Second Circuit Holds that Statutory Right to Adapt Software Preempts Contractual Terms

A recent Second Circuit decision, Universal Instruments Corp. v. Microsystems Engineering Inc. (2d Cir. 2019) provides important lessons for parties involved in negotiating software and other technology development contracts.

One key holding is that where the copyrighted software was licensed to the customer pursuant to terms of a development contract, then the customer had a statutory right, under Section 117(a) of the Copyright Act, to have a different developer modify and adapt the software for the customer’s use. And, that statutory right pre-empted any claim that the contract limited such adaptation rights.
The Second Circuit also construed license terms to allow both MSEI and the second developer to use the software anywhere in the world to service MSEI’s system.

Together, these rulings meant that once the developer had created and licensed the software, it was powerless to stop the customer from employing other companies to use, adapt, and modify the software, at least for the customer’s own business.

Parties involved in negotiating development licenses should be aware that the Copyright Act may vest additional rights in a customer beyond that provided in the contract – and that contrary contracts terms will be preempted by the law.

Microsystems Engineering Inc. (“MSEI”) is a medical device company that designs and manufactures electronics for implantable pacemakers and defibrillators. Before selling these products, MSEI subjects them to a battery of tests to ensure they are properly working. MSEI sought to automate the movements of the products to various points in the testing system, which until then were manually moved. The goal was to implement the new system in three phases, which would be successively designed, built, and implemented.

MSEI awarded the contract for the first phase to Universal Instruments Corp. The work included development and installation of software for various portions of the system. Universal completed the contract and provided the software.

MSEI then solicited bids for phase two and awarded the contract to a Universal competitor, which was responsible for developing and manufacturing components of the system. MSEI downloaded the Universal source code and provided it to the new contractor to install in the second (and later the third) phase of building the system.

Universal brought suit for, among other things, copyright infringement and breach of contract.

The License Terms

The first part of the dispute was whether MSEI’s providing the software to the second developer was within the terms of the license. The Second Circuit interpreted the license to include such use. The applicable provision of the license term provided:

If [Universal] uses any Pre-Existing Intellectual Property in connection with this Agreement, [Universal] 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.

The Second Circuit made two key interpretive holdings:

(1) The second developer was a “supplier” to MSEI within the license terms, and so was license to use the software; and

(2) The limitation to “internal use only” was not a geographic restriction, but rather allowed the software to “be used by or for MSEI's existing business – not for resale or for the use or benefit of others.” MSEI’s (and its contractor’s) use plainly qualified. So the contractor was free to copy and take the software off MSEI’s premises, so long as the purpose was to service MSEI.

These constructions of the license meant that MSEI and its second contractor were free to use the software to support MSEI’s business. But that only allowed use of the software as provided to MSEI by Universal.

What about modifications of the software to make it work better, and adaptations to new hardware (that the second contractor was also working on)? That issue was controlled by the Copyright Act.

Adaptation Rights

Section 117(a) of the Copyright Act provides a limitation on copyright infringement:

Notwithstanding the provisions of section 106 [the infringement section], 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:

(1) 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

Universal complained that in the second phase, MSEI’s contractor had modified the software and had exceeded the license. The Second Circuit, however, held that these modifications were permitted by Section 117(a).

MSEI was an “owner of a copy” of the program, because the program had been custom designed for it, delivered and installed on its equipment, and then provided by Universal at the end of the contract, with only a reservation that any modification would void the warranty. The modifications were made so that the program could be used on the new components and were limited to that purpose.

Not only did this dispose of any claim of copyright infringement for the modifications, it also disposed of any claim of breach of contract for the modification. The Copyright Act preempts state law claims that seek to vindicate rights that are the equivalent of those granted by the Copyright Act.

The Second Circuit (and most federal courts) adhere to what is known as the “extra-elements” test, which determines pre-emption based upon whether the state law cause of action has additional elements of proof beyond that needed to prove a copyright claim.

Universal’s breach-of-contract claim failed that test and was pre-empted. Its entire claim was that the modification of the software was beyond the license terms and hence breached the contract. But that is precisely the activity regulated by the Copyright Act and permitted by Section 117(a). So, its breach-of-contract claim failed.

The lesson to parties involved in software development contracts is clear: once a license to software is granted, then the party will often have a statutory right to adapt and modify the software for its own use.

Contract terms cannot be used to take away what the Copyright Act expressly permits. Since the developer is giving this right away as a matter of law, it should be aware of that and take that into account when negotiating other terms, such as price terms.