By Matt Vella
April 6, 2012

By Roger Parloff, senior editor

FORTUNE — Yesterday’s federal appeals court ruling, reinstating Viacom’s 2007 copyright lawsuit against Google’s YouTube, may be of greater importance to the nation’s technology and media lawyers than to the parties in the suit.

Viacom (VIA) and YouTube themselves have been peacefully coexisting fairly well since 2008, when YouTube initiated its Content ID filtering program, which Viacom finds satisfactory. (Earlier this week Viacom’s Paramount unit and YouTube announced a deal to rent Paramount movies from the site.) Their dispute is backward looking and finite.

Nevertheless, the decision by the U.S. Court of Appeals for the Second Circuit is of tremendous ongoing interest to the tech and content industries because it fiddles with bedrock definitions that determine the outcome of a crucial recurring question in our Web 2.0 world: When are Internet companies liable for their users’ online copyright infringing activities?

The court’s puzzling, gnarly, 39-page answer to that question, written by Judge Jose Cabranes, will certainly make lawyers earn their fees. What it gives with the right hand, it seems to take away with the left. It will give each side both ammunition and headaches in current and future litigation over such controversial businesses as cyberlockers, like and RapidShare, which are hotbeds of infringing file-sharing.

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Despite the ambiguity, though, the ruling clearly nudges the lines of demarcation modestly in the direction content-owners had hoped. It allows Viacom’s suit against YouTube to go forward “at least with respect to a handful of specific clips” for which Viacom was able to show (mainly through internal YouTube emails) highly specific knowledge of infringement on YouTube’s part. The ruling also reinstates a related class-action copyright suit against YouTube, whose representative plaintiffs include the Football Association Premier League (an English soccer organization), the French Tennis Federation, and a number of music publishers. Those plaintiffs seek damages for ongoing alleged copyright infringement on the site.

In brief statements, both Viacom and YouTube maintained that the wording of the court’s ruling amounted to a victory for it. According to Viacom, “The Court delivered a definitive, common sense message — intentionally ignoring theft is not protected by the law.” YouTube countered: “All that is left of the Viacom lawsuit . . . is a dispute over a tiny percentage of videos long ago removed. . . . Nothing in this decision impacts the way YouTube is operating.”

The ruling’s greatest contribution might be its conclusion that site-owners’ “willful blindness” to users’ infringing activity can be deemed to be “knowledge” on their part, potentially disqualifying them from the protections of the safe harbor. (Explicit recognition of the “willful blindness” principle had been proposed in the recent Stop Online Piracy Act bill, or SOPA — which was dropped after spectacular Internet protests in January — and had been one of the hot-button issues that had alarmed tech lawyers and digital rights advocates.)

Viacom’s case arises from the early history of YouTube, and illustrates well the temptations startup web businesses may have to turn a blind eye to users’ copyright infringement, at least while building scale and audience.

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YouTube launched in December 2005 and was acquired by Google (GOOG) in November 2006 for $1.65 billion. Viacom presented evidence that a large portion of YouTube’s early traffic was being drawn not by the homemade, Charlie Bit My Finger-type videos for which the site is best known, but by “premium content” — i.e., clips of copyrighted television shows or movies that were being posted by users, almost always without authorization. Many of these, including clips from The Daily Show with Jon Stewart or South Park, were owned by Viacom.

In internal emails YouTube officers estimated that 75% to 80% of the site’s traffic was drawn by such content, while a survey commissioned by Google, in anticipation of acquiring the company, reached similar findings.

There was also email evidence that YouTube’s officers understood that countenancing infringement gave it a competitive advantage over more prudent rivals, like Google Video and Yahoo (YHOO) Video, which were more fastidious about proactively removing such content. YouTube’s officers calculated that, because YouTube was attracting more eyeballs, it would be worth more to an acquirer or in an IPO. In an email exchange about a popular and infringing CNN clip concerning the space shuttle, for instance, Yahoo co-founder Jawed Karim urged leaving it on the site, noting, “we can remove it once we’re bigger and better known, but for now that clip is fine.”

Under the safe-harbor provisions of the 1998 Digital Millennium Copyright Act (DMCA), site-owners have no duty to monitor their site for infringing materials. Instead, content-owners bear the burden and expense of monitoring sites, and must bring infringing content to the site’s attention through very specific notices — typically identifying each instance of offending material by URL. So long as site owners promptly take down the material upon notification, they are home free under the DMCA, even if other users promptly restore the offending material moments later. Accordingly, many content-owners find the DMCA’s whack-a-mole remedies inadequate.

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At the same time, the DMCA does stipulate that site-owners lose the protections of the safe-harbor if they have “actual knowledge” of specific infringing activity, or “are aware of facts and circumstances from which infringing activity is apparent.” Thus, content-owners have argued that if there are “red flags” that infringing activity is ubiquitous or widespread, safe harbor should not be available.

The lower court judge Louis Stanton threw Viacom’s case out in June 2010, finding that YouTube was protected by the DMCA safe harbor provisions, notwithstanding its surveys and problematic emails. In what probably represented the high watermark for DMCA safe-harbor protections, Stanton did so even while acknowledging evidence that “the defendants not only were generally aware of, but welcomed, copyright-infringing material being placed on their website.”

Yesterday’s ruling overturned Stanton’s decision. Nevertheless, the panel still seemed to agree with Stanton that mere survey evidence showing that infringement was widespread was not sufficient to constitute either “actual knowledge” or a red flag sufficient to deprive YouTube of the safe harbor. Only emails referencing specific clips — a series of Bud Light (BUD) commercials, the shuttle launch, some soccer matches, some Reno 911 clips — seemed sufficient to constitute the sort of red flag that could strip YouTube of safe harbor protection.

The cases now go back to the district court for further proceedings.

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While Viacom does not seek damages for any clips after it entered into YouTube’s ContentID program in 2008, the class action plaintiffs do.

Under the Content ID system, cooperating content owners give YouTube samples of their content. YouTube then uses digital fingerprinting technology to detect users’ subsequent attempts to upload identical content. YouTube then allows the content owner to decide, before such material is posted, what to do with the clip — either show it, giving the content-owner a piece of the associated ad-revenues, or block it.

Nevertheless, YouTube’s Content ID system is “woefully inadequate” in practice, according to the class’s counsel Charles Sims, of Proskauer, who says it works poorly for his clients, is inconsistent with copyright law, and presents copyright holders with a coercive “take-it-or-leave-it” proposition. Thus, they seek damages for alleged infringements continuing into the present.

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