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On June 11, Pandora went in an unusual direction for a digital company: backwards.

That's when the online radio giant announced it was buying a terrestrial station, KXMZ-FM, which plays AC hits out of a small basement studio on Main Street in Rapid City, S.D. For the 42,000 Pandora users who live in the Rapid City area -- or at least, those of them that might start a personalized Pandora stream around Michael Buble or Maroon 5 -- that was great news. But for the music industry, it was a far less welcome development.

Labels and publishers saw the move as Pandora's attempt to use KXMZ to win the same royalty rates that Clear Channel (and the company's Internet radio property, iHeartRadio) has with ASCAP. If successful, it could mean a 25% reduction in royalty payments to music publishers.

"Any shred of credibility that Pandora had as the songwriter's partner is now gone," National Music Publishers' Assn. president David Israelite said at the organization's annual meeting the next day. "They are waging war on songwriters. Instead of negotiating as a partner, Pandora has decided that it will pursue their business model through lawsuits and gimmicks, and will try to fraudulently sneak in the back door with a rate that wasn't meant for them."

Pandora, of course, sees this as fair play, not overt hostility. "We don't believe we are at war with anybody and don't want to be painted with that very negative brush," assistant general counsel Christopher Harrison says. "If you go back to December [2012], we were willing to pay [the publishers] higher than before and significantly more than our competitors like Clear Channel. We wanted to avoid going to rate court, and we tried to settle this in good faith. If there is a fight, they picked it."

There is a fight, and at stake is millions of dollars -- Pandora paid 60.6% of revenue, or $258.7 million of the $427.15 million it generated for the year ended March 31, 2013, to music rights holders. And if analysts are correct that Pandora could double its audience of 70 million in the next two years, we could be talking about much more-up to $2 billion, if Pandora could match the monetization rate of terrestrial radio.

That's one reason why music rights holders -- labels and publishers -- are so outraged over what they see as Pandora's lackluster efforts to monetize its audience while implementing a series of actions aimed at reducing royalty rates. For its part, Pandora claims the rates are unfair, and don't allow the webcaster to compete with terrestrial or satellite radio. The 60.6% of revenue Pandora pays is almost five times the 12.5% of revenue that Sirius XM says it pays to labels and publishers. Pandora would say all it wants is an even playing field.

To understand the battle lines, you have to understand how Pandora pays rights holders. According to the 2009 Webcasters Act, labels are paid the greater of two buckets: 25% of company revenue, or a per-play, per-listener rate of $0.0012. To date, the latter bucket creates the larger amount of royalties. Payments to the publishers are established by negotiations with performance rights organizations like ASCAP and BMI, which are constrained by a consent decree and mediated by a rate court. ASCAP's rate is 1.85% of revenue, while BMI's is 1.75%. Both are currently in rate court, with Pandora having initiated action against ASCAP last November and BMI initiating action the day after Pandora announced the KXMZ purchase.

Why has the conflict intensified? Major publishers have withdrawn their digital rights from the PROs to negotiate directly with Pandora, a move Pandora is fighting in rate court. In the next few months, the Federal Communications Commission has to rule on whether the KXMZ purchase can move forward, and the rate courts will rule as well. There's also the coming launch of iTunes Radio, which has brought two questions to the surface as Apple has conducted its own negotiations with labels and publishers: What's the market rate for Internet radio royalties? And has Pandora, as some in the industry charge, been lax in selling advertising in order to swell its listener base and better compete with Apple?

Another question looms over the situation as well: Has Pandora finally been painted into a corner?

 

The Westergren Factor

In 2007, Pandora founder Tim Westergren made his first trip to Capitol Hill. Few in D.C. knew what Internet radio was, much less who the lanky 6-foot-2 Westergren was.

Six years later, after more than 200 meetings with senators, representatives and their staff, nearly all members of Congress recognize Westergren. Some see him as a minor celebrity, pulling out their iPads to show him what they're listening to on their Pandora channels and inviting him to speak at group functions.

Speaking in front of crowds comes naturally to the 47-year-old Stanford University graduate, who comes across as low-key and likeable. In the early days of Pandora, Westergren took to the road in T-shirts and jeans to evangelize his personalized radio service, hitting as many as a dozen cities a month, speaking in front of grade school children, nursing home residents, Fortune 500 executives and just about anybody else who'd listen. He's done about 500 town hall gatherings so far, covering every state in the nation except for Oklahoma, Alaska and Hawaii.

Though Pandora has its own lobbying firm, Twin Logic Strategies, it's Westergren who has become the face of Pandora -- the one with whom lawmakers will take meetings because they're aware that he's capable of whipping up a formidable grass-roots campaign that could flood their offices with emails, letters and phone calls.

The RIAA learned this the hard way when it went up against Pandora in 2009 regarding the Webcaster Settlement Act that was established that year. The RIAA -- which spent $2.6 million on lobby­ing compared with Pandora's $140,000 in the first half of this year -- underestimated the effect of an Internet-fueled grass-roots campaign that inundated lawmakers with "Save Pandora" calls and emails. Webcasters, led by Pandora, argued that the rate set by the Copyright Royalty Board (CRB) would put webcasters out of business and successfully lobbied lawmakers for a compromise rate. Those rates are due to expire at the end of 2015.

Pandora led a similar effort to get its listeners behind the Internet Radio Fairness Act of 2012. Instead of commercials, Pandora listeners heard entreaties to contact Congress to support IRFA, which saw streaming music companies seek lower royalty payments to labels more in line with satellite radio.

At the height of the IRFA public relations battle, publishers stepped in and voiced their dissatisfaction with Pandora's rates. They complained that out of Pandora's 60.6% revenue outlay, publishers and songwriters got only 4.3%, with labels and artists claiming the remaining 56.3%. That works out to a 13-1 ratio favoring labels over publishers, while with most other digital services, the ratio is closer to 5-1.

With the music industry in general condemning IRFA and Pandora's message muddied by the music publishing protests, the legislation never came to vote. Rep. Jason Chaffetz, R-Utah, promises to reintroduce the act this year, however. The RIAA, and other groups representing rights holders, have come out with guns blazing, galvanizing high-profile artists to their side.

And that's not the only way the dynamics have shifted. Pandora is a publicly traded company with $427 million in revenue and a market valuation of $3.2 billion. While Pandora has racked up more than $56 million in net losses since going public in 2011, its revenue and audience continue to grow, doubling in the last two years to roughly 70 million listeners a month.

"There's a fundamental tension on Capitol Hill for public companies," RIAA spokesman Jonathan Lamy says. "Legislation is often about helping victims. Wall Street is about survival of the fittest. Those are two contradictory messages. You can't present yourself as a victim to Congress and as a successful company to Wall Street."

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