That pretty much sums it up. You signed LL's contract under U.S. laws. You recognise the copyrights of the creator and any other limits the creator has specified in writing beyond general copyright, and you are forced by the software limits to abide by the permissions granted inside SL (assuming you are not exploiting bugs in the permissions system).
How you can get that from what I posted is beyond me. A contract between myself and Linden Labs has nothing to do with another creator's copyright. It exists independently of that contract. Creator copyright can not be affected by my User Agreement with LL, as the creator is not a party to that contract.
If a creator wants to specify in writing limits that go further than a copyright, then he or she is creating a license contract with the buyer. That's a different thing than the LL User Agreement. That's an agreement between that creator and his or her customers. But a creator can not by fiat extend a license agreement to his or her customers--without informing them at the time of purchase.
Finally, the fact that the SL client transmits textures to user's computers unencrypted was a design decision; not a bug. It may have been a poor design decision--though I suspect not. Imagine the increase in lag if many textures had to be unencrypted every time they were downloaded.
Customer A (hereafter refered to as A) buys creator X's (hereafter refered to as X) avatar texture product, then decides she wants to make alterations to it. A pulls the textures out of the open GL render and alters the hue and saturation in Photoshop, draws a few lines here and there, then uploads it back into SL for personal use.
As she had the legal right to do--for personal use.
Customer B comes along and contacts X about the new product, and why it wasn't announced. She then begins to critcise the stylistic deviation from all of X's other products and how the quality of X's work is going down hill. It's then determined by X that it is an unauthorized derivative work produced by A based on X's textures.
No--it can't be an unauthorized derivative work if it is not republished. Copyright deals with the right to make copies. No copies; no copyright issue.
LL won't touch this with a ten foot pole because there is nothing to "take down"
Good call on LL's part. There is nothing to take down.
This situation happens several times over until X is no longer recognized as the creator of the original product because of so many personally altered versions in circulation. Yes, they are in CIRCULATION because everyone can see them. X's work has essentially become public domain by unauthorized proxy.
That's not what public domain means. The only way for a work to fall into the public domain is for the copyright to expire or for the creator (or owner) to explicitly release it into the public domain. Whether they are in “CIRCULATION” or not doesn't matter. Copyright is not trademark. You can't lose a copyright just because people violate it. There is no duty to enforce by the copyright owner under copyright law.
I'm not going to debate the the definition of LICENSE with you. I explained my definition and referenced a widely accepted definition. I have nothing else to add to what I've already said up to this point regarding license.
I don't know where you got your “widely accepted” definition, but it is flat-out wrong. A license is not a copyright; it's a contract. And like any other contract, both parties have to agree to it--even if by something as simple as an included license statement or a scripted “click-through”. You can't retroactively--and unilaterally--create a license.
That's just peachy. Instead of calling it texture theft, let's argue in favor of copyright violation and bring in personal needs, then turn a blind eye towards the potential damage that can have to the original creator. But, let's call it "fair use rights" because "personal needs" sounds less official.
Calling customers who are using your products in a perfectly legal manner, “texture thieves” does your business no favors. Fair use rights are an important part of copyright law. And it matters not whether you want to call it “personal needs” or not. They still exist. They are still the law. The consumer does not have to be bound by your undocumented “personal needs” just because you declare that they should be.