The billion dollar ringtones war
By Steve Gordon

Ringtones are a huge business. According to Jupiter Research, ringtones generated $6.6bn dollars in global revenue in 2006. They are also one of the most contested areas of the music business with a fierce battle being fought between major record labels and music publishers. The labels have argued for years that music publishers charge too much money for the use of their songs, and in some cases arbitrarily deny consent altogether.

Since sales of CDs have declined in almost every year since 2000, and digital sales of full songs have not made up for these losses, labels are desperate to make money from other sources. Ringtones have long been one of their few rays of hope.

Ironically the same companies that own the four major labels, Warner, EMI, Sony/BMG, and Universal, also own four of the world's largest music publishers, Warner Chappell, EMI Music Publishing, Sony/ATV and Universal Music Publishing. Nevertheless, these companies, although related by common ownership, are in a civil war.

Most ringtones are "master" tones, that is, they consist of original masters, which are owned by the labels. The underlying music, that is, the songs, are controlled by the songwriters' representatives, the music publishers. Many of the most successful ringtones are controlled by both major labels and major publishers. For instance, according to Billboard, one of the leading ringtones in fall and winter of 2006 was "New Ms. Booty" by Bubba Sparxxx. The master is owned by Virgin Records, a division of EMI Records, but the publisher is EMI Music Publishing. The labels usually charge 20 to 40 per cent of the retail price. So, for a ringtone selling for $2.99, the labels generate 60¢. to 120¢.

Prior to the decision of the Register of Copyright last October, which is the focus of this article, publishers were able to negotiate 10 per cent of retail or more, so their take for a $2.99 ringtone was around 30¢. But, ringtone companies would either make the labels pay the publisher's share, or try to negotiate the labels share down by the amount payable to the publishers. They labels weren't happy with this, but the publishers' policies regarding ringtones angered them for several other reasons, too.

The labels pay production costs running into millions for the production of master recordings, but publishers control songs simply by signing a songwriter to a contract. The compulsory license provided by Section 115 of the United States Copyright law, as discussed more below, permits anyone to make a mechanical or digital copy of a full song for only 9.1¢; So some publishers, for instance those controlling songs by the Beatles, Aerosmith and Jimi Hendrix, have refused to license their music for ringtones for any price, thus denying the labels significant potential revenues. Therefore, it was hardly a surprise that last September the labels, through their trade organization, the RIAA (Recording Industry Ass. of America), challenged the Copyright Royalty Board (CRB) to determine whether ringtones are subject to the compulsory license provided under Section 115 of the US Copyright Act. As we will discuss below, the labels won this battle. But, as we shall see, the war is far from over.

Ringtones - come and get 'em
For nearly a century, the US Copyright Law has provided that once a song or other kinds of musical works have been recorded and distributed to the public, anyone else can make and distribute recorded copies of that song by sending a notice to the Copyright Office and paying a royalty on each copy to the owner of the copyright in the song. The amount of this royalty is adjusted from time to time and is currently 9.1¢ for each sale. Because the owner of the copyright in a song cannot withhold consent, this is known as a "compulsory license."

Originally conceived with player pianos in mind (hence the rather archaic use of the term "mechanicals" to refer to the royalties paid for such uses), many believe that this provision has contributed to the dramatic growth of the recording industry in the United States by allowing artists to re-record hits or songs that would have languished in obscurity, and generating more sales of that song.

Although one is entitled to a compulsory license by complying with the procedures detailed in the Act, these steps are fairly cumbersome, and include monthly accounting obligations. All the major music publishers and many of the most important independent publishers voluntary issue licenses for the compulsory rate with easier requirements through the Harry Fox Agency, a division of the National Music Publisher's Association (NMPA), an organization controlled by the music publishing industry.

In 1995 Congress amended Section 115 to apply not only to physical sales, including CDs, but also to the digital music downloads, that is, digital phonorecord deliveries or "DPDs". But one area that was not specifically addressed was the use of songs as ringtones on cellular phones.

Music publishers took the position that although this was a license to make a digital copy of a song, it was not subject to the compulsory license, meaning that licenses had to be obtained directly from them (or from the Harry Fox Agency) on whatever terms they could negotiate with the phone companies, record labels, or other ringtone providers. Moreover, some songwriters and publishers denied consent at any price.

Why Ringtones fall under a blanket license
In response to the RIAA's formal request for a determination of the issue, and after hearing depositions from both lobbies, the Register of Copyrights, Marybeth Peters, made her decision. In a 34 page written Opinion dated October 16, 2006, she decided that ringtones are indeed subject to the compulsory license under Section 115 of the Copyright Act.

The music publishers had argued that by creating excerpts you change the fundamental character of the recording and thus ringtones fall outside the scope of S.115. Peters rejected this argument, and ruled that the Section 115 license is not limited to the reproduction and distribution of copies "of the entire musical work", and that an excerpt qualifies for the statutory licensee. The only exception, she found, is if the song is so fundamentally altered, by changing the melody or lyrics, for instance, as to become a "derivative work" in which event the consent of the copyright owner would still be required.

(Although she did not refer to them directly, the Opinion presumably also applies to "ringback tones", which are audio snippets that the caller hears while waiting for the person called to pick up the line.)

A new battle begins
So ringtones are subject to the compulsory license, and ringtone distributors can now license snippets of any song without the permission of the music publishers. Now what?

This may increase the variety of songs used as ringtones because publishers who previously denied permission, including songs by the Beatles, Hendrix and Aerosmith, can no longer withhold consent. However, Peters' Opinion left the answer to a very important question unresolved - the royalty split.

Peters concluded her opinion by writing: "[I]t is appropriate for the Copyright Royalty Judges to determine royalties to be payable for the making and distribution of ringtones under the compulsory license." Does this mean that the current statutory rate of 9.1¢ applies, or not?

According to Steve Masur, a copyright lawyer with a significant ringtone practice, the ringtone companies have a choice.

They can continue under their current contracts; or they can perhaps terminate or repudiate these and seek to enforce the compulsory rate; or they can negotiate a new rate, taking into account the ruling; or they can follow the statute for a 115 license and pay the 9.1 cent rate until it changes.

"Our reading of the decision is that the current compulsory rate (9.1¢) is the rate for ringtones until the tribunal creates a new one," says Masur.

However, a lawyer at the Copyright Office said that it is not exactly clear whether the 9.1 cent rate applies to ringtones, but since the Opinion would not supersede contracts currently in effect, and since the Copyright Royalty Board is currently holding proceeding on the new compulsory rate, the issue could be moot.

However, the CRB may not make a determination for more than a year so the question is important - a lot of money can change hands in that period, as we've seen.

Currently, master ringtones alone sell more than 6.5m downloads per week on average in the United States, according to Nielsen Mobile. And publishers often negotiated a rate of 10 per cent of retail or more. Since most ringtones exceed $2 retail price, the publishers usually receive twice the statutory rate. Switching from market rate to statutory rate of 9.1¢ could represent a drop of more than $700,000 per week or approximately $3m in publishing revenue.

Marybeth Peters' intent seems to have been to leave the appropriate rate to be determined by the CRB. One month after her Opinion, the trade groups for both the record companies and the music publishers both submitted written arguments to the CRB for what the compulsory license rates for ringtones should be. During the year to come, executives from some of the most powerful companies from the labels publishers and ringtone providers will testify at the proceeding. All of them are sure to argue that it's imperative that the CRB accept the rates that they propose.

The publishers are proposing the following terms: a rate equal to the greatest of (i) 15 per cent of revenue; (ii) one-third of the total content costs paid for mechanical rights to music compositions and right to sound recordings; or (iii) 15¢ per ringtone subject to periodic adjustments for inflation. This would mean that for a ringtone retailing at $2.99 with the record company's share at 40 per cent inclusive of the song, the payment to the publisher would be the greatest of (i) 15 per cent of $2.99, or 44.85¢; (ii) one third of 40 per cent of $2.99, or 39.86¢; or (iii) 15¢. Therefore the payment would be 44.85¢. The current standard price is 10 per cent of retail or approximately 30¢. Thus, the publishers are saying, first of all, we don’t think the compulsory license applies, but in case it does, we want even more than we are getting under freely negotiated licenses.

The RIAA, on the other hand, is asking that the rate be 7.8 per cent of wholesale. Assuming the wholesale rate for a $2.99 ringtone is approximately $1.25, the publisher would only get 9.75¢, which is only a slight increase over the current rate of 9.1¢.

Blanket benefits
Whatever the rate turns out to be, the Register's Opinion, assuming that the publishers' appeal is not successful, will have the effect of making licensing for ringtones more efficient. Although just a few publishers own a huge chunk of the most popular songs, there are tens of thousand's of publishers, and the ringtone companies previously had to negotiate for permission from any publisher that controls any particular song. Making the license compulsory removes the necessity of negotiating individual licenses while guaranteeing that the publisher and the songwriter still get paid.

Also, ringtone companies will have the ability to make ringtones of songs previously withheld from the market such as the Beatles, Jimi Hendrix and Aerosmith.

However, in regard to the appropriate rate that should apply to a compulsory license, the parties are very far apart, with the record companies trying to apply a rate that would result in publishers getting less money than they do now, and the publishers trying to get a rate that would give them significantly more money than the rates that they have been able to negotiate.

It will be up the judges of the Copyright Royalty Board to devise a rate that will fairly compensate the publishers without overpaying them considering the labels do put up much more money to produce the underlying masters than the publishers do for the songs. It is ironic though, that the labels, who have rejected the idea of a compulsory license applying to their masters, are such strong advocates of a compulsory license when applying to the songs controlled by their music publisher cousins.