Status of Kazaa not clear, howeverA federal judge in Los Angeles has handed a stunning court victory to file-swapping services Streamcast Networks and Grokster, dismissing much of the record industry and movie studios' lawsuit against the two companies. In an almost complete reversal of previous victories for the record labels and movie studios, federal court Judge Stephen Wilson ruled that Streamcast - parent of the Morpheus software - and Grokster were not liable for copyright infringements that took place using their software. The ruling does not directly affect Kazaa, software distributed by Sharman Networks, which has also been targeted by the entertainment industry. The ruling is the second major setback to date to the entertainment industry's efforts to keep a tight rein on online file-swapping, following a similiar decision in the Netherlands last year that found that Kazaa was not liable for its users' copyright infringements. If upheld, the decision could lead artists, record labels and movie studios to cast new legal strategies that they have until now been reluctant to try, including bringing lawsuits against individuals who copy unauthorised works over Napster-like networks. According to the major record labels, file-swapping is a major contributor to declines in music sales over the past few years, a trend that has thrown the industry into disarray. Debt-ridden media conglomerates are now considering sales of their music divisions even as they begin to test paid online music services intended to compete with free file-swapping networks and turn the tide. Attorneys called the ruling a blow for entertainment and record companies trying to stop the networks used to swap unauthorised copies of their works. "This is a very serious setback for the record industry and other content industries, because they've uniformly won these cases in the US," Mark Radcliffe, an intellectual property attorney at Gray Cary Ware & Freidenrich said. While the ruling in no way validates the legality of downloading copyrighted music online, it would shield companies providing decentralised file-swapping software such as Gnutella from liability for the actions of people using their products. As such, it could provide new leverage for file-swapping companies such as Grokster, Streamcast and Sharman in negotiations with record companies and other copyright holders to license works legitimately. Since Napster's $1bn, or about £640m, settlement offer with the record industry in 2001, file-swapping companies have repeatedly sought an amicable settlement with copyright holders but have been almost universally rebuffed. The court's ruling applies only to existing versions of the Morpheus and Grokster software. Earlier versions of the software, which functioned slightly differently, could potentially leave the companies open to liability. A spokeswoman for the Motion Picture Association of America (MPAA) said the copyright holders were deeply disappointed in the decision and would certainly appeal. "We feel strongly that those who encourage, facilitate and profit from piracy should be held accountable for actions," MPAA spokeswoman Marta Grutka said. "We're hoping that people aren't taking this as an invitation to continue along the path of what is clearly illegal activity." Recording industry officials said they saw some good in the ruling, but that they too would immediately appeal to the 9th Circuit Court of Appeals. "We are pleased with the Court's affirmation that individual users are accountable for illegally uploading and downloading copyrighted works off of publicly accessible peer-to-peer networks," said Recording Industry Association of America (RIAA) chief executive officer Hilary Rosen in a statement. "(But) businesses that intentionally facilitate massive piracy should not be able to evade responsibility for their actions." Wilson's decision comes in the most closely watched net copyright case since Napster's demise. The two pieces of file-swapping software affected by Friday's ruling remain among the most popular downloads on the Net, although they operate deep in the shadow of market leader Kazaa. Morpheus - once the undisputed leader - has fallen to about 120,000 downloads per week, according to Download.com, a software aggregation site operated by silicon.com's publisher CNET Networks. Kazaa, by contrast, was downloaded more than 2.7 million times during the past week. The RIAA and the MPAA sued Streamcast, Grokster, and the original parent company of Kazaa's software in October 2001, and the case has been making its way slowly through court since that time. In late 2002, both sides asked the judge for summary judgment, or a quick ruling in their favour before going to a full trial. Wilson's decision in favour of the file-swapping companies on Friday was tied to that months-old series of requests. The decision does not directly affect Kazaa, at least not immediately. At the time that Grokster and Streamcast were arguing for summary judgment, Wilson had not yet ruled that the Australia-based Sharman Networks could be sued in the United States. Sharman is scheduled to meet with RIAA and MPAA attorneys in court on Monday, to argue over whether its counterclaim against the record labels and movie studios should be dismissed. Friday's ruling, however, could change the direction of that hearing. The judge's surprise ruling marked the first validation of an argument that file-swapping supporters have been making since Napster's first controversial arrival. Peer-to-peer file-trading is a technology that can be used for activities well beyond copyright infringement, and the technology should not be blocked altogether to stop solely its illegal uses, these backers have said. In making that argument, the judge looked back to the landmark 1984 Supreme Court ruling that upheld the legality of Sony's Betamax VCR. That decision helped establish the doctrine of "substantial noninfringing use", which protects technology providers that distribute products - like the VCR or photocopier - that can be used for both legal and illegal purposes. "We are absolutely very proud of this judge for having the unusual capacity to be able to grasp the technology and its future benefit to taxpayers and shareholders around the world," said Wayne Rosso, president of Grokster. "Technology is usually way ahead of courts and legislature. The fact that judge was able to acutely comprehend (this technology) is a credit to the legal system." Much of Wilson's ruling hung on the technological differences between Napster and the newer, decentralised file-swapping services. Napster's service opened itself to liability for its users' actions by actively playing a role in connecting people who were downloading and uploading songs - a little like a physical swap meet provides the facilities for people exchanging illegal material, the judge said. By contrast, Grokster and Streamcast distributed software to people and had no control over what their users did afterwards, Wilson said. When users search for and initiate transfers of files using the Grokster client, they do so without any information being transmitted to or through any computers owned or controlled by Grokster," Wilson wrote. "Neither Grokster nor StreamCast provides the site and facilities" for direct infringement. "If either defendant closed their doors and deactivated all computers within their control, users of their products could continue sharing files with little or no interruption." It didn't matter that the companies were aware generally of copyright infringement happening using their software, Wilson added - they would have to know of specific instances of infringement and be able to do something about it, to be liable for those users' actions. That stands in stark contrast to an earlier ruling against file-swapping company Aimster, in which the judge explicitly said the file-trading company did not need to know about individual acts of copyright infringement as they were happening to be held liable for the illegal activity. Friday's decision is likely to send shock waves throughout the copyright and technology communities, which have adjusted slowly over the last year to the notion that file-trading services such as these were probably illegal. Technology companies have complained that the repeated lawsuits have stifled innovation, but many also have begun to move forward in alliances with authorised music and film-distribution services. The case will certainly be appealed. Because different courts have come to very different conclusions about the law, the issue could go as high as the US Supreme Court, a process that would likely take years. "This is far from over," said Fred von Lohmann, an Electronic Frontier Foundation attorney who has represented Streamcast in the case. "This is not the end, but it sends a very strong message to the technology community that the court understands the risk to innovation." In the interim, the ruling is likely to produce another round of interest in legislation affecting copyright issue on the net - an outcome that Wilson himself foresaw. Policy, "as well as history, supports our consistent deference to Congress when major technological innovations alter the market for copyrighted materials," Wilson wrote. "Congress has the constitutional authority and the institutional ability to accommodate fully the raised permutations of competing interests that are inevitably implicated by such new technology... Additional legislative guidance may be well-counselled." John Borland writes for News.com. News.com's Lisa Bowman contributed to this report.