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Kristelia Garcia, Private Copyright Reform, 20 Mich. Telecomm. & Tech. L. Rev. (forthcoming 2013), available at SSRN.

Differential regulation of different technologies is baked into many of our laws, often on the basis of outdated assumptions, relative political power at the time of enactment, or other quirks. Internet exceptionalism is common, but perhaps nowhere more galling than as applied to music in the US, where the interests of terrestrial radio and music copyright owners combined to produce a regime so tangled that to call it ‘Byzantine’ is an insult to that empire.

Kristelia Garcia dives deep into the details of digital music law, focusing on two case studies that she finds promising and troubling by turns. While opting out of the statutory scheme may well be locally efficient and risk-minimizing for the participants, some of the gains come from cutting artists out of the benefits. Other third parties may also be negatively affected if statutorily set copyright royalty rates are influenced by these private deals without full recognition of their specific circumstances, or if adverse selection leaves the collective rights organizations (CROs) that administer music rights too weak to protect the interests of the average performer or songwriter. Garcia’s paper suggests both that scholars must keep an eye on business developments that can make the law on the books obsolete and that specific legal changes are needed to protect musicians, songwriters, and internet broadcasters as part of the dizzying pace of change in digital markets.

Garcia reviews the complex structure of music law, which defies summary. Of particular interest, § 114 of the Copyright Act provides for statutory licensing of the digital performance right in sound recordings in some circumstances, with rights administered by an entity known as SoundExchange. Despite serving an ever-converging audience indifferent to how its music is delivered, radio providers pay stunningly varying amounts. The Internet radio provider Pandora pays more than 50% of its revenue in performance royalties, while satellite and cable providers pay roughly 1/6th the rate Pandora pays, and terrestrial radio broadcasters pay nothing at all. But §114 also allows copyright owners to negotiate with digital performing entities and agree on royalty rates and license terms that replace the statutory licenses.

Likewise, §115 allows voluntary negotiations for royalties that replace the statutory license for musical works. Historically, performance rights organizations, primarily ASCAP and BMI, have administered the performance rights in musical works. These private organizations are not creatures of statute like SoundExchange, but they operate under antitrust decrees, with “rate courts” that review their licensing fees.

In June 2012, Taylor Swift’s record label, Big Machine, cut a separate performance rights deal with radio giant Clear Channel, circumventing SoundExchange. Surprisingly, Clear Channel agreed to pay performance royalties even for “spins” on terrestrial radio, for which there is no sound recording performance right. In return, Clear Channel received a lower rate for digital performances, and possibly other special considerations such as access to unique content. It received certainty in the form of a rate calculated as a share of revenue, rather than the less predictable per-play rate that would be owed SoundExchange under the statutory license. Big Machine may take a short-term loss, but may also receive preferential treatment for its artists. Sharing revenue means that Clear Channel no longer has an incentive to limit the number of Big Machine songs it plays, as it does under the statutory per-play royalty—and that means Big Machine is likely to get more airtime to promote its artists, which may result in increased cross-promotional opportunities.

Presumably, the parties wouldn’t have bargained around the law unless the contract benefited them both. But that’s not the end of the story. Under the compulsory license, Clear Channel would pay SoundExchange a set fee per digital spin of We Are Never Ever Getting Back Together; SoundExchange would distribute most of that directly to featured and non-featured performing artists (the latter include backup singers and session musicians, who have far less negotiating power than stars) and to the copyright holder, in proportions required by the statute. By opting out of §114, Clear Channel and Big Machine avoided the need to pay artists. (As Garcia notes, in theory artists could eventually claw back a share of such deals from record labels by contract, but the point of §114’s required distributions was Congress’s determination that artists, especially non-featured performers, lacked sufficient bargaining power to secure fair compensation in the market.) They also avoided the need to pay a share of SoundExchange’s overhead. These savings are, from others’ perspectives, externalities that the parties imposed on nonparticipants.

The deal is also an attempt to ease the grossly unjustified disparity between digital and terrestrial broadcasters, but only for Clear Channel, and the fact that legal discrimination against other Internet broadcasters remains in place creates further complications. If Clear Channel can pay less than the near-crippling performance royalties than other digital broadcasters, it obtains a marked competitive advantage. The private deal additionally allows it to predict its costs with much greater certainty—through both congressional and administrative interventions, statutory rates have changed by orders of magnitude, and they have to be re-set every few years. Separately, if the long-delayed but much-desired general public performance right for sound recordings is ever enacted, requiring terrestrial broadcasters to pay royalties to record labels, Clear Channel could well end up with an advantage over its terrestrial competitors. Even if that gamble doesn’t pay off, if the future really is in digital radio, the lower digital rate may justify paying general performance royalties.

Garcia’s second example comes from the musical work side. Sony/ATV, a music publisher, accepted a lower performance royalty rate from DMX, a digital music service that provides music programming for retail stores and restaurants, in exchange for a large advance. Again, this deal enabled the parties to avoid paying artists, who evidently lack the power to force contractual change.

Moreover, songwriters—whether contracted to Sony/ATV or not—lost out because of the deal. DMX used the negotiated royalty rate (excluding the advance) to convince the rate court to lower rates across the board, reflecting the “market value” supposedly expressed in the Sony/ATV deal. A similar dynamic is possible with the Clear Channel/Big Machine agreement, since the market value of the digital performance right looks lower, despite the terrestrial performance royalties being paid as part of the overall package.

At the same time, Sony/ATV’s withdrawal lowered the value of an ASCAP license by shrinking the size of its repertoire, and by increasing transaction costs for future licensors. Sony/ATV ultimately withdrew all its digital content from ASCAP. This is going well for Sony/ATV—in early 2013, it signed a direct license agreement with Pandora that increased its royalties by 25% over the ASCAP rate—but that’s an unsurprising consequence of adverse selection. When the strongest participants with the most valuable catalogs opt out in order to cut their own deals, the average quality/value of the remaining catalogs goes down, making the CRO less desirable. And this is true even if, as a group and on average, the participants would maximize their return by banding together.

These private deals might seem to be more efficient than statutory licenses or CROs (which operate in the shadow of government regulation, including antitrust). But they are fundamentally shaped by pervasive government regulation of the music business for the past century. They are no more proof of the superiority of the “free market” than are commercially successful technologies first developed through government R&D funding. Indeed, to the extent that the rest of the market operates under pervasive legal constraints, these exceptional deals may be even more distortionary.

Still, Garcia argues, the benefits of certainty shouldn’t be discounted, especially those available through a revenue-based rather than per-play model. (Statutory rates are also capable of using revenue-based metrics, of course, and this has often been a part of proposals to fix the statutory digital performance royalty.) However, she points out that the interests of institutional stability are unlikely to coincide with the interests of artists.

Garcia uses her examples to examine arguments made by Robert Merges and Mark Lemley about the role of property rules and liability rules in encouraging the formation of private groups that engage in blanket licensing, as the CROs do: Merges argues for property rules as incentivizing the most efficient private arrangements, while Lemley contends that owners and users can and do also contract around liability rules where that’s more efficient. The existence of evasion of both compulsory licenses and private entities such as ASCAP, Garcia argues, complicates the analysis. Among other things, she suggests, the existing structures operate as starting points allowing the parties to frame defection in mutually agreeable terms, and provide a backup solution if negotiations fail. “Neither party has to commit to the terms vis a vis all partners, nor does either party have to engage in costly, multiple negotiations, since all extradeal licenses can continue under the compulsory regime.” (P. 40.)

This portion of the paper could have used more discussion of adverse selection, as well as the related issue that the music business includes a few massive, oligopolistic entities with significant market power. Sony/ATV already represents a large bloc of artists, or at least of works. In such a concentrated market, the CRO may seem like just another layer of bureaucracy. But smaller or new entrants may join a CRO like ASCAP on nondiscriminatory terms, an option Sony/ATV generally does not offer. Instead of disintermediation and diversity, the current market structure for digital music seems to favor greater concentration—a problem explored by Tim Wu in his recent book.

Legal innovation often occurs without formal legal change. The easiest to see is when enterprising lawyers discover a formerly neglected cause of action and sets off a wave of lawsuits in the same area. Here, the innovation is different—market participants didn’t bother to opt out of the statutory schemes for decades, but the visibility of Clear Channel and Sony/ATV’s decisions means that others are likely to at least consider similar moves. In a time of diminished profits and overshadowing of traditional business models, the opportunity to lock in royalty rates regardless of changed laws, rate court rulings, and the like may prove tempting.

Garcia offers two tweaks to existing law in the absence of comprehensive reform (since even its proponents agree that it will take a very long time). First, she argues, parties who circumvent compulsory licenses should be required to follow the statutorily mandated distributions to artists, so that negotiating parties can’t benefit simply by virtue of writing them out of the deal. Second, all aspects of any private agreements used as evidence to set statutory rates must be fully disclosed, to avoid misrepresenting a deal with extra components as a market rate. These are modest proposals, and quite convincing, though the second in particular is likely to draw objections around protecting trade secrets and business models.

A larger lesson is that arbitrage opportunities, such as those produced by the differing treatment of terrestrial and digital performances, won’t be ignored forever, especially when sophisticated businesses are involved. The Internet offers many opportunities to experiment with business models. But without a sensible legal structure, the experimentation may only be in aid of externalizing costs on other parties and suppressing competition.

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Cite as: Rebecca Tushnet, Disruptive Contracting in Digital Music, JOTWELL (September 10, 2013) (reviewing Kristelia Garcia, Private Copyright Reform, 20 Mich. Telecomm. & Tech. L. Rev. (forthcoming 2013), available at SSRN), https://cyber.jotwell.com/disruptive-contracting-in-digital-music/.