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The Nature of Collective Licensing

October 14, 2015

The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of “organising” production through the price mechanism is that of discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.  Again, in certain markets, e.g., produce exchanges, a technique is devised for minimising these contract costs; but they are not eliminated. It is true that contracts are not eliminated when there is a firm but they are greatly reduced.

The Nature of the Firm by R.H. Coase, Economica (1937) 386 at 390-91.

Buy Low, Sell High

Maybe you’ve heard of the 30 second MBA?  It’s called buy low, sell high.  One of the ways you get to the “sell high” part is if you keep your transaction costs low, or at least low-ish.  The fact is, if there wasn’t low transaction cost collective licensing like SoundExchange, someone would have invented it because of its inherent logic.  In a nutshell, that’s a crude summary of the Coase theorem about the economics of the firm.

There is a certain common-sense logic that you’ll end up making more money if you reduce transaction costs.  That’s one reason why we have fences instead of barking dogs and enforceable property rights instead of cudgels and single combat.  Someone might tell LT Kendrick to add The Mystery of Capital to the King James Bible and the articles of the Marine Corps Code of Conduct for his rackside reading.

It’s also one reason why we have form contracts for repetitive transactions and collective licensing for large numbers of property owners wishing to all make the same deal at the same time.  There are benefits to those in the collective by agreeing to the same terms for their rights because those rights can be licensed at a market clearing rate in a contract that can be negotiated and executed at a market clearing price.  These ideas are part of Nobel Economics Laureate Ronald Coase’s famous theory of the “firm”.

Did Coase Channel SoundExchange?

Either  Coase was channeling SoundExchange, or collective licensing is such a fundamental example of Coase’s theory of the firm that it is inevitable that the music licensing marketplace will produce a SoundExchange, an expression of collective action taken in order to produce the efficiencies of reducing transaction costs of matching buyers and sellers (or the “price mechanism”).

One significant purpose of collective licensing in the U.S. under Section 114 of the Copyright Act is to lower the transaction costs associated with repetitive licensing of sound recordings under the statutory license for webcasting, simulcasting, satellite radio, etc.  A good example of how this works is the so-called “Webcaster Settlement Acts” that in simplified form allowed SoundExchange to negotiate rates for different categories of music users that then established rates which themselves were adopted as a kind of statutory rate.  That’s a pretty elegant solution in my view that both pays attention to Coase, but also uses the government rate in a way that actually helps the market.  In fact, the SoundExchange system administering a set of statutory licenses clearly has created extraordinary shareholder value for companies like SiriusXM and Pandora so it’s safe to say that the Congress and the stakeholders involved with drafting Section 114 really got it right.  If you’re like me, you might say that the shareholders got theirs, so now it’s time for the artists to benefit, too.

This is very much in line with Coase’s work on the benefits of the firm and exchange specialists whose purpose is to avoid “the costs of negotiating and concluding a separate contract for each exchange transaction.”  Also known as avoiding the cost of negotiating and concluding direct licenses outside of the collective.

Don’t get me wrong–there’s nothing wrong with a true market mechanism that permits direct licensing outside of the collective unless those direct licenses impinge upon the benefits of the collective for other participants in the collective but not in the direct licensing.  How might that happen?  One way might be by increasing uncompensated transaction cost burdens on the collective–which could be viewed as an cost without a benefit for the other participants or as free riding by the parties to the direct license.

It is one thing for copyright owners to negotiate direct licenses outside of the exchange.  That’s an important part of voluntary collective licensing.  If this negotiation only affected those that were party to the direct license and participated in its negotiation (such as a music service and the sound recording owners party to the direct license), one would likely assume that the direct license would be economically rational if the transaction cost of negotiating the direct license was less than the benefit derived from that license to the parties.

However, sometimes when the government gets involved with rate setting these direct license “benchmarks” can create a negative externality for those not party to the direct license.  There is a risk that those who lack the leverage to negotiate a direct license will indirectly have some of the terms of the statutory license negotiated by those who do have both the means to negotiate the direct license terms and the means to lobby to get the government to have their terms imposed upon those who don’t.  This could occur if the government took the direct license rates as a benchmark for setting statutory rates outside of the direct license without the corresponding “goodies”.  We’ve certainly seen this happen with the PRO rate court decisions that negatively affected thousands of songwriters who had a single–and distorted–rate imposed on them.

Can Goodie-less Artists Pick the Rate They Want if Their Label Goes Direct?

But here’s a question:  If artists are entitled to their own share of performance royalties paid directly under Section 114, what rate should apply to their share, particularly if they were not included in any direct license negotiations and were never given a chance either to opt in to the direct license or to keep their otherwise applicable statutory rate?  Particularly if that rate ends up being higher than the direct license rate because it does not include various  non-royalty “goodies” in the direct license.

An argument could be made that a higher-than-contract rate should apply to the featured and non featured artists share of performance royalties otherwise subject to the direct license if the featured artists whose sound recordings are included under the direct license don’t necessarily participate in the goodies.  An obvious example would be any contract goodies that may accrue to the sound recording owner that are not passed through to the artists.

However economically rational the direct license may be–after taking into account all the transaction costs including royalty reporting–one has to ask if direct licensing ends up actually creating efficiencies for the entire market subject to the statutory license.  If any of these transaction costs are socialized across the entire market and imposed upon artists and copyright owners who do not get the benefits of the direct license, shouldn’t the Copyright Royalty Judges should take those costs into account when rate setting for the market as a whole?

Penumbras and Permutations: The Nature of Fragmentation

These direct licenses introduce the concept of fragmentation in the market when there was little before and may undermine at least some of the benefits of collective licensing.  So once the genie is out of the bottle on the licensee side of the transaction in the form of direct licensing, it should not be surprising that the genie wants out on the licensor side of the deal, too, in the form of rate setting.  If you’re going to buy into direct licensing as a benchmark, then why should there not be at least two different rates applicable to labels inside the direct license and outside of it–and why should artists be bound to accept a rate that’s lower just because their label wants it?  I understand this may not go over well, but isn’t it a logical extension of direct licensing?

The Copyright Royalty Judges have now submitted a “novel question” to the Copyright Office, in short, can they set different rates for differently situated copyright owners.  How do you like the fractionalization of those direct licenses now?

A2IM posted a statement about the CRJs and in support of a single statutory rate:

[I]t was concerning to A2IM when we learned about a question that the Copyright Royalty Judges referred to the Registrar of Copyrights, in connection to the ongoing rate proceeding which will determine the rate that iHeart Radio, Pandora, Sirius XM and other webcasters will pay to labels and artists whenever they perform our recordings. The Judges asked if they were permitted to consider setting different rates for different categories of labels or copyright owners. It is unclear why the CRJs are asking this question, whether they actually intend to set multiple rates, or, even if they did so, whether such segmentation would advantage or disadvantage independent labels or artists. Nevertheless, we felt it necessary as A2IM to argue on behalf of not only our membership, but all market participants, that Section 114 of the U.S. Copyright Law clearly requires only a single rate, that the whole system is based on this simple principle and that the authors of the law could not have contemplated anything else. Segmentation [or what I would call “fragmentation] would make all of us poorer, including the biggest players.

That’s an interesting concept given the direct licensing that is cropping up under Section 114.  But why should it stop with major versus indie?

Naturally, most copyright owners immediately assumed that the CRJs were seeking to distinguish between major labels and indie labels, with the higher rates going to the majors.  Since we don’t know what rates are in any of the direct deals because they are subject to confidential treatment, we can’t tell which rates the CRJs may be thinking of (if they’re thinking of any particular rates at all at the moment).

Of course, it’s entirely possible that the CRJs are thinking that if indie labels made direct deals with licensees, then maybe those rates should apply to all indies and the benchmark of those contracts should only apply to similarly situated record companies and to no one else.

What About the Artist Rates?

It is not a foregone conclusion that the direct license rate applicable to the sound recording copyright owner should also apply to the artist’s share of royalties for the same recordings unless the artists expressly agreed to be bound by those direct agreements.  Meaning that if the CRJs set one rate for copyright owners who are in a direct deal with goodies and another (presumably higher because no goodies) rate for copyright owners (and the featured and non featured artists) who are not in those deals (i.e., no goodies), then is there anything really inherently unfair about with that approach?  And if they did, shouldn’t featured artists be entitled to select the rate the is most to their benefit?

A2IM could be right, however, and the CRJs could be distinguishing between major and independent labels only.  The CRJs could also be distinguishing between majors and indies with respect to particular services or buckets (pureplay vs. NAB, small commercial vs. colleges), and could be well on their way to creating a patchwork on the sound recording owner side as they have been presented on the licensee side.

One has to ask the question, though, as to whether any of this would be happening if it were not for the services desire to fragment the cost-saving collective licensing regime.   The exchange system in Section 114 was set up, in my view, as a great benefit to the users of music.  It allows them one-stop shopping for a market-wide rate for the statutory license based on the buckets negotiated with SoundExchange under the various statutory authorities.

If the CRJs are able to slice and dice on both the licensee and licensor side of these transactions, doesn’t it seem likely that the cost of administering the price mechanism at a multiplicity of rates is going to go through the roof?  Could the per-play cost of calculating the permutations of royalty rates approach or exceed the value of the royalties generated?  It seems that this fragmentation would inevitably negate the promise of collective licensing because it would introduce substantial fragmentation and friction into the price mechanism.

Whether its rate setting that pays a different rate for indies versus majors, artists versus sound recording owners under direct versus statutory rates, or any of the rather hairy permutations that could ensue as well as the accounting and administrative cost of each, it should come as no surprise that fractionalization undermines the benefits of the collective nature of a firm administering the price mechanism.  I would need to see strong evidence to the contrary that fractionalization actually trumps the Coase theorem.

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