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Universal-EMI Merger Could Yield New Mega-Label To Threaten The Future Of Music

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WASHINGTON -- Today, music lovers have more ways than ever before to access their favorite songs and discover artists they've never heard of. Can't live another minute without "Call Me Maybe"? Download it on iTunes for just $1.29, or stream it over your smartphone with Spotify. Want to hear something different? Let Pandora Internet radio pick something for you, or turn to Grooveshark, a sonic Facebook, to see what other music nerds are listening to.

The digital revolution that Napster heralded at the turn of the millenium finally seems to be bearing fruit. At the time, record labels decried the file-sharing program as an existential threat to the industry. To protect record sales, they sued everyone from tech startups to children, and lobbied Congress for new laws to curb piracy.

Now, though, digital music services have gone mainstream, promising listeners a world of perfectly legal possibilities and an end to the major labels' vice grip.

If only it were so.

Far from becoming obsolete, the four largest record labels -- Universal, Sony, Warner Music Group and EMI -- now control almost 90 percent of the music market. And if the Federal Trade Commission signs off this week on Universal Music's controversial $2 billion takeover of EMI, the new behemoth would control over 40 percent of the market alone -- enough to make the company the gatekeeper for all sonic innovation, from Silicon Valley to Sweden.

Artists are also worried about the merger's consequences. "It's all totally stacked against the creator," said Casey Rae-Hunter, who heads the Future of Music Coalition, an organization representing independent and unsigned musicians. "And the Universal-EMI merger gives them even more leverage to do really scary things."

The American Antitrust Institute warned last month that the merger would lead to both "diminished consumer choice" and "diminished innovation," and urged the FTC to block the deal. The European Union is expected to thwart some of the merger's effects abroad, forcing EMI to sell off 60 percent of its European catalog before it gives a green light to the merger.

A Universal spokesman defended the deal, telling The Huffington Post that opposition to the merger is "based on a lot of hypothetical assumptions and misconceptions that are not grounded in the realities of the music business today."

Sony and EMI declined to comment for this article. Warner Music also declined to comment, but in a recent Senate hearing, the company criticized the Universal-EMI merger as bad for big labels and independent artists alike, and claimed it was open to digital services, noting that it was the first record label to embrace iTunes.

Meanwhile, digital music companies are struggling to stay afloat. Over the past decade, major labels have used their market power to extract wildly expensive licensing agreements from new digital services -- pricey enough to render almost all of them unprofitable. Pandora lost over $16 million last year, while Spotify lost more than $55 million.

Big labels have bludgeoned less fortunate startups out of existence with lawsuits. If the FTC approves the Universal-EMI merger, Grooveshark could be the next casualty.

Today, the same giant record labels that attempted to outlaw both the portable MP3 player and the CD burner during the 1990s now have a stranglehold on digital innovation, and they remain nearly as hostile to new services as they were to Napster.

"This was supposed to look a lot different," said Rae-Hunter, who also runs the tiny, independent record label Lux Eterna and records as The Contrarian.

"We were supposed to not just solve the access problem about reaching new audiences, but also to monetize that activity in a way in which 99 percent of that activity was not captured by the major labels," Rae-Hunter said. "But we see now that the majors still dictate the terms."

'NAPSTER HAS CHANGED EVERYTHING'

A decade ago, even at the height of the war against Napster, the writing appeared to be on the wall for the major labels. In the spring of 2001, Eagles singer Don Henley traveled to Washington to cheer on the digital revolution.

To Henley and many other artists, the nation's largest labels were little better than loan sharks. At worst, they were career saboteurs.

"A typical artist could sell a half-million records and not see one dollar in royalties," Henley told the Senate Judiciary Committee, which was debating a congressional response to Napster. "It is as though you have paid off your mortgage and the bank still owns your house."

Nor were the major labels especially kind to their customers. A year before Henley's testimony, they settled with the FTC for colluding to raise CD prices, a practice that had generated $480 million for the labels over three years.

"Napster has changed everything," Henley said. By failing to establish a sustainable, standardized system for licensing digital music, "the record industry fiddled on the sidelines while the digital revolution went on without them."

In the years since Henley's testimony, the music market has changed dramatically. According to data from the Recording Industry Association of America, a trade group representing major labels, U.S. sales revenue peaked at $14.8 billion in 1999 (one of the years in which the FTC accused the labels of colluding to raise CD prices). That annual figure is now closer to $7 billion, a decline fueled by lower prices online, piracy and a sluggish economy.

But last year, the industry's slide finally stopped. Sales revenue actually grew, while the total number of purchases reached an all-time high. A little over half of all music sales today are digital, not physical.

One service above all others has been responsible for creating a viable commercial market for music online: iTunes.

Since opening its music store in 2003, Apple has become the largest music vendor in the U.S. By 2009, it was responsible for 25 percent of all U.S. music sales, physical or digital.

Labels take 70 percent of the retail sales from iTunes -- a bigger cut than they take from traditional record stores. And by offering listeners a legal service that is as convenient as Napster was, and where songs cost as little as 99 cents, iTunes radically diminished the appeal of illegal downloading.

When Apple CEO Steve Jobs prepared to launch iTunes, he did what every digital music startup has done since: negotiate licenses with the big labels.

Traditionally, whenever a record is purchased in a store or a song is played on the radio, songwriters and publishing companies receive a small portion of the proceeds. These royalties are set by Congress, which limits the amount that big publishing companies can demand from radio, while at the same time securing a stream of income for songwriters. Radio stations have never had an obligation to pay royalties to performers or record companies, however. For the most part, radio has served as a free advertising platform for the labels.

On the Internet, by contrast, a new service must obtain a license from whoever owns a recording. There are no statutory royalty standards for recorded music in the digital universe, giving record companies the ability to demand any form or amount of payment they want from a new tech startup. Without buy-in from the major record companies, any new platform is limited to a tiny fraction of the music universe -- a situation that isn't very attractive to most listeners or to venture capitalists looking for a return on their investments.

Apple needed the majors to get iTunes moving, and Jobs sought a licensing deal with one label that could serve as a template for the others. He eventually got Warner on board, then Universal and EMI. But as Walter Isaacson detailed in his biography of Jobs, Sony Music dragged its feet. From Sony’s perspective, iTunes wasn't just Apple's play for the digital music software market, it was a major bid for the hardware market, too, which would dramatically increase the appeal of Apple's iPod and threaten Sony products like the Walkman.

"The holdout was Sony, in part because Sony had Sony Electronics, thought Walkman should be the heir to the digital future, and didn't want to license to a competitor," Michael Nash, former head of digital music for Warner Music, told HuffPost.

Sony eventually decided to get on the iTunes train, however, rather than risk being left at the station.

"After Jobs had other labels on board, Sony thought it would make them look bad, that they would lose out not being part of the launch," Nash said. "And [they] knew there was a credible threat that iTunes could launch without Sony, that they'd get left behind."

No single company could hijack the entire process if others wanted to play ball.

According to Paul Vidich, a former Warner Music executive who closed the iTunes deal, the pending merger between Universal and EMI could put an end to that state of affairs.

"Without a UMG-EMI license, they won't have a business," said Vidich, referring to new digital startups. "Within the new UMG-EMI there will be only a handful of senior executives who make these key licensing decisions. So this small group will become the gatekeepers for music startups that require these licenses. The psychology, pay packages and strategic interests of these executives will have an outsized impact on diversity and innovation in the entire online music industry."

A post-merger Universal could convert the current oligopoly effectively into an monopoly, with a single company determining the commercial viability of all innovation in the digital music space.

"When you get to a position where you have a 40 percent market share, you can dictate the terms of new services, and that can be quite harmful to innovation," said Martin Mills, founder of Beggars Group, which co-owns some of the biggest independent labels in the world, including XL and Matador Records.

Not that tech companies are necessarily angels, either.

Apple's dominance of the music downloading sphere has led to separate antitrust inquiries from the Department of Justice, with some record labels complaining about Apple punishing them for marketing arrangements with Amazon, the second-biggest online music retailer.

And many music industry executives have long blamed Apple's low prices and popularization of individual song purchases for the decline in more lucrative sales of full albums.

Apple and Amazon did not respond to requests to comment.

"Whether there was any intelligent way to resist [the digital revolution] is an open question to me. It's not like the newspaper and magazine business have done it any better," said Danny Goldberg, former CEO of both Mercury Records and Warner Brothers Records, who now manages artists including Tom Morrello.

"I don't think the music business is as venal as, say, Wall Street," Goldberg said. "I also don't think that tech companies and computer companies are populated by saints who only care about freedom."

STICKING IT TO STARTUPS AND ARTISTS ALIKE

The iTunes talks demonstrated that a multibillion-dollar corporation running its own sophisticated legal and lobbying operations could take on the major labels and win. Silicon Valley entrepreneurs armed with a few million dollars in venture capital generally don't fare so well. Neither do artists, especially independent ones with even fewer resources at their disposal.

In January of 1999, Rob Reid started Listen.com, with the goal of becoming the dominant online music source. But none of the major labels would license to him. For three years he held out, developing music databases to sell to search engines and licensing symphonies from Europe to give the business something to show investors.

Finally, in the summer of 2002, the labels cut a deal. At the time, the Department of Justice was investigating the labels for potential antitrust violations, and labels felt enormous pressure to sign deals with independent providers. DOJ eventually dropped its inquiry, but Reid said that two separate major record labels sent his team contracts with identical typographical errors.

Rather than attempt to take on Apple and Amazon in the market for music sales, most digital music startups tend to tackle online streaming. Listen.com became the streaming service Rhapsody and was sold to RealNetworks and Viacom in 2003.

Digital licensing agreements for streaming services today still follow the same general terms of the deals that Reid signed, he said. First, labels demand a large upfront cash advance, which is recouped through a complex royalty scheme. If the royalties never equal the advance, the labels still keep their original payment.

Labels then get to calculate their royalties in one of two ways, whichever is more lucrative. They can take a small amount every time one of their songs is streamed -- frequently about a penny per play -- or just take a set percentage of the service's total revenues.

Typically, Reid said, the upfront advance is so high that the royalty regime is mostly academic: Digital platforms rarely generate enough money to send labels a check beyond the original advance. But if they do, he said, services routinely send half or more of their total income to the major labels.

That's an enormous amount of revenue for a startup to cede, and far more than FM radio, which pays the record labels absolutely nothing.

Major labels control so much of the world's music catalog, however, that new providers have to ink deals with them before turning to independent labels or unsigned artists. The bigger the label, the bigger the cut of the service's revenue they can demand -- and the worse the eventual deal for independent artists.

"For a subscription service, there is a collective pot of money that can be divided up among record companies based on their market share," said Beggars Group's Mills. "If Universal's market share is 40 percent, they automatically come in and ask for 55 or 60 percent of that pie. By the time these services get around to talking to small labels, the pie's gone. And that, I think, is harmful to artists and to the market."

Indeed, while streaming services pay out millions to major labels, independent and unsigned artists are left with just fractions of a penny per play.

"I hate Grooveshark and Spotify," said Rebecca Gates, former lead singer of the band The Spinanes, which had been signed to the independent record label Sub Pop. Gates now releases her own music. "I own two of my records, and if they are on Grooveshark or Spotify, it is without my approval."

Gates received strong reviews for her latest record and has been experimenting with selling digital versions directly to her fans. So far, operating outside the digital licensing world remains an uncertain experiment, but she's been able to finance a European tour with the proceeds, which is more than most independent artists can claim for streaming proceeds.

Labels now often demand equity in the new digital services as part of a licensing deal -- a situation analogous to the labels owning stock in brick-and-mortar record stores. All four major labels are currently shareholders in Spotify, for example.

When some of your biggest shareholders are major labels, your company may be in a good position to fend off competitors. But it also becomes very difficult to criticize the labels or negotiate a better deal down the line.

Spotify and Grooveshark did not respond to requests for comment. But Napster co-founder Sean Parker, who now sits on Spotify's board, has publicly praised the merger between Universal and EMI.

"They're all two-year deals, and the labels have full visibility into the financials, as shareholders and from royalty statements," noted Reid. "So if a service is getting any kind of profit margin, the labels are going to come right back and negotiate a new contract that eats that margin. It seems impossible for these services to generate any kind of sustainable profitability."

Record labels would likely be unable to make such extreme licensing demands if the music market were more diverse, however. If the world's music catalog were more evenly distributed among more record companies, for example, new services could launch more easily, without the approval of a few big labels.

'SEVERE HARM TO COMPETITION AND CONSUMERS'

Like other startups before it, Grooveshark, which launched in 2007, has been seeking licensing deals with record labels of all sizes. In 2009, the company inked its first (and so far, only) agreement with a major label EMI.

But Universal has never been keen on Grooveshark. Instead of cutting a deal, Universal has accused the new service of copyright infringement and repeatedly sued, most recently in late 2011 for $17 billion -- roughly 850 percent of what they agreed to pay for all of EMI, and more than double the annual sales revenue of the entire U.S. recording industry.

In January of this year, two months after agreeing to the Universal merger, EMI changed its tune, claiming that Grooveshark had missed a $100,000 payment on its licensing arrangement, and terminated the contract. EMI then sued the startup for copyright infringement as well. Grooveshark, which declined to comment for this story, noted at the time that it had paid EMI $2.6 million to date under the licensing arrangement. After settling the intial lawsuit, EMI has filed new infringement cases against Grooveshark, and the two companies remain embroiled in litigation.

Grooveshark is still functioning, but its days may well be numbered. And its current situation may be a harbinger of what's to come if the FTC approves Universal's acquisition of EMI.

"In simple terms, the post-merger firm would have a strong incentive and increased ability to exercise market power to undermine, delay and distort new digital distribution business models, in a market that has been a tight oligopoly for over a decade," said Mark Cooper, director of research for the Consumer Federation of America. "The FTC must take steps to prevent this severe harm to competition and consumers."

And just as Don Henley pointed out to Congress in 2001, for musicians looking to make money in the digital age, the best hope remains new music services. The existing regimes are simply not profitable for artists. Only a tiny fraction of the money that labels extract from digital providers ever makes its way into musicians' pockets. As The Root detailed in 2010, the average artists sees just $23.40 for every $1,000 in music sold.

The convenience of downloading and listening to music online isn't going away. You'll still be able to download "Call Me Maybe" -- or whatever the next big major-label smash may be -- with a single click. But while services like iTunes and Spotify have changed the music market, the next generation of innovation, along with the ability to obtain more obscure music tailored to your tastes, remains jeopardized by major label dominance of the digital sphere.

This appears in our weekly iPad magazine, Huffington, in the iTunes App store. This story appears in Issue 27, available Friday, Dec. 14.

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