Copyright before Contract: The Role of Copyright Preemption in Software Licensing

By James Carlson

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In Universal Instruments Corp. v. Micro Systems Engineering, Inc., No. 17-2748 (2d Cir. May 8, 2019), an opinion from the U.S. Court of Appeals for the Second Circuit illustrates the fine line where contract terms may conflict with the U.S. Copyright Act.  Unlike with patents and trademarks, the Copyright Act provides an explicit preemption clause governing when a legal claim under state law is eliminated by copyright law.  In Universal Instruments, the court found that the Copyright Act’s authorization to modify a computer program under 17 U.S.C. § 117(a) preempted a breach of contract claim in a software licensing agreement.

The Copyright Act provides an explicit preemption test for determining whether a legal claim under state law is preempted by copyright law.  Specifically, the explicit preemption test is codified in 17 U.S.C. § 301(a), which states:

[A]ll legal or equitable rights that are equivalent to any of the exclusive rights within the general scope of copyright . . . in works of authorship that are fixed in a tangible medium of expression and come within the subject matter of copyright . . . whether created before or after that date and whether published or unpublished, are governed exclusively by this title. Thereafter, no person is entitled to any such right or equivalent right in any such work under the common law or statutes of any State.

Under the test in § 301(a), there are two prongs for finding copyright preemption. See Briarpatch Ltd. v. Phoenix Pictures, Inc., 373 F. 3d 296, 305 (2d Cir. 2004).  The first prong is a subject matter requirement that determines whether the particular work involving a state legal claim falls within the type of works protected by the Copyright Act.  In the first prong, courts looks to whether the type of work is fixed in a tangible medium and falls under one of the enumerated protected works in 17 U.S.C. § 102, such as literary works, musical works, dramatic works, etc.  Moreover, the second prong is referred to as the general scope requirement that is “satisfied only when the state-created right may be abridged by an act that would, by itself, infringe one of the exclusive rights provided by federal copyright law.”  See Briarpatch at 305.  As such, “the state law claim must involve acts of reproduction, adaptation, performance, distribution or display.”  See id.

Recently though, the U.S. Court of Appeals for the Second Circuit in Universal Instruments Corp. v. Micro Systems Engineering, Inc., No. 17-2748 (2d Cir. May 8, 2019) (“Universal Instruments”) applied the copyright preemption analysis to a licensing agreement regarding the development of software source code for a server and various product testing stations.[1]   The Universal Instruments court found that while a licensing agreement failed to provide specifically that the licensee had a right to modify software source code, 17 U.S.C. § 117(a) of the Copyright Act preempted any state law claim for exercising this right.

Turning to the facts in Universal Instruments, Micro Systems Engineering, Inc. (“MSEI”) solicited bids for the development of a Test Handling System (“THS”).  Universal Instruments Corp. (“UIC”) won the bid for phase one of the THS development, but lost the bid for phases two and three of the THS to Missouri Tooling & Automation, Inc. (“MTA”).  After winning the bid for phase one, UIC and MSEI executed a purchase agreement in June 2007.  Section 8.2(d) of the purchase agreement is provided below:

If [UIC] uses any Pre-Existing Intellectual Property in connection with this Agreement, [UIC] hereby grants MSEI, MSEI’s subcontractors, or suppliers, a non-exclusive, royalty-free, worldwide, perpetual license, to use, reproduce, display, of the Pre-Existing Intellectual Property for MSEI’s internal use only.  (Emphasis added.)

As shown in the above excerpt of the purchase agreement, MSEI’s subcontractors and suppliers received a non-exclusive license to “use, reproduce, and display” UIC’s pre-existing intellectual property.  However, phases two and three of the development of the THS required MTA to adapt the server source code to the design specifications for those phases.  In April 2010, MSEI awarded one of UIC’s competitors, MTA, and not UIC the bid for phase two of the THS.  Accordingly, with the server source code provided by UIC for phase one, MTA was able to complete phases two and three of the THS.

In July 2013, UIC filed suit against MSEI and MTA, alleging copyright infringement, misappropriation of trade secrets, breach of contract, unfair competition, unjust enrichment, and promissory estoppel.  The district court dismissed the claims for promissory estoppel, unfair competition, and unjust enrichment with respect to MSEI based on judgment on the pleadings.  The district court then proceeded to trial on the remaining allegations for copyright infringement, misappropriation of trade secrets, breach of contract, and unjust enrichment with respect to MTA.  Following trial, the district court found as a matter of law that UIC (1) had a protected intellectual property interest in the server source code, (2) had transferred copies of that property to MSEI, and (3) had offered no evidence that MSEI exceeded the scope of its license under the purchase agreement by giving MTA the server source code.  Regarding the misappropriation of trade secrets, the district court found these claims time-barred.

On appeal, the appellate court affirmed that the purchase agreement was not breached with respect to using and reproducing the server source code, and that any state law claim for modifying the server source code was preempted under 17 U.S.C. § 117(a) of the Copyright Act.   With respect to the breach of contract claim, the Universal Instruments court found MTA was a “supplier” under § 8.2(d) of the purchase agreement, where “the plain meaning of ‘supplier’ unambiguously includes a component manufacturer like MTA.”  As a supplier, the purchase agreement authorized MTA to “‘use, reproduce, [and] display’ the intellectual property for MSEI’s ‘internal use only.’”  The court interpreted “internal use only” to mean that “the pre-existing intellectual property could be used by or for MSEI’s existing business — not for resale or for the use or benefit of others.”  The court subsequently found that “[b]ecause there is nothing in the record to suggest that the server source code was used for anything other than for MSEI in subsequent phases of its THS, MSEI’s provision of the server source code to MTA and MTA’s use of the server source code for MSEI’S benefit did not exceed the scope of the license.”  (Emphasis added.)  Therefore, the appellate court held MSEI’s reproduction and MTA’s use of the server source code qualified as an “internal use” under the purchase agreement, and thus, a non-infringing use under copyright law.

Turning to the breach of contract claim for modifying the server source code, 17 U.S.C. § 117(a) of the Copyright Act states:

Making of Additional Copy or Adaptation by Owner of Copy.—Notwithstanding the provisions of section 106, it is not an infringement for the owner of a copy of a computer program to make or authorize the making of another copy or adaptation of that computer program provided . . . that such a new copy or adaptation 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 . . . .  (Emphasis added.)

In the Universal Instruments opinion, the appellate court found that while MSEI did not have formal title in the server source code, MSEI was an owner of a copy of the server source code under § 117(a).   The appellate court reached this decision based on MSEI paying UIC “over $1 million for the combined hardware and software solution,” UIC providing a copy “with the sole condition that MSEI assume[d] the risk of invalidating the warranty . . . ,” and UIC’s grant of a “a perpetual, worldwide license” to the software.

Furthermore, the appellate court then analyzed MTA’s conduct to determine if MTA’s modifications qualified as an “essential step” under § 117(a).  In particular, the appellate court found that MTA’s adaptation of the server source code (1) “help[ed] improve efficiency of the [THS] line,” (2) “enable[d] the server software to ‘support. . . communicating with all of the [new] stations.’”, and (3) was “‘designed to improve [the server source code’s] functionality in serving the business for which [it was] created.’”  Thus, the court held that MTA’s adaptation was also an “essential step in the utilization of the computer program in conjunction with a machine.”

Finally, the appellate court analyzed MTA’s adaptation to determine whether the server source code was used “in no other manner” than as an “essential step” under § 117(a).  UIC contended that MSEI’s modification of the server software to operate with new machines, rather than the existing machines created by UIC, defeats MSEI’s claim to protection from § 117(a).  The appellate court disagreed and further noted as a matter of law that “[t]here is nothing in the record to suggest that the server source code was used for any purpose other than to adapt the system to handle new testing stations for MSEI’s internal use.”  Moreover, the appellate court emphasized “the server software customized by Universal for MSEI was part of the first phase of MSEI’s multi-phased test handling system project” and UIC “was aware that the project had additional phases . . . [and] it had no guarantees that it would be chosen to supply the later phases.”

Therefore, as an owner of a copy of the server source code, MSEI was within its rights under the Copyright Act to authorize MTA to modify the server source code in the manner as performed by MTA.

In conclusion, copyright holders should note the ability to contract has certain limits as shown in Universal Instruments.  Where a contract provision is similar to a right granted by the Copyright Act, copyright holders should be extra careful with respect to whether their bargained for consideration is truly protected.  Copyright holders in software should be especially aware of the licensing ramifications where contract rights conflict with the fair use doctrine, the first sale doctrine, and DMCA provisions in regard to “reverse engineering.”

Regarding other areas of intellectual property, similar preemption issues may arise under federal patent law and trademark law even where these branches of intellectual property lack explicit preemption statutes.  Under the Supremacy Clause of the U.S. constitution, state laws are preempted where the respective state law conflicts with the aims of a federal regulatory scheme.  Therefore, we recommend that licensing agreement provisions are analyzed with respect to federal court jurisprudence and changes to the United States Code.  In particular, intellectual property owners should be warned that opposing counsel may surrender specific rights during licensing negotiations based on the knowledge that federal law prevents you from ever enforcing those rights.

[1] While use of the source code for both the server and the product testing stations was at issue in Universal Instruments, MTA only modified the server source code.   As such, this article is primarily directed to the legal issues regarding the server source code as those issues are the ones that relate to copyright preemption.   Both the district court and the appellate court found no breach of contract with respect to the use of the source code for the product testing stations.