The E-Music Trap

Pushed by the popularity of MP3 files and song-sharing sites such as Napster Inc., music labels are the first players in the entertainment industry to jump -- for the most part, unwillingly -- into online digital distribution.

"The record companies must compete online," Time Warner Inc. President Richard Parsons said at market researcher Jupiter Communications Inc.'s recent Plug.In Forum 2000 online music conference in New York. "The legitimate players in the business have been missing in action."

All eyes are on the five major music labels -- Universal Music Group Inc. (a fully owned subsidiary of Seagram Co. Ltd.), Sony Music Entertainment Inc., EMI Group PLC, BMG Entertainment (the music unit of Bertelsmann AG) and Time Warner -- as they untangle the issues of copyright, royalties, and secure distribution in an attempt to capture a share of an online music business that is expected to be worth US$5.4 billion by 2005 in the United States alone, according to Jupiter.

The biggest stumbling block for music labels has been the issue of copyright, particularly when it comes to paying royalties. For the labels to tap in to the gold-mine potential of their back-music catalogues, all artist contracts need to be revisited to include royalties generated from digitally downloaded music.

Furthermore, it didn't help that the music labels shied away early on from establishing a user-friendly copy-protection scheme to protect their music from being downloaded, copied and traded without payment to the labels, leaving an opening for Napster to launch its music file-sharing software and Web site.

They retaliated by filing a copyright-infringement lawsuit against the company.

At the very least, Napster -- which claims it has 21.3 million current users and adds a million users per week -- has proven there is a huge demand for downloadable music.

When a federal judge issued an injunction in July requiring Napster to shut down its file-sharing of copyrighted material while the Recording Industry Association of America Inc. (RIAA) lawsuit was pending, users flocked to free file-sharing sites, such as Gnutella and Scour, and continued to do so even after Napster was granted a temporary reprieve from the injunction.

"If Napster were to get shut down, users would very rapidly ... coalesce around one of the Napster-related sites," says Eric Scheirer, a media and entertainment analyst at Forrester Research Inc. in Cambridge, Massachusetts.

"These sites set the bar for what the industry needs to provide."

Thus, the major music companies are finally responding to the surge in popularity of Napster and similar sites by implementing online distribution schemes of their own.

"The major labels were all scared of [online digital music], but now they've overcome that fear and are starting to come to grips with the technology," says Simon Scott, vice president of strategic markets at InterTrust Technologies, a digital rights management company in Santa Clara, Calif., that has been hired by Universal Music Group and America Online Inc.

Universal, Sony and EMI have announced plans to offer digital music downloading subscriptions by the end of the year and have already begun pilot programs that offer individual music tracks for digital download, with prices that range from $1.99 to $3.50. BMG and Time Warner -- which will combine its music unit with EMI by the end of the quarter -- are also expected to launch similar services by the end of the year. Time Warner (through its Warner Brothers Music Group division), BMG and EMI have also settled their lawsuits against MP3.com Inc. and have struck licensing deals with the music downloading site. Sony and Universal, however, have yet to reach settlement terms with MP3.com.

The popularity of file-sharing sites has shown that the major labels are losing their case in the court of public opinion, which points to a serious problem: public relations. Past industry decisions, including the decision to charge more for cheaper-to-produce CDs than for vinyl records, have made the labels fairly unpopular with consumers.

Government authorities don't appear to like the labels' pricing practices either. In May the labels settled a price-fixing lawsuit filed by the U.S.

Federal Trade Commission, agreeing to end the requirement that stores adhere to minimum prices in advertisements. Then, on Aug. 9, 28 states filed their own suit charging the major labels and some brick-and-mortar retailers with CD price-fixing. Such government scrutiny will help force the labels to show they are serious about offering legitimate alternatives to Napster.

"The last thing you want when you're trying to shut down a business is to face monopoly charges. I think that the major labels are extremely incented right now to do licensing deals with people they feel comfortable with," says Louise Velazquez, interim president of Gigabeat, a Palo Alto, Calif.-based search technology company that runs the Gigabeat.com music gateway site. And it's not just the lawsuits -- they don't want to miss any opportunities for the Christmas sales season, for example.

Few users downloading songs from the Internet are worried about copyright issues when they already feel ripped off by the music industry.

"There is obviously not a big guilt factor about Napster, as proved by traffic on its site and sites similar to it," says Barclay Dutson, president of research and consulting group Vision Consult, based in Welwyn, England.

Dutson says the CD price-fixing lawsuit against the labels is hardly surprising, and it will just add fuel to the ongoing PR war between the music labels and the Internet.

"The labels clearly won the first round [with the Napster injunction], but Napster is still up, and now you've got this counterattack [with the price-fixing lawsuit]," Dutson says. "At events like music conferences, you can see that the PR is generally against the music labels. By taking this stance, they are losing the PR war."

Building consumer appeal

Industry insiders agree that it's up to the labels to make compliance with copyright laws easy and desirable for people.

"It's like contraception: If you don't make [the technology] easy to use, people won't use it," says Andrew Robins, InterTrust's marketing and commercial development manager.

How to make it easy for consumers to locate, purchase, store and listen to music distributed online, with copyright protection transparent to the consumer, is a problem that new retailers such as EMusic.com are trying to tackle by testing out new ideas such as subscription services.

Subscriptions are better than paying for single downloads because paying for each download can be awkward, says Gene Hoffman, founder, president and CEO of EMusic.com, which beat the major labels to the market with a subscription service launched July 24. Hoffman is hoping to attract fans with quality MP3 tracks with no imperfections in coding and unencrypted files that can be used anywhere or burned onto a CD. In August, the company announced a deal to distribute songs from the Universal catalogue.

"Napster has educated the music industry and consumers to the potential of [the Net]," Hoffman says.

The idea behind EMusic.com and other sites is that consumers won't necessarily go directly to the labels' sites to get tunes but rather to content aggregators that will help consumers find music they are interested in and store it for them online.

Forrester's Scheirer says consumers wouldn't go to labels to find music because they may not know the label an artist is signed with, for example. "There has to be some kind of aggregated content in a central location that you would go to; perhaps owned by a label but not branded as such, and operated independently," he says.

A place for intermediaries

Also emerging is a new breed of middleman: the music service provider that connects the labels with online storefronts.

"We'll have licensing deals with the major labels," says Jim Long, CEO of RioPort, in San Jose, Calif. RioPort offers online music retailers solutions for content hosting, supply, copyright, and transaction management. "It will be far easier for a music site to go through us rather than have to strike individual deals with every label."

Long says one payment scheme consumers may find attractive is tacking the music bill onto the monthly Internet access bill. "When your stereo is hooked to the Net, it will be easy ... to download what you want and have what you spent show up on your phone bill, or your ISP bill," Long says.

One technical challenge that still needs to be resolved is the issue of interoperability among different copy-protection and DRM schemes, such as those from InterTrust and Microsoft.

"Right now, there is no one standard that allows you to play any file on any machine," says Peter Beverley, vice chairman of Magex, a London-based company working on the money issues of digital distribution in partnership with InterTrust. "But in the future, it will evolve to one or two standards as we see an emergence of standards."

But some think the subscription model will fail, including Andrew Hughes, a programmer who is currently working in the United Kingdom to develop a program similar to Napster, called Metallicster, which he claims will circumvent the copyright issues that plague Napster.

"I don't really think that [subscription services] will make much difference; it is only another way for the companies to get money, but it is not a very good way," Hughes says.

"When this system [of subscriptions] is introduced," said Hughes in an e-mail interview, "I will probably be just as likely to spend money on a CD, and just as likely to not pay for a digital version of the song by getting it from something like Napster. I personally believe that the music industry is trying to cope with something that they have no understanding of."

Leveling the playing field

Most industry observers agree that the labels will not disappear anytime soon, mainly due to their skill in promoting and marketing artists. But many musicians are hoping the Internet will loosen the grip that the major labels have had on artists and their recordings.

Speaking after Time Warner's Parsons at Jupiter's Plug.In conference, Michael Diamond (also known as Mike D.), a member of the hip-hop group Beastie Boys, reiterated a common musician's complaint: It's tough for artists to make deals with major music labels that give them rights to lucrative master recordings.

He added that the Beastie Boys were only able to sign such a deal with Capitol Records because the group is a worldwide moneymaker. But bands need the labels for their broad reach and their ties to brick-and-mortar stores, he added.

"As a band that reaches a good-sized audience ... we need to reach a lot of people, and the way to do that is still in the retail environment," Diamond says.

Still, the Internet could strengthen smaller "development labels" that can nurture regional artists' careers, because they could use the Net to cut distribution costs associated with the physical world and make money on sale quantities that wouldn't be profitable in the physical world, EMusic's Hoffman noted.

As the market players jockey for position online, the Internet appears to be opening up a broad spectrum of possibilities. "There should be more revenue generated globally by the industry, and that is by the industry as a whole, not just the major labels," Forrester's Scheirer says. "Lower costs [and] higher margins can benefit the major labels, but smaller companies and artists should benefit even more; in many cases they [the labels] will see smaller versions of themselves on the Web, with networks of smaller companies providing the same kind of value-add that the labels now provide."

Although the music industry is still sorting out how labels and artists will get paid for their content on the Web, the way the music industry is grappling with these copyright-related issues points to how online distribution of other media such as video and books will take shape.

"What's happening in music will definitely have an impact on video, movies and books," Hoffman says. "With books and music you have a pack-rat mentality of collecting things. But there is going to be a changeover in video and books like there has been with music."

[Editor's Note: For more on how the Internet is revolutionizing media and entertainment, see Feature: Napster Stirs Apprehension in Movie Industry.]

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