers thought was a long shot. The ruling also contained a similar refusal to dismiss in the Bertelsmann case. Some third-party attorneys immediately issued statements indicating that Patel’s decision would “create a buzz in corporate boardrooms,” but it actually was more a procedural ruling than an evidentiary ruling. In fact, Patel only could have ruled in favor of the motion to dismiss had it appeared “beyond doubt that the plaintiff can prove no set of facts in support of [its] claim that would entitle [it] to relief.” She has said that a tertiary claim is viable, but mainly just opened the door for discovery, and in no way reflects judgment on what evidence may be discovered.

;It’s very important not to blow this case beyond what it currently is, which is at a preliminary stage,” warns Michael Cohen, an antitrust, trade competition lawyer with Heller Ehrman White & McAuliffe.
Looking Forward

UMG now will produce a discovery schedule to Judge Patel, and the case will proceed from there. It is worth noting that Hummer Winblad may present a two-part defense, with the first part being that Napster itself was never actually committed copyright infringement. The preliminary injunction only found that Napster likely would have been liable in the RIAA suit, not that it actually was liable. If Hummer wins this argument, then the suit fails and, amazingly, Napster could resume its free file-sharing activities (although new owner Roxio would have to escape current contracts with record companies).

More likely, however, this case will come down to Hummer Winblad’s level of control over Napster, and how far downstream copyright infringement flows. Liability of contributory copyright infringement would mean that Hummer Winblad both knowingly contributed to infringement of another, and substantially participated in the act. The VC firm didn’t need to know of the actual acts (i.e. John Doe downloading a Pearl Jam song), but simply has reason to know that John Doe would do so. Vicarious infringement would apply if Hummer Winblad is found to have had the right and ability to supervise the infringing activity, and also to have had a direct financial interest in such activities.

On its face, contributory infringement seems an easier case to prove, as everyone – including Hummer Winblad investors – had active knowledge that copyrighted materials were being swapped via Napster. The later case of vicarious infringement is tougher, as Napster file-swapping did not take place on a central server, and Hummer Winblad never actually profited from any file-swapping. In fact, the only money Hummer Winblad made off Napster involved t-shirt and hat sales.

In both cases, the central issue will be the level of control Hummer Winblad had over Napster. Judge Patel sidestepped an opportunity to pierce the corporate shield, when she essentially avoided the question of Hummer Winblad’s culpability as an investor. Instead, she focused on its level of control over the company (multiple board seats, interim CEO).

Such a ruling is good news for VCs, as many have expressed concern that they could be held liable just for making a minority investment in a company that somehow breaks the law – whether that be copyright law or some type of intellectual property infringement. In fact, non-control investors in Napster did not get sued. Angel Investors LP of Danville, Calif. added $1.5 million to Hummer Winblad’s $13.5 million investment, but was not named as a defendant in the UMG case.

On the flip side, however, a final verdict against Hummer Winblad could spell trouble for certain buyout firms, particularly those that exercise a lot of management control over their portfolio companies.