Online Music Companies Outplayed

By eweek  |  Posted 2001-01-29

Online Music Companies Outplayed

The music lovers dream of a digital "Celestial Jukebox" has turned into an entrepreneurs nightmare, and critics maintain major record companies are to blame.

Using aggressive lawsuits, outrageous licensing demands and strong-arm tactics that range from refusals to share promotional materials to monopolistic threats, Internet music executives said the powerful recording industry has made it nearly impossible for dozens of companies to profit from their dreams of using technology to transform the music business.

The five major record companies, which have grown fat and powerful as middlemen in the brick-and-mortar world, are using their copyrights as bludgeons against musics digital new wave, they said.

"The labels have been incredibly reluctant to license their catalogs to anyone in the digital world, because its all about control," said David Pakman, founder and president of business development and public policy at Myplay, an online music locker service. "If they want to license their catalog to you, they want to be restrictive, because they dont want you to do things they havent thought of. They dont want someone else to build a humongous business that they are not a part of."

As a result, dozens of music start-ups, including and, have gone out of business. Of those that have survived, many are limping along on the cash reserves they built up two years ago because venture capitalists are afraid to fund them. Shares of publicly traded Internet music companies have fared far worse than the rest of the industry, even though the controversial, but wildly popular, file swapping service Napster clearly demonstrated the huge demand for digital music.

Record companies, for their part, insisted they have a right to control the ways others use their music. Their copyrights, after all, represent a substantial financial investment. Embracing Internet distribution while protecting copyrights, they said, is an enormous challenge theyre working hard to meet.

"We are agonizing to make every realistic, fair deal that we can make," said Ted Cohen, vice president of new media at EMI, one of the five major record labels. "It has to be equitable all around, but there is no desire to be onerous and unfairly restrictive."

Some critics and legal experts, however, said the industry is being just plain greedy.

"Anything that allows flexibility or allows someone else to make money, theyre not willing to do," said Pamela Samuelson, co-director at the University of Californias Berkeley Center for Law and Technology. Some of their practices, she said, "raise serious antitrust questions."

But the president and chief executive of the powerful Recording Industry Association of America (RIAA) said she is "puzzled" by the accusations of controlling tactics. "I think its silly," Hilary Rosen said. "Its obvious its in the record companies interests to expand their distribution options." Rosen said she is frustrated by the "sense of entitlement" she sees at many Internet start-ups. "Some companies say: Because I want it, you should license it. Clearly, the business model has to make sense."

Critics understand the major labels are merely trying to protect their established businesses from inevitable change that threatens their strength. But in doing so, they said, they have strayed far from the original intent of copyright law.

"The law says nothing about control," said Jonathan Potter, executive director at the Digital Media Association (DiMA). "Its about enhancing creativity for the public good. If the copyright holder isnt putting out content, then how is it benefiting society? Have we lost our focus on incentive?"

The controversy has caught the attention of Senator Orrin Hatch, R-Utah, chairman of the powerful Senate Judiciary Committee and a musician. He issued a harsh warning to the record industry in a recent address at the Future of Music Policy Summit in Washington, D.C.

"I do not think it is of any benefit for artists or fans to have all the new, wide distribution channels controlled by those who have controlled the old, narrower ones," he said. "This is especially true if they achieve that control by leveraging their dominance in content or conduit space in an anticompetitive way to control the new, independent music services that are attempting to enhance the consumers experience of music."

Some members of DiMA are calling for legal remedies, in the form of so-called "compulsory licenses," which would require the record labels to open their collections to third parties on preset terms.

DiMA, which was launched two years ago, now has more than 70 members, including America Online and RealNetworks. It is building a lobbying presence in Washington. However, it has a formidable opponent in the established and influential RIAA, which maintains that broad compulsory licenses would impose terms that dont fairly compensate them for their investments in artists. Licensing terms should vary according to the business model, record company executives have said, and should be negotiated case by case.

Meanwhile, as the debate rages over whats fair play, more and more Internet music companies are going under.

"Its a little scary to see an entire industry folding in on itself," said Philip Fracassi, senior vice president of production and distribution at House of Blues Digital. "All the content is in the hands of five companies — its a very scary thought."

The Changing Business Model

The Changing Business Model

Since the beginning of recorded music, record companies have owned a pivotal position in bringing the sounds of artists to the ears of consumers. But when the revolutionary MP3 technology first burst onto the scene, allowing music files to be made small enough to easily zip around the Internet, the world was ripe with exciting new possibilities. Consumers could have access to far more music than flows through traditional channels, perhaps via a "celestial jukebox" device that could access every song ever recorded.

That promise threatens the record industrys traditional business model.

A record company makes money by signing contracts with artists it thinks are likely to sell records. In exchange for the rights to their recordings and a cut of the profits, the company markets and advertises the artists and pays the costs of making and distributing CDs. But, guessing which artists will succeed isnt easy and recording costs are high. Since most of the picks are not profitable, record contracts tend to give a sizable cut of CD sales to the record labels — many times more than what the artists get — and require that the artists pay back CD costs from the royalties they earn.

EMIs Cohen compared the record companys role to that of a venture capitalist: investing in many opportunities, most of which fail, but profiting from the successes.

Once a significant fraction of music sales are in digital form, however, the economics suddenly change. A lot of attention has been given to file sharing technologies, and how hard it is to collect payments. But the record industry has a bigger problem. On the Internet, music can be recorded and distributed far more cheaply, so this sort of intermediary role may no longer be necessary.

To Eben Moglen, a law professor at Columbia University and a self-proclaimed anarchist, record companies "are irrefutably dying. The economics of their industry are unsustainable."

Most critics, however, arent predicting the demise of the record industry, at least in the near term. But, they said, uncertainty about their future is behind the big labels attempts to control the start-ups business models, at the expense of consumers and artists.

Troubles With Licensing

Troubles With Licensing

Following the MP3 revolution, there was an avalanche of start-ups trying to build innovative businesses on digital music. From music and music video download sites and Internet radio stations, to sites that evaluate musical tastes and custom CD creators, there was a rush to use technology to change the way consumers get music.

But most of these businesses required licenses from all the major record labels — which control more than 80 percent of available music. In the brick-and mortar world, by contrast, retailers can get all the music they want to sell at a standard price.

Those who tried to run their businesses without the proper licenses have been hit with aggressive litigation. And those trying to negotiate said the terms offered by the major labels were not viable. Executives said they were asked for large advances, outrageous fees and even chunks of equity — sometimes 30 percent to 40 percent of their companies.

"Its difficult because people are trying to create business models out of the dust," said Fracassi at House of Blues, which has found its niche by offering Webcasts of live concerts. Companies arent going to get favorable licensing deals "unless you have another aspect of your business that you can use to leverage the labels to work with you. They dont think they need any more promotion on the Internet."

Two years ago, New York-based Sputnik7 asked Sony Music Entertainment for some videos to add to its fledgling entertainment site. While major record companies actively try to get their videos played on cable channels, Internet executives said, their attitude is entirely different when dealing with Internet companies.

"When we asked Sony for videos — and we didnt want their mainstream videos; we were looking for the cutting-edge stuff that they probably could not get played on cable anyway — they just said, No, " said David Beal, Sputnik7s CEO. "They were looking for ridiculous amounts of money, or a piece of the company. It was ridiculous. Sony wanted a huge piece of equity in the company.", a custom CD site, closed its doors this month because it couldnt get enough music to retain its customers. It had obtained only one licensing deal, with EMI, in exchange for a 40 percent stake in the company. "Clearly, there are more music companies than 40 percent equity chunks," said Larry Lieberman, the former president of global marketing at the company. last year chose to walk a fine legal line, claiming that its service, which allowed users to stream their music from the companys Web site, was "fair use" and didnt require a license. The RIAA sued the company because its service transferred the music from a central database, rather than requiring users to upload it. After losing initially, MP3 reached settlements with the major labels. But other Internet companies said the labels are now using that deal as a precedent, making the onerous licensing terms accepted under duress the baseline for the rest of the industry.

"They take the weakest link, then they put their boot on their throat, and that becomes the standard for everyone else," DiMAs Potter said.

Meanwhile, many companies, unable to make viable licensing deals, limit their services to what they can safely do without a license. Such compromises, they said, hurt their ability to innovate and lure customers.

"The licensing process has been so arbitrary and has been done on terms that are not viable for business," Myplays Pakman said. "Its easy to get licenses — you just have to agree to really bad terms."

Myplay was the first company to offer an online "locker service" like MP3.coms. For now, Myplay requires its users to upload their music, although a central database makes the process far easier. Pakman said hes been negotiating with the labels for a license for such a database for more than a year, but the terms were never favorable. Now, he said, the licensing costs four times what it did before the settlements.

Pakman said the labels wanted 1.5 cents every time a song is transferred from the database and .25 cent to .5 cent each time its played, making it impossible to support the service by advertising alone. He said he doesnt believe consumers will pay to play music they already own.

"The general point is that what everyone is doing is brand new in every shape and form," said Bob Roback, president of Launch Media. "We would like all of the record companies to be doing music video-on-demand licenses and broader grants of licenses for the use of audio."

Launch has considered offering a locker service from time to time, he said, but "as soon as weve requested a term sheet, we look at that and we cant find a way to make the numbers work."

If companies want to make a profit from offering locker services to consumers, they should have to pay a rate that makes sense for the label, EMIs Cohen said. "Owning the movie [on DVD] doesnt give you virtual rights to it wherever you go."

The Digital Millennium Copyright Act, an addition to the copyright law enacted in 1998, provides a compulsory license for noninteractive Webcasts that are similar to radio programs. But no price was set, so companies wishing to take advantage of the license must negotiate with the RIAA as the agent of the labels, or submit to an ongoing arbitration.

Meanwhile, Potter said, several Internet companies said they could not get the standard promotional clips available to terrestrial radio — unless they agree to negotiate with the RIAA instead of taking part in the arbitration. Potter thinks the RIAA wants to use such deals to influence the arbitrated price.

Given the popularity of Napster-style services, the Internet music industry is trying to move toward subscription models, where consumers pay a monthly fee to access a large collection of music. But while many companies want to offer such services, only one, Streamwaves, has gotten a license from a major label, EMI, to launch one. Some Internet companies said the labels seem to want to limit such services — or offer those themselves. Universal Music Group has launched its own streaming subscription service at

Hatch has signaled that licensing practices are something he has his eye on. "I expect to see the market provide fair, nondiscriminatory licensing of music, not just cross-licensing among major labels," Hatch said in his recent address. "I intend to do what I can to see that happen."

Encryption Equals Control

Encryption Equals Control

For now, digital media companies are focused on licensing, but legal experts said a recent law protecting encrypted content provides yet another means for the record industry to control the market.

The Digital Millennium Copyright Act includes a section that makes it illegal to circumvent technological measures that control copying or accessing copyrighted material. In other words, once a song is encrypted, hacking the encryption is against the law.

The record and movie industries pushed for the provision, saying it was necessary to prevent tools that enable illegal copies of content from being widely disseminated.

Legal experts argued, however, that there are legitimate reasons for hacking the record companys protections, such as "fair use" rights for consumers to copy content for which they have already paid.

Moreover, critics said, encryption schemes enable entertainment companies to dictate business models to the rest of the industry. Entertainment companies can include usage rules as part of the encrypted content, or they can require other companies to support their preferred business model before they get access to the keys.

But in the computer industry, there is a tradition of reverse-engineering products in order to compete with them. For instance, Compaq reverse-engineered the BIOS — or basic input/output system — on the IBM PC to enable software written for IBM computers to also run on a Compaq PC.

The Digital Millennium Copyright Act provision has exemptions for reverse-engineering and encryption research, but many legal experts said theyre too narrow.

Last year, the movie industry won a court battle to protect its DVD protection scheme; the ruling said the owners of the Web site could not post or link to software that defeats the protections for DVDs. The ruling prompted an outcry from copyright lawyers and civil liberties advocates, who said the law violates the First Amendment and should be declared unconstitutional. The case is now being appealed.

While it hasnt yet proven popular, the recording industry, too, is selling encrypted content. And efforts like the Secure Digital Music Initiative are attempting to develop a secure framework for music distribution.

Cohen said hes sympathetic to the movie industrys position on DVDs.

"When DVD came out, you could buy high-quality movies for 20 bucks," he said. "Then someone says: Im striking a blow for freedom. Im cracking the protection scheme. In the last year and a half, weve gotten to the point that, because it can be done, its OK."

What Now


What Now?

While people on all sides of the debate acknowledge the growing tension, the digital media industry is on hold, waiting for the various battles to play out in the courts, and possibly Congress.

Many of the new media executives took heart from Hatchs recent speech. "We need to think as creatively about licensing options, about technological and legal and legislative solutions, as music creators and technologists think about their creations," he said.

Meanwhile, EMIs Cohen is optimistic that the record industry can meet the challenge of the Internet.

"The music business is always full of innovation, followed by incredible apprehension, followed by assimilation," he said. "There is no easy solution to all this, but Im really trying to contribute toward working toward it."

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