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DivX (DIVX) took a step closer to being forced to walk the plank after suffering their first legal setback in their copyright dispute with Universal Music Group. In a legal filing published late Tuesday night, Judge Dana Sabraw dismissed DivX’s request to declare Stage6 legal, ahead of their UMG piracy trial.

The dispute originally started in December 2006, when UMG notified DivX that several of their videos were showing up on their Stage6 website. In the original cease and desist letter, UMG didn’t provide DivX with a list of the infringing videos, but still demanded that DivX remove all Universal content. A month later, UMG sent a second letter, only this time identifying specific videos that they had problems with. DivX promptly removed the videos in question and didn’t hear from UMG’s legal department for another 8 months.

After this 8 month period of awkward silence, UMG approached DivX and agreed to license their content, albeit at a very steep cost. In order to atone for their past sins, UMG wanted DivX to pay them $30 million.

Sensing a shakedown, DivX balked at the deal and decided to take their chances in court. They had fully complied with all of the provisions of the DMCA and if UMG wanted to punish them, they’d need to attack the DMCA’s safe harbor provision to do it. After calling their bluff, UMG dragged their heels on filing a lawsuit, but the potential threat for conflict still created a real problem for DivX. With the company trying to spin off their Stage6 asset, these storm clouds of uncertainty cast a long shadow over the legality of their Stage6 operations.

With UMG threatening legal action against the site, DivX was forced to choose between trying to sell the asset at a discount or trying to see if they could ride this storm out. With UMG seemingly content to continue to accrue alleged damages, DivX felt compelled to ask the courts to rule on whether or not Stage6 was protected under the safe harbor provision.

DivX took a huge risk by pushing this issue. If they are right, then their wager will certainly pay off. If the courts can establish the legality of their Stage6 website, it would remove a lot of the uncertainty surrounding the business and would allow potential suitors to feel more comfortable about its long term potential. If DivX is wrong though, the consequences could be severe.

Six weeks after DivX filed for declaratory relief, UMG finally made good on their threat and filed a lawsuit against DivX accusing them of piracy. By bringing DivX up on charges, they were able to successfully argue that their trial was a more appropriate venue for this question to be answered. While this does represent a setback for DivX, I doubt that the result was entirely unexpected.

Still, through legal maneuvering, UMG has been able to regain control over home court advantage and they’ve put themselves into a position where they can always settle or walk away if things start to look bad. Even if DivX sticks with the full court press, they may not end up with the declarations that they were hoping for. In the discussion section of the judgment, Sabraw sympathized with DivX, but couldn’t justify running a separate trial now that DivX is facing legal action.

Defendants argue declaratory judgment is an incomplete remedy since this action does not include all parties to the lawsuit pending in the Central District. Furthermore, since Plaintiff cannot identify all copyrights at issue, Defendants argue the remedy in this Court is limited to adjudicating only the copyrights named.

The Court agrees with Defendants. Although the fear of uncertain litigation may have initially justified Plaintiff in filing this action, Defendants have since filed a lawsuit in the Central District that eliminates the uncertainty. Moreover, the DCMA [sic] safe harbor analysis Plaintiff seeks here will be more completely and efficiently undertaken in the Central District, where the court will be able to determine Plaintiff’s compliance with respect to particular copyrights that Defendants identify in the course of those proceedings.

While it may appear that DivX has lost round 1, the dismissal of this case won’t be the end of this dispute by a long shot. With the declaratory issue now out of the way, DivX will need to focus on defending themselves against UMG’s lawsuit. Even though DivX’s initial lawsuit has been dismissed, they’ll still get an opportunity to defend their website. Still, until DivX can reach some kind of resolution, the lawsuit will certainly make it more difficult for them to separate their Stage6 assets from their core business. With rising bandwidth bills, the credit crunch and legal questions surrounding this asset, it may be difficult for them to find a buyer who is willing to get involved in this kind of dog fight.

Sensing that conditions weren’t right, DivX pulled back on their plans for Stage6 in December and in a press release announcing the resignation of Jordan Greenhall, they also warned that their Stage6 transaction wouldn’t be finished by the end of the year like they had planned. The company promised to update investors in the first quarter of 08′ and with DivX expected to report earnings soon, you can bet that Stage6 will be a hot topic on their next conference call. The plan that DivX management lays out will be critical in determining how investors interpret the financial results.

Last quarter, investors rewarded DivX by focusing on their non-gaap growth and ignoring the Stage6 and compensation expenses. If DivX still plans on spinning off Stage6, then it’s fair for investors to ignore the rising bandwidth costs and focus on the value of the underlying asset.

If DivX’s legal battles really mean that they need to hold onto Stage6 in order to maximize its value, then investors may be in for a shock when they realize that Stage6 is really a long term investment. Facing the prospect of a drawn out legal battle, they may not take as much comfort in “one time” charges or expenses.

The answer to the Stage6 riddle isn’t an easy one, but after years of profiting from their popularity in the pirate community, it’s ironic to see DivX’s finally starting to feel some heat over the activities of their community. Even beyond the copyright liabilities, there is a significant cost for DivX to foot the bill for pirated Stage6 content and I suspect that DivX isn’t anymore enthusiastic about piracy on Stage6 than UMG is. There’s no way to know how this all will end, but I have a feeling that it's going to take a lot longer than what people are anticipating.

Source: Can DivX’s Safe Harbor Protect It from Stage6 Pirates?