Facing an investigation by the Federal Trade Commission and a class action lawsuit, Netflix has dropped plans to run a second contest on its Web site.

In September 2006, the online DVD rental company launched the Netflix Prize contest. It gave 50,000 contestants data from almost 500,000 customers, like movie information and ratings. Competitors were then asked to create an algorithm that could predict 10 percent better than Netflix how the customers would rate other movies.

That contest ended in the summer of 2009, just before Netflix announced its plans for the second contest: a program to better predict movies that its customers would like.

For the second go-around, the company announced plans to release even more customer information, including demographics like age, zip code, gender, and previously rented movies.

The announcement quickly drew criticism from privacy advocates and led to a class action lawsuit as well as an FTC investigation.

The agency contacted Netflix with a number of concerns about the second contest, from a possible violation of Section 5 of the FTC Act to the concern that anonymized information could easily be re-identified to specific consumers.

Netflix responded by agreeing to drop the contest and follow “certain parameters” regarding its use of consumers’ data in the future. For example, the company said it would not publicly release customer information for future contests and would contractually obligate researchers with specific limitations on data use.

In addition, a class action lawsuit was filed against the company, claiming that the first contest violated the federal Video Protection Privacy Act as well as California law and Netflix’s own privacy policy. One of the plaintiffs, a closeted lesbian, claimed that the release of her information made it possible for her to be outed because of the “gay-themed” movies she had rented.

The company cancelled the second contest, which closed the FTC investigation, and it settled the lawsuit with undisclosed terms.

Netflix Chief Product Officer Neil Hunt announced the cancelation on the company’s blog but left open the possibility of future contests.

“We will continue to explore ways to collaborate with the research community and improve our recommendations system so we can constantly improve the movie recommendations we make for you. So stay tuned,” Hunt wrote.

Why it matters: With privacy rights on the top of the FTC’s agenda and the subject of multiple high-profile lawsuits, Netflix’s plans to release consumer information as part of its contest could not have come at a worse time. Any company making significant changes to privacy practices and the use of customer information should be prepared to face scrutiny from the public, media, and FTC.