Digital music: The battle rages on by Kim Thai @FortuneMagazine August 13, 2009, 12:22 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons Squabbles over the rates and rights online radio should pay highlights a fundamental problem: the music industry is broken. Musician Nathanson is frustrated with the recording industry. Photo: Chapman BaehlerThe music industry has become that annoying dysfunctional family you don’t want to hang out with. Think Everybody Loves Raymond, but not funny. The latest episode: infighting among online radio stations, artists and labels over royalty rates and who should pay what to whom and for how much. For two years, Internet radio webcasters negotiated with artists on rates and last month the parties reached a set of agreements that essentially sets royalty rates based on a site’s size. Across the web, it was declared that Internet radio had been saved. Listeners thought for a split second that perhaps the fractured music business had reached digital détente. And just maybe, fans thought, executives could focus on more important things, like making great music and figuring out how to grow the industry. But they were wrong. Yes, artists and webcasters have reached a decision. But now online radio operators such as Pandora have declared war on traditional terrestrial radio. Here’s the issue: Even after forging an agreement with the artists, Internet radio webcasters still have to pay two kinds of copyright royalties — a fee to the performers and a fee to the owners of recordings, traditionally known to be the record labels. (Although more and more, singer/songwriter-types make up both categories now.) For years, old-school radio did not have to pay the performance royalty. A house committee has passed a bill seeking royalty parity for ‘net radio, and it’s being reviewed by the Senate this week. But instead of seeking to eliminate one set of royalties from webcasters, online radio players want their terrestrial counterparts to pay just like they have to. The webcasters figure if traditional radio has to pay both sets of rates, the sheer volume of payments will lead to an overall reduction in the royalties any one operator has to pay. “We pay much more than (terrestrial) radio,” Pandora founder Tim Westergreen says. “We just wanted to be treated more evenly, so it’ll lead to some reduction in rates.” Pandora, which has 32 million users, is on track to make $40 million in revenue this year, but the company says half of that will have to go toward performance royalty rate payments. Similarly, Live365, with 10 million registered users, will have to give about 30% of its revenue to pay off performance royalty rates. Meanwhile, the webcasters are struggling to grow revenue amid a slowdown in advertising spending. To keep its royalty costs down Pandora has capped music streaming per listener to 40 hours a month — users are charged a fee for listening beyond the 40th hour. Slacker has a “premium” service where users pay $3.99 a month for unlimited song skips, and Last.fm had to start charging €3 per month for most international subscribers. Only CBS CBS , which acquired Yahoo YHOO radio’s LAUNCHcast, offers unlimited music for free. (Listeners must endure banner ads and streaming commercials in between songs.) And how do artists feel about the royalty rates Internet radio companies have to pay? Depends on which artist you ask. Singer and songwriter Matt Nathanson says he thinks the value that comes out of the exposure of Internet radio is much more than the actual amount that the artist gets from the performance royalty. On average, last year an artist earns $3,615 a year off of performance royalties, according to SoundExchange. “It’s a pittance,” he says. But Nathanson, who testified before Congress on behalf of Pandora, is one of the few musicians defending Internet radio. Most artists see the argument as black and white: to be paid or not to be paid. “Why do artists have to be paid? Because people should get paid for their work — it’s that simple,” says Mary Wilson, one of the original members of The Supremes. But Nathanson argues that it’s much more complex than that, and that artists could be supporting a cause that could do severe damage to the music industry. “You start choking this new technology and ruining the music ecosystem, then you f*** everyone over,” Nathanson says. But like Nathanson says, this battle for royalties goes way back — arguably, as far as 1952 when the Recording Industry Association of America spawned out of a need to represent and organize artists to delegate financial and legal concerns for the then oh-so-cool vinyl records. But somewhere along the way, RIAA’s representation lost footing. It and record labels began alienating musicians and songwriters with rules and overzealous management. It was a slow tension that brimmed under the surface for decades, but artists, songwriters and fans could not do much — that’s just how the system worked. But then in the summer of 1999, everything went to hell. Napster brought a new wave of piracy with teenagers downloading Livin’ La Vida Loca for free, which made the RIAA move quickly to shut down the service and then go after the most prolific pirates in the downloading world. So it’s no surprise that the RIAA and record labels lobbied to Congress in 1998 about making webcasters pay performance rates. It was a push more out of fear than reason. Fast forward to today. Yes consumers pay for digital music on iTunes, but Apple’s AAPL digital music store hasn’t restored the music industry to its glory days. Far from it. (Why do you think artists like Madonna are doing deals with concert promoter Live Nation LYV ? For big-name performers the real money is made through live shows.) The question has become: “How do you have a healthy business model and how do you sustain it?” Nathanson says. “I’m not a hippie, but I think there’s a smart way to exist as a business and a fucking stupid way, and the record labels have existed in the stupid way for a long time. Instead of shifting their business model, they’ve just tried harder to get money from other places.” An RIAA-petitioned study found that the more free sources a person listens to — streaming or not — the consumer’s less likely to actually buy music. “If you have that essential substitution, why would you pay?” says Steven Marks, RIAA’s executive vice president and general counsel. “That’s the result of that kind of behavior. It’s problematic. You’ve got very little coming back to the artist.” But he denies the RIAA is trying to kill Internet radio. “That’s a very 1999 criticism,” Marks retorts. “We’re experimenting in every possible way with new services and new ideas.” Music lovers are surely hoping some of those experiments pan out.