Month: February 2022

Spotify ESG fail: Governance

[This is an extension of Spotify’s ESG Fail: Environment and Spotify’s ESG Fail: Social. “ESG” is a Wall Street acronym often attributed to Larry Finkat Blackrock that designates a company as suitable for socially conscious investing based on its “Environmental, Social and Governance” business practices. See the Upright Net Impact data model on Spotify’s sustainability score. As of this writing, the last update of Spotify’s Net Impact score was before the Neil Young scandal.]

Spotify has one big governance problem that permeates its governance like a putrid miasma in the abattoir: “Dual-class stock” sometimes referred to as “supervoting” stock. If you’ve never heard the term, buckle up. I wrote an extensive post on this subject for the New York Daily News that you may find interesting.

Dual class stock allows the holders of those shares–invariably the founders of the public company when it was a private company–to control all votes and control all board seats. Frequently this is accomplished by giving the founders a special class of stock that provides 10 votes for every share or something along those lines. The intention is to give the founders dead hand control over their startup in a kind of corporate reproductive right so that no one can interfere with their vision as envoys of innovation sent by the Gods of the Transhuman Singularity. You know, because technology.

Google was one of the first Silicon Valley startups to adopt this capitalization structure and it is consistent with the Silicon Valley venture capital investor belief in infitilism and the Peter Pan syndrome so that the little children may guide us. The problem is that supervoting stock is forever, well after the founders are bald and porky despite their at-home beach volleyball courts and warmed bidets.

Spotify, Facebook and Google each have a problem with “dual class” stock capitalizations.  Because regulators allow these companies to operate with this structure favoring insiders, the already concentrated streaming music industry is largely controlled by Daniel Ek, Sergey Brin, Larry Page and Mark Zuckerberg.  (While Amazon and Apple lack the dual class stock structure, Jeff Bezos has an outsized influence over both streaming and physical carriers.  Apple’s influence is far more muted given their refusal to implement payola-driven algorithmic enterprise playlist placement for selection and rotation of music and their concentration on music playback hardware.)

The voting power of Ek, Brin, Page and Zuckerberg in their respective companies makes shareholder votes candidates for the least suspenseful events in commercial history.  However, based on market share, Spotify essentially controls the music streaming business.  Let’s consider some of the  implications for competition of this disfavored capitalization technique.

Commissioner Robert Jackson, formerly of the U.S. Securities and Exchange Commission, summed up the problem:

“[D]ual class” voting typically involves capitalization structures that contain two or more classes of shares—one of which has significantly more voting power than the other. That’s distinct from the more common single-class structure, which gives shareholders equal equity and voting power. In a dual-class structure, public shareholders receive shares with one vote per share, while insiders receive shares that empower them with multiple votes. And some firms [Snap, Inc. and Google Class B shares] have recently issued shares that give ordinary public investors no vote at all.

For most of the modern history of American equity markets, the New York Stock Exchange did not list companies with dual-class voting. That’s because the Exchange’s commitment to corporate democracy and accountability dates back to before the Great Depression. But in the midst of the takeover battles of the 1980s, corporate insiders “who saw their firms as being vulnerable to takeovers began lobbying [the exchanges] to liberalize their rules on shareholder voting rights.”  Facing pressure from corporate management and fellow exchanges, the NYSE reversed course, and today permits firms to go public with structures that were once prohibited.

Spotify is the dominant streaming firm and the voting power of Spotify stockholders is concentrated in two men:  Daniel Ek and Martin Lorentzon.  Transitively, those two men literally control the music streaming sector through their voting shares, are extending their horizontal reach into the rapidly consolidating podcasting business and aspire soon to enter the audiobooks vertical.  Where do they get the money is a question on every artists lips after hearing the Spotify poormouthing and seeing their royalty statements.

The effects of that control may be subtle; for example, Spotify engages in multi-billion dollar stock buybacks and debt offerings, but has yet makes ever more spectacular losses while refusing to exercise pricing power.  

So yes, Spotify is starting to look like the kind of Potemkin Village that investment bankers love because they see oodles of the one thing that matters: Fees.

On the political side, let’s see what the company’s campaign contributions tell us:

Spotify has also made a habit out of hiring away government regulators like Regan Smith, the former General Counsel and Associate Register of the US Copyright Office who joined Spotify as head of US public policy (a euphemism for bag person) after drafting all of the regulations for the Mechanical Licensing Collective;

Whether this is enough to trip Spotify up on the abuse of political contributions I don’t know, but the revolving door part certainly does call into question Spotify’s ethics.

It does seem that these are the kinds of facts that should be taken into account when determining Spotify’s ESG score.

Songwriter Inflation Adjustments Must be Mandatory

Both the consumer price index and the producer price index increased this month and the Federal Reserve is making noises like it intends to increase interest rates and reduce what is called the Fed’s “balance sheet”. Once again, the freeze on mechanical royalties for physical records like CDs and vinyl and failure to index to the consumer price index looks increasingly irresponsible if not downright antagonistic. If you agree that songwriters need to have a cost of living adjustment permanently built into all statutory rates, we have to also recognize that may be a heavy lift and needs to be supported by evidence. Here’s a few ideas.

Consumer Price Index

US Inflation Rate Jan 2020-Jan 2022
The Consumer Price Index tracked a 7.5% increase in inflation, and even excluding energy and food prices the CPI rose 6% (which applies to all those who don’t drive and don’t eat).

The next chart shows increases in the categories of goods that make up the CPI.

The January inflation rate is the highest since February 1982. If you don’t remember what was happening in February 1982, it was the end of the 1970s stagflation with supply side “exogenous” shocks to a number of sectors including energy. The other hallmark of the 1970s and early 1980s corresponding to the staglation is a black swan (we hope) increase in the prime rate of lending. The prime rate exceeded 20%.

One could say that the only reason that the prime rate is not much higher today is because the Federal Reserve adopted a zero interest rate policy (or “ZIRP”) in response to the 2008 financial crisis as did other central banks in other countries. The idea was that cheap money would encourage banks to make loans to borrowers as well as other banks and more debt would stimulate the economy. That’s why interest rates have been at or near zero for so long. (Not everyone thought this was a good idea, including me.) The truth is we don’t really know what interest rates would be absent the central banks’ distortion of the credit markets–perhaps for all the right reasons, but distortions nonetheless.

Increases in the 1970s prime rate caused all interest rates to increase, including credit card rates and mortgage rates. We are accustomed to seeing mortgage rates around 5% partly due to ZIRP, but mortgage rates were much higher in the 1970s. This caused a contraction in the number of people who could qualify for a mortgage and extremely high mortgage payments for those who could (not to mention “points” paid to compensate for the credit risk).

Remember the Federal Reserve’s mission is to use monetary policy to keep inflation under control and unemployment low. There are two policy “weapons” the Fed has to accomplish its mission: interest rates and the money supply. When the Fed adopts a ZIRP, what happens if those low rates don’t have the desired stimulus? That just leaves the money supply when zero interest rates lead to a “liquidity trap.”

With interest rates at their lower range (or “lower bound”) the Fed stimulated the money supply in a particular way called “quantitative easing” which involved increasing the money supply by creating money to buy treasury notes in a special way (not exactly printing money, but effectively similar) and also buying mortgage backed securities and other bonds in the open market. This was especially true in “busted offerings” when the government financed deficits with Treasury notes purchased by the Federal Reserve. And yes, that does sound rather hinky.

We’ll come back to that ZIRP policy and quantitative easing in another post, but let’s just say for now that the Federal Reserve provided more money to certain kinds of banks than they’d ever seen before in an effort to stimulate the economy without raising inflation. Yet they must have always known that an easy money policy was inflationary and due to ZIRP they had limited options–to kick the can down the road. Like a balloon payment in a mortgage, the devil would come for his due at some point. That time may be now.

Whenever inflation goes up, there is an assumption–fueled by those who wish to avoid blame–that inflation is just transitory and will recede if the central banks take anti-inflation steps, such as raising interest rates by targeting even higher interest rates on Federal Funds (currently 0.25%) on top of an already higher 10 Year Treasury Bond.

If the Fed raises rates by .25% five times this year as projected by banks like Goldman Sachs, that will essentially double the interest payment on government bonds which fuels both federal spending and the national debt. The problem with that is the higher interest rates proposed by the central bank also affect government borrowing to service the $30 odd trillion dollar national debt. Maybe you can withstand your credit card rate increasing by five percent, but the government cannot.

As you can see from the charts above, some of this inflation is increasing at an increasing rate. It is going to take time to recede. Energy markets are fluid, for example, but rents are not. The conventional wisdom is that mortgage rates and home prices vary inversely to each other. Mortgage rates can also have an effect on rental prices, too; the harder it is to qualify for a mortgage, the more people have to rent, so rental prices go up. Rental prices are also sticky, meaning that once they go up, they don’t decline very rapidly or at all. Ask yourself the last time a landlord cut your rent?

Speaking of the government’s credit card, it is important to look at the effect that inflation has on interest rates for another reason: many people have been dealing with the cost of inflation is by putting it on the credit card. Not everyone has a seven figure base salary.

Credit card interest rates are currently averaging around 14.5%, which means that if you don’t have a good credit score, you’ll probably pay closer to 20%. Bear in mind that the Federal Reserve has announced its intention to hike interest rates multiple times this year, so if that happens those in the riskier tier will be paying closer to 25% by December and people with “good” credit will be paying closer to 20%. Both of which are loan shark rates.

Bands are prone to maxing out credit cards in the best of economic times so are likely to be especially hard hit just with increased interest payments on existing balances. This multiplier effect is important because on top of everything else the cost of inflation for people who have been putting it on the credit card is going to be many times worse than it is for people who have been paying cash. This is not something that you really wanna mess with, so if there’s any possible way and I mean any possible way you can either stop making it worse or start paying down that credit card do it because this is going to get very weird.

Producer Price Index

The Producer Price Index rose 1.9% in January to 9.7%. Remember, the PPI is a leading indicator of future inflation because producer prices foreshadow increases in future goods as lower priced inventories decline and price increases are in part passed through to consumers (or are in part absorbed by firms to sustain demand).

Inflation Expectations

Should songwriters expect inflation rates will effect the statutory rates in the coming years? Remember that inflation expectations can have a direct effect on actual inflation because those expectations determine wages–if you think inflation will rise, you ask for higher wages. You see this on the interactive streaming mechanical rates (which recently were amended to include a cost of living adjustment), but for some reason not on the physical.

Determining inflation expectation requires survey data, and the benchmark surveys of consumer sentiment and inflation expectations are conducted by the University of Michigan. US inflation expectations for the next 12 months rose to 5% in February of 2022 from 4.9% in January. That is the highest level of 1-year Inflation expectations since July of 2008.

Conclusion

All this confirms again that inflation for the foreseeable future is not and will not be “transitory.” Statutory rates should be indexed to inflation for the foreseeable future. This should not even be a question (and was the rule in the latter half of the 1970s, and all of 80s and 90s). If the Copyright Royalty Board will not include a cost of living adjustment in all statutory rates, perhaps it should be imposed on them.

Spotify’s ESG Fail: Social

Investopedia ESG criteria

[This is an extension of Spotify’s ESG Fail: Environment]

I started to write this post in the pre-Neil Young era and I almost feel like I could stop with the title. But there’s a lot more to it, so let’s look at the many ways Spotify is a fail on the Social part of ESG.

Before Spotify’s Joe Rogan problem, Spotify had both an ethical supply chain problem and a “fair wage” problem on the music side of its business, which for this post we will limit to fair compensation to its ultimate vendors being artists and songwriters. In fact, Spotify is an example to music-tech entrepreneurs of how not to conduct their business.

Treatment of Songwriters

On the songwriter side of the house, let’s not fall into the mudslinging that is going on over the appeal by Spotify (among others) of the Copyright Royalty Board’s ruling in the mechanical royalty rate setting proceeding known as Phonorecords III. Yes, it’s true that streaming screws songwriters even worse that artists, but not only because Spotify exercised its right of appeal of the Phonorecords III case that was pending during the extensive negotiations of Title I of the Music Modernization Act. (Title I is the whole debacle of the Mechanical Licensing Collective and the retroactive copyright infringement safe harbor currently being litigated on Constitutional grounds.)

The main reason that Spotify had the right to appeal available to it after passing the MMA was because the negotiators of Title I didn’t get all of the services to give up their appeal right (called a “waiver”) as a condition of getting the substantial giveaways in the MMA. A waiver would have been entirely appropriate given all the goodies that songwriters gave away in the MMA. When did Noah build the Ark? Before the rain. The negotiators might have gotten that message if they had opened the negotiations to a broader group, but they didn’t so now they’ve got the hot potato no matter how much whinging they do.

Having said that, you will notice that Apple took pity on this egregious oversight and did not appeal the Phonorecords III ruling. You don’t always have to take advantage of your vendor’s negotiating failures, particularly when you are printing money and when being generous would help your vendor keep providing songs. And Mom always told me not to mock the afflicted. Plus it’s good business–take Walmart as an example. Walmart drives a hard bargain, but they leave the vendor enough margin to keep making goods, otherwise the vendor will go under soon or run a business solely to service debt only to go under later. And realize that the decision to be generous is pretty much entirely up to Walmart. Spotify could do the same.

Is being cheap unethical? Is leveraging stupidity unethical? Is trying to recover the costs of the MLC by heavily litigating streaming mechanicals unethical (or unexpected)? Maybe. A great man once said failing to be generous is the most expensive mistake you’ll ever make. So yes, I do think it is unethical although that’s a debatable point. Spotify has not made themselves many friends by taking that course. But what is not debatable is Spotify’s unethical treatment of artists.

Treatment of Artists

The entire streaming royalty model confirms what I call “Ek’s Law” which is related to “Moore’s Law”. Instead of chip speed doubling every 18 months in Moore’s Law, royalties are cut in half every 18 months with Ek’s Law. This reduction over time is an inherent part of the algebra of the streaming business model as I’ve discussed in detail in Arithmetic on the Internet as well as the study I co-authored with Dr. Claudio Feijoo for the World Intellectual Property Organization. These writings have caused a good deal of discussion along with the work of Sharky Laguana about the “Big Pool” or what’s come to be called the “market centric” royalty model.

Dissatisfaction with the market centric model has led to a discussion of the “user-centric” model as an alternative so that fans don’t pay for music they don’t listen to. But it’s also possible that there is no solution to the streaming model because everybody whose getting rich (essentially all Spotify employees and owners of big catalogs) has no intention of changing anything voluntarily.

It would be easy to say “fair is where we end up” and write off Ek’s Law as just a function of the free market. But the market centric model was designed to reward a small number of artists and big catalog owners without letting consumers know what was happening to the money they thought they spent to support the music they loved. As Glenn Peoples wrote last year (Fare Play: Could SoundCloud’s User-Centric Streaming Payouts Catch On?,

When Spotify first negotiated its initial licensing deals with labels in the late 2000s, both sides focused more on how much money the service would take in than the best way to divide it. The idea they settled on, which divides artist payouts based on the overall popularity of recordings, regardless of how they map to individuals’ listening habits, was ‘the simplest system to put together at the time,’ recalls Thomas Hesse, a former Sony Music executive who was involved in those conversations.

In other words, the market centric model was designed behind closed doors and then presented to the world’s artists and musicians as a take it or leave it with an overhyped helping of FOMO.

As we wrote in the WIPO study, the market centric model excludes nonfeatured musicians altogether. These studio musicians and vocalists are cut out of the Spotify streaming riches made off their backs except in two countries and then only because their unions fought like dogs to enforce national laws that require streaming platforms to pay nonfeatured performers.

The other Spotify problem is its global dominance and imposition of largely Anglo-American repertoire in other countries. The company does this for one big reason–they tell a growth story to Wall Street to juice their stock price. In fact, Daniel Ek just did this last week on his Groundhog Day earnings call with stock analysts. For example he said:

The number one thing that we’re stretched for at the moment is more inventory. And that’s why you see us introducing things such as fan and other things. And then long-term with a little bit more horizon, it’s obviously international.

Both user-centric and market-centric are focused on allocating a theoretical revenue “pie” which is so tiny for any one artist (or songwriter) who is not in the top 1 or 5 percent this week that it’s obvious the entire model is bankrupt until it includes the value that makes Daniel Ek into a digital munitions investor–the stock.

Debt and Stock Buybacks

Spotify has taken on substantial levels of debt for a company that makes a profit so infrequently you can say Spotify is unprofitable–which it is on a fully diluted basis in any event. According to its most recent balance sheet, Spotify owes approximately $1.3 billion in long term–secured–debt.

You might ask how a company that has never made a profit qualifies to borrow $1.3 billion and you’d have a point there. But understand this: If Spotify should ever go bankrupt, which in their case would probably be a reorganization bankruptcy, those lenders are going to stand in the secured creditors line and they will get paid in full or nearly in full well before Spotify meets any of its obligations to artists, songwriters, labels and music publishers, aka unsecured creditors.

Did Title I of the Music Modernization Act take care of this exposure for songwriters who are forced to license but have virtually no recourse if the licensee fails to pay and goes bankrupt? Apparently not–but then the lobbyists would say if they’d insisted on actual protection and reform there would have been no bill (pka no bonus).

Right. Because “modernization” (whatever that means).

But to our question here–is it ethical for a company that is totally dependent on creator output to be able to take on debt that pushes the royalties owed to those creators to the back of the bankruptcy lines? I think the answer is no.

Spotify has also engaged in a practice that has become increasingly popular in the era of zero interest rates (or lower bound rates anyway) and quantitative easing: stock buy backs.

Stock buy backs were illegal until the Securities and Exchange Commission changed the law in 1982 with the safe harbor Rule 10b-18. (A prime example of unelected bureaucrats creating major changes in the economy, but that’s a story for another day.)

Stock buy backs are when a company uses the shareholders money to buy outstanding shares of their company and reduce the number of shares trading (aka “the float”). Stock buy backs can be accomplished a few ways such as through a tender offer (a public announcement that the company will buy back x shares at $y for z period of time); open market purchases on the exchange; or buying the shares through direct negotiations, usually with holders of larger blocks of stock.

Vox’s Matt Yglesias sums it up nicely:

A stock buyback is basically a secondary offering in reverse — instead of selling new shares of stock to the public to put more cash on the corporate balance sheet, a cash-rich company expends some of its own funds on buying shares of stock from the public.

Why do companies buy back their own stock? To juice their financials by artificially increasing earnings per share.

Spotify has announced two different repurchase programs since going public according to their annual report for 12/31/21:

Share Repurchase Program On August 20, 2021, [Spotify] announced that the board of directors [controlled by Daniel Ek] had approved a program to repurchase up to $1.0 billion of the Company’s ordinary shares. Repurchases of up to 10,000,000 of the Company’s ordinary shares were authorized at the Company’s general meeting of shareholders on April 21, 2021. The repurchase program will expire on April 21, 2026. The timing and actual number of shares repurchased depends on a variety of factors, including price, general business and market conditions, and alternative investment opportunities. The repurchase program is executed consistent with the Company’s capital allocation strategy of prioritizing investment to grow the business over the long term. The repurchase program does not obligate the Company to acquire any particular amount of ordinary shares, and the repurchase program may be suspended or discontinued at any time at the Company’s discretion. The Company uses current cash and cash equivalents and the cash flow it generates from operations to fund the share repurchase program.

The authorization of the previous share repurchase program, announced on November 5, 2018, expired on April 21, 2021. The total aggregate amount of repurchased shares under that program was 4,366,427 for a total of approximately $572 million.

Is it ethical to take a billion dollars and buy back shares to juice the stock price while fighting over royalties every chance they get and crying poor? I think not.