Why Spotify's Appeal of The CRB Rate Decision Is A Huge Deal For Songwriters And Publishers

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Spotify

Is Spotify suing songwriters? The company says no.

But it did file an appeal to the Copyright Royalty Board’s rate determination, which consists of a three-step formula that ultimately produces a royalty amount that is paid to publishers, and thus songwriters, in exchange for a mechanical license -- or, in other words, for the right to host the song. This formula has been in use since 2008, the year Spotify debuted, when on-demand streaming was still in its infancy.

Songwriters and publishers were both very happy with the CRB rate determination handed down in January 2018, which saw the three-step formula percentages increase for songwriters, publishers and performance rights organizations substantially from 10.5 percent to 15.1 percent through the end of 2022. At the same time, the decision increased the other percentage barometer for establishing the publisher payout from 21 percent of what Spotify pays labels to 26 percent of what it pays to them. Yes, indeed, they were very happy.

 

Which helps explain why songwriters, publishers and trade groups were upset when Spotify, alongside Google, Pandora and Amazon, filed a notice that it would appeal the CRB’s rate increases.

If anything is changed in the formula due to the appeal, the result could decrease the amount of money that would have been paid to songwriters and publishers if the determination was left to stand. So while Spotify may not technically be suing songwriters, it’s a sure bet the company is hoping for an outcome from its planned appeal filing that may make songwriters unhappier than they are now.

What Does Spotify Want?

In its blog post on the appeal, Spotify says it thinks songwriters should be paid more than they were getting under the prior five-year license; and it also says it supports the 15-percent-of-total-revenue rate, one of the three prongs in the rate formula used to determine payments for publishing royalties.

Instead, it says a key aspect of its appeal will be over how the formula applies for bundles. But every type of service is based on the same three-step formula, with slight variations depending on the type of service. (Spotify didn't respond to a request for comment by press time.)

Moreover, the other services filing an appeal -- Amazon, Pandora and Google -- might be focusing on a different aspect of the CRB determination. So the digital services likely will be arguing to change some aspect of that formula, which again would lower payouts to songwriters.

During the rate trial last January, most of the digital services, including Spotify, argued that rates should stay the same, meaning holding the rates 10.5 percent of total revenue or 21 percent of payments to labels, whichever is greater. So yes, in effect, the services were arguing against the increases that ultimately were awarded to songwriters and publishers in the rate formula. Additionally, all the services also were asking that the mechanical floor component -- more on that below -- be eliminated, which, if that were granted, might even result in a drop in overall publishing payouts.

There’s no telling which angle the digital services will use to appeal. One could be appealing the process by which the CRB judges reached their decision. If that’s the case, and the Appellate court judges agree that the process was flawed, they could reject the latest determination and leave things as they were previously. That also would make songwriters unhappy.

What Is The Rate Formula?

Either way, the key to the appeals will likely revolve around the rate formula, which is complicated. Moreover, it is an “all-in” formula, because it sets the amount for mechanical licenses by also taking into consideration the performance royalties paid to performance rights organization by digital services. The latter payments are set through negotiations between the PROs and the services, or, if those negotiations fail, a consent decree imposed by the rate court.

Essentially, the rate formula is calculated by the greater of three distinct buckets of money as mandated by the CRB: percent of total revenue; percent of payments made to labels; and the mechanical floor, determined by subscriber count. But it’s a little more complicated than just that.

The first part of the all-in formula determines what is known as the headline rate. The CRB judges ruled that the headline rate, which previously was 10.5 percent of total revenue, will increase each year between 2018 and 2022 by about one percentage point, beginning at 11.4 percent of revenue for 2018 until it hits 15.1 percent in the final year of the license. Most of the digital services, including Spotify, wanted the CRB judges to hold that rate at 10.5 percent.

The rate formula also includes a second step, which measures the percentage of revenue paid to the labels for royalties on sound recordings. Whichever of those two produces the most revenue is chosen to be the bucket used as a measurement in the final step of the formula. According to the latest CRB ruling, the total cost of this second bucket -- which previously was set at 21 percent for the five years before 2018 for paid subscription tiers -- will be measured at 22 percent of content costs in 2018, rising by a percentage point each year until it reaches 26.2 percent in 2022.

Confusing, right? Here’s an Example

Consider the month of September for Spotify’s paid tier for portable on-demand streaming. According to the statements the company and its agent, the Harry Fox Agency, sent to publishers for that month, the service had total revenue of $157.1 million, while its payments to labels totaled $84.3 million. So for Spotify, 10.5 percent of total revenue comes out to $16.5 million, while 21 percent of payments to labels comes out to $17.7 million. The latest rate determination by the CRB eliminates an intermediate step but when that  step was used for determining the Spotify publishing payment in September, it still ultimately resulted in the 10.5 percent of revenue being measured against the 21 percent of content bucket, with the latter bucket being the greater amount so that means the $17.7 million advances to the next step in the formula.

At this point, the formula calls for subtracting performance royalties, which for Spotify usually hover around six percent of total revenue for each month. In September, that performance pool totaled $9.4 million, which, subtracted from that $17.7 million, leaves a bucket for this second step of $8.3 million.

And that brings us to the final step: building another bucket by multiplying each paid Spotify subscriber by 50 cents, also known as the mechanical floor. With 23.175 million subscribers in September, this final bucket totaled nearly $11.6 million. Since that $11.6 million is greater than the $9.16 million from the second step, the $11.6 million became the mechanical royalty bucket that is paid out to publishers and songwriters.

What’s the Final Publishing Royalty Payout?

Remember, there are two royalties being paid here: performance royalties, which are paid to the PROs; and mechanical royalties, which are paid to publishers and songwriters, and which we just determined through the rate formula above.

When you add the performance pool of $9.4 million to the mechanical pool of $11.6 million, it combines for a total publishing payout of nearly $21 million for that month of September, which comes to 13.35 percent of Spotify’s total revenue, or 24.9 percent of its payments to labels. Notice that those revenue totals are both larger than the new headline rate of 11.4 percent of revenue, and the 22 percent of payments to labels, as mandated by the CRB.

In 2018, Spotify’s paid tier for the entire year distributed $244.4 million to publishers, or 13.37 percent of the $1.227 billion in total revenue its paid tier produced. That means, for Spotify, the main determining factor every month is not the 10.5 percent of total revenue, nor the 21 percent of payments to labels. It’s the 50 cents per subscriber cost -- the mechanical floor. In fact, according to the CRB decision, in 2015, the mechanical floor was triggered as the payment mechanism about 43 percent of the time for all digital services, rather than total revenue or payments to labels.

The Real Battle Is Over The Mechanical Floor

During the CRB rate trial, Spotify and practically every other digital service argued that the mechanical floor mechanism should be eliminated from the formula. They claimed it added uncertainty to their business models, and that it often resulted in a “windfall” to copyright owners. The CRB judges ruled against them and kept the floor as the final step in the formula.

With that floor kept in by the judges, if history is any indicator, the end result each month could produce a payment greater than both percentage metrics used in the formula’s first two steps. That means that the rate likely would rise above the 15 percent level Spotify says it supports -- which might happen even before 2022, when the 15.1 percent headline rate is officially set to kick in.

If the services appeal the mechanical floor and get it eliminated, it very well could result in a reduction of payments to songwriters and publishers, despite the statements that Spotify is now making regarding bundles. This reduction is probably what the other services are trying to achieve with their appeals, even if Spotify itself is true to its word and limits itself to appealing the bundling component. In any event, removing the mechanical floor would surely make songwriters unhappy.

How Else Could Digital Services Reduce Rates?

The other way the services could get a reduction in payments would be to ask for a broader definition of “service revenue,” which would increase the amount that services can deduct from its total revenue calculation. Or, for mixed bundles, the ask might be for a change in the parameters of what qualifies. In looking at service revenue, if, for example, a service is allowed to deduct up to 15 percent of its total revenue due to costs -- like commissions it has to pay for bringing in advertising, or marketing costs in attracting paid subscribers -- the reduction of total revenue also would reduce publishing payouts, because it would affect the percentages in the rate formula.

During the CRB rate trial, Spotify asked for the reduction to be broadened so that it can subtract more costs for things like app store payments -- over which it just sued Apple in the European Union -- as well as expenses for carrier billing and credit card transaction fees.

What Will Happen With The Appeal?

The appeal can play out any number of ways. The appeals court could modify or vacate the determination and remand it back to the CRB judges with instructions on how to further proceed; or the appeals court could enter its own determination and look at any number of factors brought up by the digital services during the appeal.

In other words, the appeals process could turn into a can of worms for publishers and songwriters who were happy with the CRB determination and increases they now have.

One lawyer who works on behalf of digital services claims the appeal has a very small chance of succeeding, and believes that the appeal courts will defer to the CRB judges’ decision. But while it may be unlikely in that lawyer’s view, the services have at least one thing going for them: the determination was a split decision, with CRB Judge David Strickler actually agreeing with the services to hold the rates at the same levels as the preceding five year period.

But given all that, it will certainly be interesting watching Spotify make whatever case it’s going to make in light of statements that it has already publicly made to the SEC. As it does from time to time, the SEC queries publicly-traded companies on their filings to ensure that the publicly-traded companies are disclosing all relevant information to shareholders.

In February 2018, the SEC specifically wanted to know why the CRB board rate increase “will not materially impact your business, operating results and financial conditions.” In early March 2018, Spotify answered that, because of the mechanical floor of 50 cents per subscriber, the new percentages won’t have an “immediate impact” on its results for 2018 or 2019. Moreover, it added, because of discounts decreed by the CRB to the student paid subscription plans from 50 cents to 25 cents, and the introduction of a family plan rate of 75 cents per subscriber, the company said it “does not expect the resulting U.S. mechanical royalty payments to be greater than the royalties the Company would have paid under the prior royalty rate structure.”

If its payments are likely to stay at the same level for the next two years, even with the rate increases, then anything that Spotify or the other digital services are appealing, if successful, seem likely to result in a rate decrease. And that, indeed, would make songwriters and publishers unhappy.

This story was edited so that the old CRB rates from the preceding five years were used in calculating Spotify’s September publishing payments, instead of the new CRB rates.