Big Music Labels Have Digital Trust Issues

As they fight in court to clamp down on piracy, the major record labels have also tried to coax music fans to switch from free downloading to paid services.

But when music fans go shopping for hit albums online, their money buys them something less than what they get on most CDs.

The music is the same, and the sound quality is hard to distinguish. But there is a wide gap between what buyers can do with a CD and what they are allowed to do with a legal download.

With most CDs, buyers can make unlimited copies, transfer the songs to any portable electronic device and post samples to their blogs. By contrast, all of the songs sold online by the major record companies are wrapped in electronic locks that restrict copying, deter sharing and limit portability.

The restrictions are intended to be tight enough to discourage piracy but loose enough not to crimp the average music fan’s behavior. Still, the variety of incompatible protection technologies being used by online stores, music services and manufacturers means that music fans might buy tracks online that their portable devices cannot play.

The disparity between CDs and downloadable songs is “a manifestation of how challenging the digital media transition is” for the major record companies, said analyst Michael McGuire of GartnerG2.

The major labels are not forced to use electronic locks, also known as digital rights management technology. A number of online outlets sell songs as MP3s, an unrestricted format that millions of music fans have been using for several years.

But MP3s offer the labels the least amount of control over how the songs are put on the market and what people do with them. They can only be sold, not rented, and they cannot be kept from a wide array of uses that the labels neither authorize nor profit from, including file sharing and podcasting, in which audio files are downloaded into portable devices.

“You’ve got a bunch of people who’ve set up businesses based on total control, and you’ve got a bunch of parts of the chain saying, ‘We’re giving up revenue,’ ” McGuire said. “They have to adjust to think about, ‘How do I monetize this world now beyond the initial transaction?’ ”

Some record companies, most notably Sony BMG and EMI, are starting to close the gap between CDs and downloads. Aided by technology firms such as Macrovision Corp. and SunnComm International, they have found a way to put electronic locks on their CDs that are even more restrictive than the ones on their downloadable songs.

Hundreds of independent labels, though, have taken a different tack. They are making downloads available as MP3s that can be freely copied and transferred to any portable device.

Sales of independent-label MP3s are small in comparison with major-label downloads -- EMusic, the leading MP3-based subscription service, has sold 40 million tracks in the last 16 months, the same amount that Apple Computer Inc.’s market-leading iTunes Music Store does in a single month.

But EMusic Chief Operating Officer David Pakman said that his company’s customers bought significantly more tracks than the average iTunes user. “Maybe one reason is that, when given a different value proposition and lots of flexibility, people tend to consume more,” Pakman said.

The major labels have declined Pakman’s entreaties, in part because they do not trust their online customers not to sabotage their business. Although label executives have felt that way since the advent of cassette tape recorders, the explosion in online piracy and the deep drop in CD sales since 2000 have stiffened their resolve to protect their wares.

Rather than embracing MP3, the major record companies have relied on formats that support digital rights management technology, such as Microsoft Corp.’s Windows Media Audio. Movie studios, video game outlets and book publishers have taken a similar path, clamping electronic locks on their digital products.

To Lawrence Kenswil, a top digital-media executive at Universal Music Group, the problem is not what people do at home with the music they buy.

“The problem is that it goes outside of that original buyer’s household,” he said. “That kind of sharing or copying is where we lose revenue. That’s where we’re trying to replace those illegal activities with legitimate services so people can share legally. There’s no easy answer.”

Universal’s goal, Kenswil said, is to have the same set of rights and restrictions on a song no matter how it is delivered. “That’s a world we’re a long way away from,” he said, in part because Universal does not believe CD copy-protection technology is ready for the U.S. market.

The company is particularly concerned about the inability to transfer songs from a copy-protected CD to Apple’s market-leading iPods because they use incompatible rights management technologies. IPods make up about 75% of the market for digital music players, said Greg Joswiak, a top marketing executive at Apple.

The compatibility issue has not stopped Sony BMG or EMI, however. Sony BMG plans to release all of its new CDs in a copy-protected format by the end of the year, while EMI is testing the technology on selected releases.

Supporters of the MP3 format argue that the major labels are locking the wrong barn.

The major labels’ downloadable tracks are widely available as bootlegged MP3s online, free of electronic locks. And if there is enough demand for a track, it will pop up as an MP3 even before it goes on sale as a digital download, said Chief Executive Eric Garland of Big Champagne, a company that tracks file-sharing networks.

“If you asked any consumer who downloads digital music which format they preferred, MP3s would feature highly,” said Beth Appleton of independent label V2, a subsidiary of Richard Branson’s Virgin Group. “As consumers, we want the ability to transfer our music to the devices we own -- MP3 players, iPods, mobile phones, rip to CD and not have our choice of device instructed by the format we download our music in.”

V2 has deals with several outlets that distribute MP3s, Appleton said, adding, “V2 believes we should provide consumers the opportunity to buy MP3s legally and trust that they understand the implications of sharing such files illegally.”

Paul Vidich, a former Warner Music Group executive in charge of digital distribution who is a special advisor to Time Warner Inc.’s America Online, said the labels “have to take reasonable steps to protect copyrighted material” to fulfill their obligations to artists and shareholders. The point is to give customers a clear boundary, “which is: You bought it, it’s yours, you don’t have the right under the law to upload it and make it available to the world.”

Many music fans believe that buying a song entitles them to venture past that boundary, and not just on file-sharing networks.

“It’s not just me getting possession of that file, it’s what I do with it,” said McGuire of GartnerG2. “Do I put it in my blog? Am I podcasting it?”

Although podcasting could be a tremendous way for fans to promote the sale of music, McGuire said, the major labels want to be compensated for it, and there is no mechanism to do that yet.

“If we see all the other pieces get in place, like podcasting licenses, etc., then you might see the labels place less emphasis” on rights management, McGuire said.

Meanwhile, EMusic’s payments to independent labels grow steadily each month as it adds subscribers, who pay $10 a month to download as many as 40 MP3s.

“They’ve been paying us consistently better than anybody else after iTunes,” said John Cornett, vice president of new media at OM Records in San Francisco.

Bob Frank, president of Koch Records in New York, said his company’s royalties from EMusic and other subscription services had grown more than 50% in recent months.

Pakman of EMusic, which is owned by Dimensional Associates in New York, said he didn’t expect the major labels to sell new releases as MP3s, but he would like them to try the format with older tracks.

“If you’re locking the CD down” with copy-protection technology, “you sort of box yourself out of experimenting with different price points and different usage levels on the digital side,” Pakman said. “I don’t know that that’s the right business decision.”