The venture capital industry is beset by lawsuits. LPs sue GPs, newspapers sue LPs and failed entrepreneurs sue the nearest deep pocket. The vast majority of these suits may prove inconsequential to the private markets at large, but California Central District Court case 03-2785 stands out as an exception.
In layman’s terms, this case is known as: Lots of Record Companies versus Hummer Winblad Venture Partners.
“This is a case that could turn not just venture capital on its head, but all of corporate America on its head,” says Karen Dewis, who runs the corporate group of McDermott, Will & Emery in Washington, D.C. “The law has been developed so that there is a corporate veil between a company and its shareholders, but the record companies in this case are possibly going to pierce that veil.”
At issue is a pair of decisions by San Francisco-based venture shop Hummer Winblad, which focuses on making early-stage software investments. In May 2000, the firm invested $15 million into the controversial file-sharing pioneer Napster Inc. in a Series B deal. Hummer was the sole investor in the round
As part of the deal, the firm also installed Hank Barry, a Hummer Winblad partner, as interim CEO. Barry’s background as an entertainment lawyer was believed to be an asset to Napster as it battled against copyright infringement charges from the recording industry.
Both decisions, of course, proved disastrous. Napster – which provided a peer-to-peer community that allowed users to exchange, illegally, digital music files – never turned a dime under Barry’s brief watch. And the file swapping company was sold to Bertelsmann AG in late 2000. The German media giant agreed to pay $8 million to Napster creditors, but shareholders received nothing.
Such failure, however, did not satisfy the recording industry. Instead, companies like Universal Music Group and EMI Group argued that financial support for Napster was the root facilitator of online music piracy. Moreover, they believed that Hummer Winblad bore more responsibility than typical VC investors because it had installed one of its own as CEO.
On April 21, 2003, a handful of record companies filed civil charges of copyright infringement against Hummer Winblad, as well as Barry and John Hummer, who served on the Napster board alongside Barry.
The plaintiff list has since grown to 16, although no specific damages have been requested.
This lawsuit was part of the entertainment industry’s high-profile campaign against activities it perceives as unlawful.
Critical to the complaint are allegations that Hummer Winblad had the ability to control Napster’s activities through its CEO Barry and its board positions.
Most attorneys with knowledge of the suit say that Hummer Winblad will prevail. But they also say that VCs should pay close attention in case of an upset.
“Any ruling against Hummer Winblad probably wouldn’t so much be about their investment as it would be about their proactive conduct in acting as officers of Napster,” says Michael Cohen, an antitrust, trade competition lawyer with Heller Ehrman White & McAuliffe. “So there could be some chilling effect as to how investors view and envision themselves in the management and operations of a company.”
For example, could Timberline Venture Partners be liable for decisions it made on the board of StreamCast Networks Inc., which has picked up Napster’s dropped baton with a software product named Morpheus?
StreamCast and other second-generation file-swappers like Grokster and Kazaa were found not liable of copyright infringement in April 2003 because they did not maintain a central database like Napster, but there is little doubt that the record industry would like to retry the cases via a different avenue.
Karen Dewis is particularly concerned about the possibility of a record industry win, because it could set off a wave of suits that she believes would challenge the sanctity of shareholder rights.
“A board member can be held liable as an individual, but not the shareholder who supplied the board member,” she says. “Maybe if they were running the company as part of their own company, but that’s not what happened [with Hummer Winblad and Napster].”
Some pundits have suggested that Hummer Winblad’s real problem wasn’t so much its investment, but its decision to name one of its own as CEO. Timberline, after all, didn’t make such a move and was spared the defendant bills when StreamCast was brought to court.
If a judge finds saliency in this argument, then many VC firms will have no choice but to rethink the roles of operating partners who often are asked to take temporary positions with portfolio companies.
Imagine – in an extreme scenario – if a life sciences investment firm installed a partner as CEO or COO of a medical device company, which made a device that was used during a surgical procedure in which a patient dies.
The company itself would be liable for such a catastrophe. But would the VC firms be held accountable in addition to the company? Take this hypothetical one step further and consider the limited partners in the VC firm, such as ones that sit on advisory committees. Would they be held accountable, too?
Where It Stands
All of these possibilities, of course, rely on the premise that Hummer Winblad loses its case.
In mid-February, Hummer Winblad was awaiting word on a pair of motions. The first was a motion to dismiss the case, and that argument was expected to be heard in last February by presiding Judge Dale Fischer.
The second was a motion to move the case out of Los Angeles and to San Francisco, where U.S. District Judge Marilyn Patel, who has previously ruled on Napster-related matters, could preside.
Plaintiffs in the case are opposing both motions.
The music companies assert there is a cause for liability against Hummer Winblad because of two reasons.
First, they argue that the defendants engaged in contributory copyright infringement by maintaining and facilitating Napster’s system for unauthorized copying.
Second, they assert that even if Hummer Winblad did not contribute directly to the infringing activities, its potential financial gain from its investment in Napster, coupled with it not exercising its authority to curtail the company’s activities, constitute vicarious copyright infringement.
This case is noteworthy because illegal file swapping is a contentious issue for the music industry, which has stepped up its attack against online music piracy, by suing hundreds of people for illegally distributing copyrighted music over the Internet.