Special Report -- The Pandora Wars: 'You Can't Be Victim to Congress and Success to Wall St.'

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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."

 

The Publishers Fight Back

There is general resentment in the music industry that a company with $3.2 billion market capitalization pleads poverty with the public, Congress and the CRB. Many industry executives point out Pandora's management team is now made up of millionaires.

 

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Still, some see it all as business, nothing more. One executive says that while he doesn't agree with ­Pandora's attempt to get lower rates, he also says it's unfair to paint its team as greedy millionaires.

 

"I remember a lot of years when Pandora executives were looking for hotel special rates, couldn't afford to pay for dinner with other industry executives and were flying out on the red-eye to save one night hotel payment," that executive says. "They had an idea, worked hard and managed to hold on through tight financial times, and now they are being rewarded. That is the American dream. I don't begrudge them it."

Another industry executive sees Pandora's maneuvering in rate court and the CRB as "engaging the industry in a three-dimensional chess game" and labels Pandora "a worthy adversary."

In truth, the industry's opposition to IRFA marked a rare moment of true unity. Labels and publishers don't share common interests-or a tactical approach -- when it comes to Pandora. They're competing for the same pool of money. The publishers are outraged about the split favoring labels 13-1, and have taken the strongest actions.

For its part, Pandora seems to have been surprised by the publishers, who entered the IRFA skirmish despite the fact that it didn't directly effect them. Pandora maintains that it's just protecting itself from the music industry, particularly the trend of publishers withdrawing digital rights from the U.S. performance rights societies, ASCAP and BMI.

EMI withdrew some of its catalog in April 2012 from ASCAP, while Sony/ATV withdrew all its digital rights (including the remaining EMI rights) from ASCAP and BMI on Jan. 1. Meanwhile, Universal Music Publishing Group and BMG withdrew their respective digital rights from ASCAP on July 1, while Kobalt is scheduled to do so on Oct. 1. Warner/Chappell, which originally said it would withdraw from ASCAP on July 1, has postponed until Jan. 1, 2014. As for BMI, UMPG, BMG, Kobalt and Warner/Chappell have served notice that they intend to withdraw on Jan. 1, 2014, from that society.

Publishers feel that ASCAP and BMI can't realize market rates for licensing because both operate under consent decrees signed with the U.S. government. Because of the consent decree, once a service asks for a license, it's immediately allowed to begin playing music, even before rates are negotiated.

If rate negotiations prove fruitless, each performing rights organization has a federal rate court, both in the Southern District of New York, where a rate trial can be heard. Each has a separate judge assigned to one of the respective PROs, deciding on rates.

That's why the major music publishers began considering the direct licensing route. EMI Music Publishing began exploring that option in May 2011 and actually pulled its copyrights from ASCAP in April 2012, followed by Sony/ATV beginning Jan. 1, 2013. In the case of the latter, Sony/ATV negotiated a rate equivalent to 5% of revenue from Pandora, sources say, for its songs, an almost 25% improvement from the 4.1% the service had paid out in 2011.

Since then, UMPG also has negotiated a direct deal with Pandora, and sources say it achieved an even higher rate than the one paid to Sony.

Can iTunes Put Pandora In A Box? 

Even while it engages in direct negotiations with publishers, Pandora must have had its eye on another set of negotiations: Apple conversations with labels and publishers to launch iTunes Radio in the fall. The details, now that they are known, appear to actually have been designed to put Pandora in a box.

In looking to launch a service similar to Pandora’s, Apple engaged in direct licenses rather than a pure-play license under the Webcaster Settlement Act of 2009, which calls for a per-performance rate or 25% of overall company revenue, whichever is greater. In Apple’s case, 25% of company revenue would be $39 billion. Yet, even though Apple is obtaining direct licenses, it has agreed to a rate structure that some say is higher than Pandora’s. 

On the label side, while Pandora pays a rate of $0.0012 per play per listener or 25% of revenue, the rate Apple has agreed to pay is $0.0013 per play per listener, plus 15% of advertising revenue, against a minimum of 45% of revenue or $21.25 per 1,000 listening hours. The 45% of revenue minimum is almost double the 25% that Pandora would have to pay, assuming Pandora was able to grow its advertising and subscription revenue enough so that the revenue bucket would be bigger than the per-play rate.

From any angle, it looks more expensive than the Pandora rate. And from a Machiavellian viewpoint, it looks designed to ensure that Pandora’s royalty payments will be set higher at the next CRB rate determinations. 

Meanwhile, for publishers, as part of its iTunes Radio negotiations, Apple has agreed to direct deals with publishers that will pay a rate 10% of the pub service’s revenue, or double the rate Pandora pays. And this is something the publishers plan on introducing to the ASCAP and BMI rate courts. So far, Sony/ATV, including EMI Music Publishing; Warner/Chappell; UMPG; and BMI have signed the Apple deal.

In December—when Pandora was still negotiating with Sony/ATV and aware that direct negotiations were occurring between the majors and Apple—Pandora offered up a royalty rate to ASCAP that it says was substantially higher than the one it was then paying. While Pandora and ASCAP decline to identify that rate, some say that it amounted to about 4.7% of revenue, which represented a 14.6% increase, if the equivalent increase was offered to the other PROs. 

But ASCAP turned down that rate, to the disappointment of Pandora executives. Earlier, when EMI withdrew its digital rights, Pandora perceived it as an injustice. According to documents Pandora filed with the ASCAP rate court, ASCAP rewrote its bylaws so that publishers can pick and choose which digital services they can negotiate directly with. In other words, direct negotiations would only be used by the major music publishers with large services like Pandora and iTunes Radio, while all of their other competitors would still be able to get blanket licenses that included the large music publishers.

 

The Market-Rate Showdown: Who Will Blink First? 

Pandora is being challenged on all sides by a hostile music industry, between the turndown of its offer of a higher rate, the rewrite of ASCAP’s bylaws aimed at (in Pandora’s view) Pandora, the publishers helping to scuttle its IRFA campaign, the labels designing deals with Apple that could drive up Pandora’s royalty and publishers withdrawing digital rights from PROs in hopes of achieving greater payments. 

Publishers see Pandora’s acquisition of KXMZ as a move for lower rates. Pandora insists the strategy is more about licensing security. Pandora’s motion may say it’s eligible for lower rates, but the digital camp sees that move as a way to counter the higher rate that publishers are going to make the case for in rate court.

 

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For their part, music executives have been outraged by the terrestrial acquisition, which they say turns logic on its head. Publishers claim that since terrestrial radio already pays $400 million in royalty fees, they agreed to allow their much smaller digital operations of terrestrial radio station to pay the same rate. 

 

In fact, the main gist of motions in both the ASCAP and BMI rate courts is about licensing coverage. 

To boil it down: Pandora is arguing that its consent decree licenses with ASCAP and BMI includes all of the music from all of the publishers who are now withdrawning their rights from those PROs. Pandora believes it has a BMI consent degree license that covers the period of Jan. 1, 2013-Dec. 31, 2017, and disputes any withdrawal of digital rights from the PRO license during that period. It further argues that by allowing publishers to withdraw and “extort” higher new media rates—which the PRO can then turn around and cite as a benchmark in the rate court hearing—it “seeks to make an anticompetitive mockery of the BMI consent decree and of this rate court.”

Pandora argues that it asked ASCAP for a license beginning Jan. 1, 2011, and has been operating under an interim license; since it owns KXMZ, it claims it’s now eligible for the rates negotiated by the Radio Music License Committee and has asked the court to rule under the consent decree that the EMI withdrawal was invalid.

Executives in the publishing community respond that just because Pandora asked for a five-year licensing period doesn’t mean it’s entitled to it. What if Pandora had requested a 50-year license?

ASCAP filed a petition with the FCC to deny Pandora’s acquisition of the Rapid City terrestrial station. The petition labels the acquisition a “theatrical media stunt designed to draw attention to what Pandora wrongly perceives as an unfavorable royalty payment structure.” ASCAP makes the argument that investment advisor ownership of Pandora’s stock may tip it beyond the 20% threshold applied to foreign ownership of a U.S. media property, another reason to deny the acquisition.

Meanwhile, the publishers and Pandora are maneuvering over how the direct licenses will be presented in rate courts. Which brings up the question: What is market? Is it the 1.7% of revenue that terrestrial radio pays? Is it 4.3% that Pandora paid? Or is it the 10% that Apple has agreed to? 

While Sony/ATV achieved a higher rate of 5%, Pandora argues that’s not a market rate because Pandora “had a gun to their head,” in the words of one executive sympathetic to Pandora’s position. When it was negotiating with Sony/ATV for the direct license, it requested a complete list of Sony/ATV’s ASCAP copyrights so that it could pull those songs if it couldn’t agree on direct deal. But, according to the rate court document filing, Sony/ATV told Pandora to get that list from ASCAP, and the PRO supposedly ignored Pandora’s request. Likewise, BMI also refused to provide a list of Sony/ATV copyrights, according to Pandora filings with the rate court.

Since it didn’t have a list of Sony/ATV’s songs, Pandora couldn’t pull them and would have been in copyright violation if it didn’t agree to the Sony terms. 

But a lawyer who often represents the publishing community says Pandora has it backwards: The publishers have a gun to their head because of the compulsory license and the consent decree. 

As for the deal Pandora has since negotiated with UMPG, apparently it’s a short-term contract that protects Pandora from copyright infringement. Sources say it achieved an even higher rate than Sony/ATV did for its ASCAP registered songs. Will the court view UMPG’s deal with Pandora as a market-negotiated rate? If UMPG provided a list of its ASCAP songs to Pandora, then the service had a choice on whether it wanted to pull UMPG’s songs or agree to a rate.

And if the publishers want to go to a direct world, they better be prepared for the consequences, say executives in the digital service providers communities.

“Pandora prefers to license under the blanket license where songs don’t compete on price,” Pandora’s Harrison says. “That’s part of the reason Pandora is able to play songs from more than 100,000 different artists every month. In a world where songs compete on price, there will be winners and losers.” 

While services like Spotify may need the entire catalog, Pandora can still function nicely with fewer tracks. It’s not like every song in the world that sounds similar to a particular track is needed to satisfy users.

“I don’t know how he did it, but [Sony/ATV chairman/CEO] Martin [Bandier] has convinced these smaller publishers that they will get the same rate as the bigger ones,” the lawyer says. “But digital services could run a service without songs from Diane Warren, even though she is a phenomenal writer. When they don’t get offered the same rates or the digital services begin pulling down catalogs, they will get painted with the same brush of screwing the publishers, but at the end of the day, the publishers are screwing themselves.”

Another lawyer who works with music digital services says, “The thinking that the large publishers can withdraw their songs from the PROs will result in everyone’s rate going up is just nonsense.” 

But all that’s a long way off. In the next few weeks, the ASCAP rate court is expected to decide if Pandora has a license in effect that covers the publishers that are withdrawing digital rights, with the actual rate trial expected to begin in the fall. The BMI rate case is still in the early stages. And if the FCC rules in favor of Pandora’s move into the terrestrial radio world, it could impact any rate court rulings. Meaning the end of this war in nowhere in sight.