Sony Sues Rdio Executives for Fraud, A Cautionary Tale for Entrepreneurs

I’m on the alert for signals and other signs and portends that the Bubble Riders are about to bring down the U.S. economy yet again.  My theory is that Dot Bomb II: All Dogs Go to BK is casting right now, and will go into principal photography later this year.  Three signs are Spotify’s bonds (where a year maturity can be a “century bond“), Deezer’s busted IPO and of course the Rdio bankruptcy.

When bubbles burst, the harsh reality of the rules of bankruptcy suddenly become part of the vocabulary instead of aggregating bricks-and-clicks niches or facilitating user-centric content. And before you think that Rdio’s disaster is Pandora’s blessing, realize we also may be seeing a bubble bursting signal with the lawsuit that Sony Music filed against Rdio executives Anthony Bay, Elliot Peters and Jim Rondinelli.

The cautionary tale begins right there–note that this lawsuit is against these men individually.  If the case withstands the various means of dismissing it before it gets started which time will tell, this is about personal conduct, not the corporate actions of Rdio which has filed for bankruptcy.  Another reason that Sony may be suing these men individually is to pursue their action outside of the bankruptcy court that has jurisdiction over Rdio, a legitimate, but potentially intricate maneuver.

Of course you should realize that we haven’t heard the other side of the story yet, so keep that in mind.  There will be defenses and another side to the facts.  But what you should also keep in mind is that given the current state of the business, if a streaming service owes you money, you will have virtually no way to find that out.  Streaming services are very snide about affording artists and especially songwriters the right to conduct a royalty compliance examination (or “audit” for short, although it has nothing to do with CPAs, GAAP or financial audits).  Often the only time an artist or songwriter knows they are owed money is when the service goes bankrupt and the creator finds their name on the unsecured creditors list.

According to the Sony lawsuit (read it here) the defendants seem to have been some or all of the negotiating team for Rdio that came to Sony and asked for help.  Pay close attention to the timeline and remember that if your company is insolvent and either shuts down or actually files for bankruptcy, what you did in the run up to your bankruptcy will get scrutinized in bankruptcy.  Or as I prefer to call bankruptcy, volunteering to have a federal judge oversee every breath you take and ever have taken (key concepts are highlighted):

Unbeknownst to SME [Sony Music Entertainment], however, at the same time that Rdio was negotiating the amendment to its Content Agreement with SME, it was simultaneously negotiating its deal with Pandora—under which Rdio would file for bankruptcy [also known as a “prepack” or “prepackaged bankruptcy” usually requiring the advance approval of the creditors, including SME in this case]; Pandora would  buy Rdio’s assets out of bankruptcy; defendant Bay (as part-owner, executive officer, and  director of Rdio’s secured creditor) [potentially conflicting duties in a bankruptcy setting] would expect to be first in line to receive proceeds of the Pandora  deal; and SME (as an unsecured creditor) would receive pennies on the dollar for the amounts owed to it under the amended Content Agreement.

To summarize Sony’s allegations:  You guys came crying to us about renegotiating your deal, we were nice and gave you a break.  Even while you were crying to us, you were conspiring with Pandora to screw us because you knew that we would be in a weak position compared to the secured creditors like you.

That highlights another part of the cautionary tale–while officers and directors of a company have a fiduciary duty to stockholders under “normal” circumstances, when the company is essentially or actually insolvent, that fiduciary duty shifts to the creditors including the unsecured creditors.  Why?  (For a trip down memory lane on this subject, see the New York Times coverage of a judge’s ruling that denied Bertelsmann the ability to bid on Napster assets due to the “divided loyalty” of Napster’s CEO, a former Bertelsmann executive.)

Because the law puts the onus on the officers and directors to protect the creditors when it is likely that the officers and directors are the only ones who know that the company is going under.  Is this surprising?  On the schoolyard, you are supposed to protect the weaker kid before they get beat up, especially before they get beat up by your crazy brother.

The difference in these streaming service bankruptcies is going to be numerosity–the number of unsecured creditors will include every songwriter, artist, publisher and record company who is owed money.  Another reason why experienced digital service royalty auditors like Keith Bernstein of Royalty Review Council advises creators lucky enough to have an audit right to audit annually.  Don’t wait around for the service to go bust.

And here it comes in the next paragraph of Sony’s complaint:

Defendants knew that, had SME learned about Rdio’s negotiations with  Pandora at any time during the negotiations to amend the Content Agreement, SME would have  demanded immediate payment of the $5.5 million that Rdio owed to SME, and would have refused to grant Rdio further access to the recordings owned by SME. That in turn would have  diminished Rdio’s business and jeopardized the secret proposed sale to Pandora….Unbeknownst to SME at the time, Rdio had one day earlier signed a Letter of Intent with Pandora concerning the intended bankruptcy filing, which would prevent Rdio’s performance of its obligations to SME under the Renewal Amendment. Rdio never intended to fulfill the commitments it made in the Renewal Amendment.

I would point out that it takes two to tango (or maybe four or five in this case) and I’m surprised that Pandora isn’t in this lawsuit as well.  It would have made sense for Pandora to ask for some evidence that Rdio had the approval of all of its creditors (or at least all of the major creditors) before committing to buy Rdio’s assets.  Gutting the company of its ability to earn revenues (like buying its major assets and hiring its relevant employees) has its own set of problems.  Time will tell.

The timeline in this case is crucial:

On July 8, 2015, Pandora presented Rdio with a preliminary Letter of Intent to proceed with a sale of Rdio’s assets in bankruptcy. This was followed by further negotiations that culminated in a signed Letter of Intent between Rdio and Pandora on September 29, 2015, one day prior to Anthony Bay’s signing of the Renewal Amendment with SME. In other words, Rdio and Pandora had agreed in writing to proceed with a bankruptcy sale before Bay executed the Renewal Amendment [with SME]….

A material provision of the Renewal Amendment was Rdio’s obligation to pay SME $2 million on October 1, 2015—the day after the Renewal Amendment was executed.  This presented a dilemma for Rdio: the Pandora deal would be jeopardized either upon Rdio’s taking $2 million in cash out of its business, or upon Rdio failing to make the payment to  SME and putting its ongoing access to SME’s content at risk. To escape this bind, Defendants made false statements designed to induce SME to extend the due date for the payment rather than terminate the Renewal Amendment. Defendants Bay and Rondinelli fraudulently misrepresented to SME that Rdio was raising capital that would enable it to make this payment, when in fact Rdio was finalizing its deal with Pandora, under which Rdio would pay SME neither the $2 million, nor the monthly fees it owed for the rights to SME’s content that Rdio continued to exploit, nor the millions of dollars in other payments required under the Renewal Amendment.

And here is the Old Testament ending you knew was coming, sure as Cain and Abel:

As detailed below, Rdio ultimately succeeded in hiding the Pandora deal from SME until November 16, 2015, the date on which Rdio and Pandora signed an Asset Purchase Agreement and Rdio filed for Chapter 11 relief. As a result of this fraud, SME lost millions of dollars owed to it by Rdio.  Each of the Defendants was an officer or director of Rdio, and each of them knew of and participated in the fraud on SME. Defendants Bay and Peters were both personally involved in Rdio’s simultaneous negotiations with Pandora and SME, and knew that Rdio’s representations to SME were false. In addition, Defendants Bay and Rondinelli personally made fraudulent misrepresentations to SME in furtherance of the fraudulent scheme.  Defendants’ fraudulent actions substantially harmed SME, and enriched the individual Defendants by making the Pandora deal possible.

These are very serious charges, and Sony has a lot to prove.  But the cautionary tale is this: When you get into these situations, streamers have to be very careful about the sequence in which you do things and be very clear with all concerned about who benefits.  The timing of pre-bankruptcy events that affect the value of the bankruptcy estate will definitely get questioned.

On the licensor’s side, you have to always ask yourself, what happens if they go bankrupt tomorrow?  Is my minimum guarantee going to get caught up in the bankruptcy, either as a preference or am I never going to see the money?  There are ways to get comfortable with this, but it requires some extra precautions.

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