Home > Uncategorized > Dangerous Shoals: SIRA Letters of Direction are a Land Grab

Dangerous Shoals: SIRA Letters of Direction are a Land Grab

August 30, 2006

The Subcommittee on Intellectual Property, the Internet and the Courts of the U.S. House of Representatives is currently negotiating the Section 115 Reform Act (aka “SIRA”). Section 115 of the U.S. Copyright Act is the section that establishes a statutory license for songs that have previously been released on what is called a “phonorecord” (either digital or physical record).

The purpose of SIRA is to establish in the law a mechanical royalty for on-demand streaming audio and a regime of “designated agents” to collect and disburse that royalty. The royalty rate, rightly or wrongly, is left to future negotiation.

As is frequently the case with legislation in Washington, SIRA has picked up a wart—a section that seems to come out of nowhere that relates to the principal purpose of the bill in only the most tangential of ways, but yet is a HUGE change to the way business is done. SIRA’s wart is called “letters of direction.” Although artist groups, the U.S. performing rights societies, NMPA, the Songwriters Guild and the Nashville Songwriters Association have opposed the offending language, it appears that the RIAA was able to get the problem language inserted in the draft bill.

If the current letter of direction language becomes law, it is only a matter of time (likely minutes) before a firestorm of artist relations problems with the industry’s most successful artist-writers erupts. The concept is against long-standing industry practice and has nothing to do with the purpose of SIRA. It must go and here’s why.

A letter of direction is a simple concept: Someone who is entitled to money says don’t pay me, pay them. Artists use letters of direction with producers as a matter of course, and are directing the artist’s record company to pay a portion of the artist’s royalties to the producer.

Traditionally, a letter of direction in the music business, such as a producer letter of direction, is not binding on the payor; for example, record companies insist that almost every producer letter of direction starts out proclaiming that the document is being acknowledged by the label solely as an accommodation to the label’s artist, meaning the record company can stop complying with it at any time.

When might that happen? When the record company has to make a payment of a share of artist royalties to a producer when the artist royalty account is in an unrecouped position, meaning that the payment to the producer is an additional advance to the artist and puts the artist’s account further in the red.

Realize that as a matter of common practice, record companies have not hired producers directly in over 30 years. Record companies require the artist to do so, hence the letter of direction that permits the producer to be paid by the label even though the producer is not hired by the label.

Also realize that it is an even more well-settled norm that record companies do not recoup advances from mechanical royalties that the record label would have to pay to the artist as a songwriter. This is so well-settled that if the lawyer representing a new artist-writer with no leverage is offered a first draft record deal with a provision in it that allows the label to recoup record advances from mechanical royalties payable to the artist-writer, the label will typically remove it if the artist lawyer so much as grunts effectively something close to “take that out”.

Thus, industry norms about letters of direction have been settled for over 30 years, which in this industry qualifies them as “well settled” in my point of view. I am at a loss to understand why members of Congress have not been better informed on this issue by industry groups.

When most people think of an “advance” under a record deal, they are thinking of the contractual advances payable to the artist. These advances are hardly ever recoupable from mechanicals. (Realize there are two different categories of advances: contractual advances that are fixed in the artist agreement, and “additional advances” that are not fixed in the artist agreement but which are categories of payments that are described in the artist agreement.)

There are other charges that are deemed to be “advances” that are not listed in the contract. These are more what lawyers would call a right of “offset”, usually contingent charges against mechanical royalties that the label would otherwise pay to the artist-writer derived from record sales that are not protected from recoupment: overpayments of either advances or royalties (within the control of the record company), union penalties caused by the artist’s neglect (but largely within the control of the record company), unexcused overbudget (within the control of the record company), and costs attributable to indemnity claims for which the artist has agreed to indemnify the record label (such as claims for copyright infringement). These items are frequently “deemed” to be advances under the record deal recoupable from all sources of income, including contractual advances and mechanical royalties payable to the artist-writer or their music publishing company or administrator.

Even the more onerous agreements would not find a record company attempting to recoup advances (contingent or otherwise) from writers or publishers not related to the artist-writer.

It is also important to understand what is meant by “mechanical royalties” in these recording agreements. All recording agreements include a direct mechanical license from the artist to the record company for all songs recorded by the artist. The artist-writer either grants a license in works they own or control, or agrees to grant a license for their own work and obtain a similar license for co-written works or cover recordings. This is usually called the “controlled compositions” clause and has its own set of warts that I won’t go into but acknowledge. Record companies rely on this grant of rights in order to pay mechanical royalties at a lower rate than is otherwise required by law. This is an extensive provision in most record deals and can run to several pages in length. Remember–this provision covers mechanical royalties that the label pays to the artist who is also a songwriter. It creates favorable rates for the label and connects the mechanical royalty payment to an artist-writer (or their publisher)–and ONLY that royalty stream–to the rest of the recording agreement.

The older, especially pre-digital era, term recording artist agreements contemplated that the label would offset these “additional advances” against mechanical royalties the label would otherwise be paying—on the sale of records. These “additional advances” were not recouped by having the artist-writer send a letter of direction to ASCAP, BMI, the Harry Fox Agency or SESAC. Neither were they recouped from foreign earnings, synchronization licenses, ringtones, or the like. Rather, the label would offset certain claims against mechanical royalties that the record company—not a publisher, an administrator or performing rights society, and certainly not any other third party–would otherwise pay to the artist-writer or their designee.

If one tried to find the logical corollary from the physical world to the digital world in order to interpret what the likely intention of the parties was when entering into such arrangements, the better analogy would likely be to permanent downloads. Permanent downloads are most like records.

On-demand streaming is not like a physical record, and is an entirely new beast when compared to physical records. That is–by the way–the reason there is a need for SIRA in the first place.

Further justification for the analogy is seen in “pass-through” licensing under Section 115(c)(3). The record companies extend their existing mechanical licenses to include mechanical royalties for permanent downloads under Section 115(c)(3) in the pass-through licensing that is so unpopular with publishers. However–the labels will not extend 115(c)(3) licensing to subscription services that permit on-demand streaming precisely because such services are a new and different beast. So in fairness, there should be nothing that prohibits a record company from deducting its contractual offsets from mechanical royalties payable on permanent downloads under pass-through licensing permitted by Section 115(c)(3).

This ain’t that, though.

There was a time about 50 years ago when record companies typically cross-collateralized not only advances and recording costs across artist albums, but also advances and recording costs against mechanical royalties paid by the record company to artist-writers. It became increasingly rare that record companies actually exercised this right, and starting about 30 years ago usually would not even insist on the right. Shortly after artist lawyers began realizing that the label would take the language out, protecting mechanical royalties from recoupment under the record deal became a “religious” issue.

There is a certain inescapable logic to this division: There are two copyrights in each sound recording, the sound recording copyright and the copyright in the song recorded in that sound recording. When an artist signs with a record company, the artist gives up the artist’s rights in its sound recordings to the label in return for a royalty on sales of the artist’s records and an advance against future royalties. If the artist is also a songwriter, then the artist-writer can go to a music publisher in a separate deal and get another advance against future songwriting income—such as the mechanical royalties contemplated under SIRA.

The more items that can be recouped from mechanical royalties, the harder it is to get a meaningful music publishing deal. It is important for everyone involved in the SIRA debate to remember that mechanical royalties and other songwriter royalties are very often the only source of income for a new artist, as most of the advances paid by the record company for a new artist go to pay for recording, tour support and the like.

This is not news to record companies, who very often adjust artist advances lower because they anticipate the artist being able to get a publishing deal particularly in the current economic climate. In fact, the record company with a music publishing affiliate (i.e., all major labels and their related publishers) will often refuse to pay the full statutory rate to artist-writers unless the artist-writer does a publishing deal with the label’s music publishing affiliate.

It should not be surprising that the specter of record companies recouping advances from mechanical royalties has taken on “religious” proportions. The fundamental reason for the importance of the issue is economic: If a record company can cut off the flow of mechanical royalties, it will be virtually impossible for an artist-writer to garner a significant advance under a publishing agreement when mechanical royalties are the principal source of the publisher’s recoupment of an advance against publishing revenues earned by the artist-writer’s songs.

SIRA’s wart involves both these concepts. Somehow—we can speculate how—some language appeared in SIRA permitting record companies to require designated agents to honor letters of direction that direct the designated agent to pay mechanical royalties to the record company.

The current language is as follows:‘‘(I) LETTERS OF DIRECTION.—
‘‘(i) IN GENERAL.—A designated agent shall comply with a letter of direction submitted under clause (ii) or (iii) [below] which instructs the designated agent to pay all or part of the royalties otherwise payable to the copyright owner to another person.

‘‘(ii) RECOUPMENT OF ADVANCE.—A copyright owner that receives an advance payment from a sound recording company under a contract entered into before June 1, 2006, that has not been recouped by the sound recording company shall, at the request of the sound recording company, submit a letter of direction to a designated agent instructing the designated agent to pay royalties otherwise payable to the copyright owner to the sound recording company until such time as the advance payment made by the sound recording company to the copyright owner is recouped by the sound recording company.

‘‘(iii) MISSING COPYRIGHT OWNER.—
In any case in which a sound recording company is, after reasonable efforts, unable to locate a copyright owner that received an advance payment from the sound recording company that has not fully been recouped by the sound recording company, the sound recording company may submit a letter of direction to a designated agent directing the designated agent to pay royalties that would be due the copyright owner to the sound recording company.”

A Subsection by Subsection Analysis

Let’s take each section in turn:‘‘(i) IN GENERAL.—A designated agent shall comply with a letter of direction submitted under clause (ii) or (iii) [below] which instructs the designated agent to
pay all or part of the royalties otherwise payable to the copyright owner to another person.”

There is nothing on the surface that seems alarming about this language. Aside from the fact that it is there at all, of course. Someone who is entitled to be paid royalties can always instruct the payor to pay a third party, particularly in this case when the payor is merely acting as an agent for the copyright owner. It is not necessary to amend the U.S. Copyright Act in order to accomplish this simple and ministerial goal.

So why this concern? Why have this language at all? We can only speculate, but one reason might be out of concern for policies such as those established by the U.S. performing rights organizations that effectively prohibits a writer from assigning their writer’s share of income to anyone. If you wanted to be certain that your letter of direction would be honored, you would want to prohibit the designated agent from being able to refuse to take the letter of direction. (This is, of course, a RADICAL departure from the labels’ own policies about letters of direction, all of which are “accommodations” to the artist and can be disregarded as the labels choose as well as a RADICAL departure from the practice at performing rights organizations.)

One would also assume that giving the record labels the ability to require designated agents to accept letters of direction would almost certainly preclude the designated agents from being able to offer advances to get artist-writers to affiliate with them, putting artist-writers at a distinct disadvantage in such negotiations and hobbling the ability of designated agents to compete in the marketplace. This for the same reason that artists fought for so long to protect their ability to make a favorable publishing deal. So section (i) is unnecessary for starters.

On to section (ii):‘‘(ii) RECOUPMENT OF ADVANCE.—A copyright owner that receives an advance payment from a sound recording company under a contract entered into before June 1, 2006, that has not been recouped by the sound recording company shall, at the request of the sound recording company, submit a letter of direction to a designated agent instructing the designated agent to pay royalties otherwise payable to the copyright owner to the sound recording company until such time as the advance payment made by the sound recording company to the copyright owner is recouped by the sound recording company.”I understand that the labels think this language protects them on “branding deals”. A branding deal is an arrangement like Korn and Robbie Williams did with EMI—the label pays a huge advance up front that is recoupable from all sources of the artist’s income for a period of time for certain records. Fine—the artist-writer and their label will enter into a highly negotiated private contract that deals with this, believe you me.

Realize one problem with branding agreements that cross-collateralize publishing—the artist-writer who signs a branding deal has to have their publishing available to give up for cross-collateralization. Simple, right? Not so much. Many times publishing agreements are coterminous with recording agreements, but if not, the “old” publisher will either have to be bought out, often an expensive proposition, or the publishing will not be available for the new branding agreement until the “old” deal terminates so the advance under the branding deal is adjusted accordingly.

Absent a branding deal, there should be no cross-collateralization of recording advances and mechanical royalties. So the only time that the suggested language for SIRA would come up would be in complex negotiations between sophisticated parties when it is not needed and if anything creates an additional wrinkle that likely to be overlooked to someone’s detriment.

Blending these different recoupment streams make branding deals a matter of careful negotiation and drafting between sophisticated parties. It’s all working now, so isn’t the result continued diligence in negotiation rather than amending the U.S. Copyright Act?

I’m sorry, but I think that amending the Copyright Act is a big deal. Maybe that’s because I don’t view it as my private playpen. But then I’m just a country lawyer from Texas and I’m not as smart as these city fellers, so I must be missing something due to a lack of sophistication.

Some of the arguments in favor of the letters of direction section in SIRA are that branding agreements are the future of the industry as labels find “new” income streams. First of all, these are not “new” streams of income, other than it is “new” that the labels get to participate in any of them. One could just as easily argue that branding agreements are a game of chicken with the greater fool–who’s going to either take less or pay more when the music stops as it were.

But if the reason the letter of direction language is in the SIRA bill is because branding agreements are the future—why does section (ii) only apply to agreements before June 1, 2006? If the “it’s the future” argument were true shouldn’t the date in the bill say the opposite? Agreements entered into after June 1, 2006?

Note also that the language is not limited to mechanicals that would otherwise be collected by the record company. Under the current bill, the letter of direction applies to ALL royalties collected by the designated agent, another major departure from a good 30 years of practice. Consider that designated agents may end up collecting monies from a variety of sources other than on demand streams—ringtones, ringbacks, synchronization for YouTube-type sites. ALL these royalties would get swept under a letter of direction in the language as currently drafted.

So—the suggested language in SIRA would create a right that the labels typically don’t have under contemporary artist agreements unless they bargain for it—and pay the freight. I am aware that one label negotiator has asked how will the labels recoup their advances if they don’t have this right? The answer is, they would recoup the same way they’ve recouped for the last 30 years—from record royalties. The sky is not falling.

By the way—I’m not suggesting that artists get a free ride here. Fair is fair. Record companies invest in a highly risky business, and they are more than entitled to a return on their investment. No one gets into high risk undertakings to break even. But this SIRA business is the wrong way to do it.

‘‘(iii) MISSING COPYRIGHT OWNER.—
In any case in which a sound recording company is, after reasonable efforts, unable to locate a copyright owner that received an advance payment from the sound recording company that has not fully been recouped by the sound recording company, the sound recording company may submit a letter of direction to a designated agent directing the designated agent to pay royalties that would be due the copyright owner to the sound recording company.”

Ah, yes, the “missing” copyright owner. There sure is a lot of attention being paid to “missing” copyright owners lately. I’m touched by all this concern.

Ask yourself what kind of copyright owner is most likely to be (i) missing, (ii) have received an advance from a “sound recording company” that is (iii) not recouped. EMI Music Publishing? I don’t think so. Warner-Chappell? Probably not. Sony-BMG? Nope. Universal? Get a life. Peer Music? Highly unlikely.

The most likely person to be the kind of “copyright owner” described in the statute will be the artist-writer themselves who has either held onto their copyrights or gotten them back by painfully negotiated reversion of copyright, paying off their publishing advance, or some other means.

And when is an artist-writer most likely not to be found after a “reasonably” diligent search? How about if they’re dead?

Note a few things about this section: First, the record company only has to look for the copyright owner, not the copyright owner or their heirs or executors. Arguably, heirs would be “copyright owners” by the descendibility rules of the Copyright Act, but the section doesn’t clearly contemplate record companies finding heirs or executors.

Further, the advance is “an advance payment from the sound recording company that has not fully been recouped by the sound recording company”. This clause doesn’t say “an advance payment from the sound recording company that has not fully been recouped by the sound recording company that the recording agreement concerned permits to be recouped from monies otherwise payable under this section”. No, this section covers ANY advance.

And it goes on: The label can unilaterally submit the letter of direction to the designated agent: “the sound recording company may submit a letter of direction to a designated agent directing the designated agent to pay royalties that would be due the copyright owner to the sound recording company.” Note well–the royalties to be paid to the record company are “royalties that would be due the copyright owner”. ANY royalties, not just royalties payable under SIRA.

Designated agents may well be existing companies such as the Harry Fox Agency or one of the big publishers that can meet the designated agent thresholds (a whole other megillah). So if the intention is to permit recoupment under SIRA, the bill needs to say that, or if it’s to permit recoupment of ALL mechanicals, then it needs to say that. Of course, if it says either the cries of pain will echo across the land in the offices of artist lawyers. But if the drafting doesn’t make this distinction, then–as drafted–SIRA has an unintended consequence.

SIRA–as drafted–permits recoupment against all royalties payable by the designated agent. Not just royalties under the new subsection (e) for streaming mechanicals, but any royalties that the designated agent might collect. So if the designated agent is collecting mechanical royalties for permanent downloads or for other forms of phonorecords (such as physical CDs), or if the designated agent collects for ringtones, ringbacks, etc., at some point in the future, does that mean that the letter of direction can include those royalties as well? That may or may not have been the intention, but I certainly wouldn’t want to be arguing the case on behalf of the artist-writer given the sweeping language in the bill.

Subsection (iii) is also inconsistent with subsection (ii): Does subsection (iii), or section (e)(l) entirely, apply solely to artist agreements entered into prior to June 1, 2006? The upshot of the “missing” copyright owner section is that the artist-writer who manages to get their copyrights back and dies or is otherwise AWOL with an unrecouped balance on any record deal they ever had–not just their current record deal–may find that their mechanical royalties have vanished, even if their representative carefully negotiated a no-crossing provision in their original artist agreement. And since the provision applies to any artist agreement before June 1, 2006, count on labels submitting letters of direction to designated agents that the designated agents will be required by law to accept regardless of what the artist agreement requires or permits.

Realize also that there is going to be a retroactive payment under the Harry Fox Agency-RIAA agreement once the rates are established and the designated agent rules are set up. There will also be a liquidation of all monies currently being held by the online services in “liability accounts”. Under these letter of direction rules, the labels stand to obtain a windfall if they say they’ve tried to find the artist-writer but were unsuccessful.

Realize one other thing: New York State Attorney General Elliot Spitzer obtained an agreement from the major labels and some publishers to pay over unclaimed royalties to the states of New York and California under the unclaimed property statutes of these states. Another section of SIRA precludes the states from applying the unclaimed property statutes to monies payable under SIRA.If the unclaimed property statutes don’t apply, and an artist-writer copyright owner cannot be found (which would qualify the artist as a candidate for protection under the unclaimed property statutes for record royalties), the label can now take mechanical royalties to be applied to unrecouped balances. Admittedly, there would be no payable but unclaimed royalties if the artist was unrecouped, but I note this additional twist.

Conclusion

I think it’s clear that when you consider each section of SIRA relating to letters of direction, there is nothing in the statute that cannot be solved by private contract, it disturbs decades of practice in the music industry and would mandate a regime that is simply not the way the railroad is run.

Moreover, implementing the letters of direction would create a huge new benefit, both retroactively under subsection (ii) and prospectively and retroactively under subsection (iii).

Since the downside of the provision is so great, and since the provision accomplishes nothing that cannot be (and has not been) addressed in private contracts, then it is probably better to have the language stricken from SIRA altogether. No one will be harmed because the language (and even the concept) doesn’t give anyone anything they either don’t already have or couldn’t get in a reasonable negotiation. If I were the negotiator, I would not be inclined to give up anything to have the language removed as it should never have been in the legislation in the first place since it is entirely contrary to industry practice. Mr. Kafka already holds the copyright on that story.

Another fine mess you’ve got us in, Ollie. Clearing publishing for digital exploitation has been a major roadblock in opening a legitimate digital marketplace for nearly a decade. The songwriters, publishers and online music services are getting really close to a deal on SIRA, which has enough problems of its own to solve. Can we please just stay focused on getting the publishing issue dealt with and not serve up red herrings?

Copyright 2006 Christian L. Castle, All Rights Reserved.

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