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Source: FreeBSD Handbook

Example:

Around this time, some rather unexpected storm clouds formed on the horizon as Novell and U.C. Berkeley settled their long-running lawsuit over the legal status of the Berkeley Net/2 tape. A condition of that settlement was U.C. Berkeley's concession that large parts of Net/2 were “encumbered” code and the property of Novell, who had in turn acquired it from AT&T some time previously. What Berkeley got in return was Novell's “blessing” that the 4.4BSD-Lite release, when it was finally released, would be declared unencumbered and all existing Net/2 users would be strongly encouraged to switch.

What does the term encumbered code actually mean?

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It is a general legal term, not specific to software or intellectual property. An "encumbrance" means "a claim by someone to some legal rights relating to something owned by someone else". https://en.oxforddictionaries.com/definition/encumbrance #1.1

For example, in the property that I live in, there is an "encumbrance" that the owners of the neighbouring property must be allowed access to do maintenance on the parts of their own house which are only accessible from the land surrounding my house.

Thus "encumbered code" means computer code that is subject an encumbrance - i.e. to a claim of legal rights by a third party.

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Encumbered code is software that cannot be freely distributed due to intellectual property rights.

UNIX Systems Laboratories (USL), later acquired by Novell, sued Berkeley Software Design (BSD) claiming parts of BSD/386 copied from Net/2 were derived from UNIX and therefore the intellectual property of USL.

In the settlement, BSD stipulated that Net/2 was encumbered by UNIX copyrights. Meanwhile, USL disclaimed any intellectual property rights to software in 4.4BSD-Lite, which left that distribution unencumbered.

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    Close, except that it's not just about free distribution - for a software to be considered open source it has to give a whole host of freedoms, including freedom to modify it and distribute modifications, and to distribute in binary form. So a lot of software that is freely distributable, for example, "shareware" software, would still be considered encumbered by the open source community. – DepressedDaniel Mar 16 '17 at 3:08
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Encumbered code here means code in Net/2 that Novell claimed to own as a result of its purchase of UNIX from AT&T. Unencumbered code means code that was rewritten in a way that preserved UNIX functionality and removed the legal headache that came with corporate ownership of UNIX.

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