Pandora Sees the Light On Audit Rights

Music industry licenses that require a music service to pay a royalty to a copyright owner have traditionally included what’s come to be called an “audit clause”.  Because so much information required to actually confirm that royalties are paid properly is under the control of the person doing the paying, the control of that information by the party in whose interest  lies the underpayment creates significant moral hazard.

Under Pandora’s new version of the direct publishing license for their on-demand streaming service currently being circulated by MRI, we get some good news.  Here’s why….

In the MRI license Pandora has dropped many of the restrictions on royalty compliance examinations (commonly called “audits”) that it tried to get the Copyright Royalty Judges to impose on artists and record companies through the sound recording statutory license.  SoundExchange conducts these audits under the compulsory license on behalf of featured artists, nonfeatured artists and sound recording owners.

This will, no doubt, come up on one of the appeals of the CRJs, so hopefully the ruling of the Copyright Royalty Judges (called “Web IV”) on this issue will now be moderated by reality in the form of this new Pandora commercial benchmark.  And we all know how important Pandora’s contracting practices are for benchmarking the law the rest of us must live under.

Digital services are new to royalty audits and have perpetuated the charade started with the very record companies these services are quick to criticize–this time that somehow only certified public accountants have the qualifications to conduct royalty audits of the services.

There is a great tradition in record deals of trying to load up as many restrictions as possible on the artist’s auditor to suppress the number of “inbound” audits coming at the record company.  Almost all record companies will drop the CPA requirement, because in reality everyone knows that royalty compliance has nothing to do with GAAP, financial statements or any of the other tools of the CPA’s trade.  More on this below from a Warner Music Group executive.

Royalty compliance examinations are a science of knowing where to look, knowing when you’re being lied to, and having the means to hold feet to the fire.  And due to the complexity of streaming and its billions of lines of royalties, an auditor also needs to have the technical expertise, staff and systems to manage enormous volumes of data.

This is not a knock on CPAs, but that expertise has nothing to do with GAAP or the skill set tested by the CPA licensing examinations.  The reason that a digital service traditionally wants a CPA requirement is that (1) it is usually more expensive (unnecessarily so), and most importantly (2) very few CPAs do royalty compliance examinations of digital services so the service is likely to be audited by someone who doesn’t know where–or how–to look.  (All due respect to CPAs, but royalty compliance–especially the specific skill set required for digital service audits–is simply not part of their training.)

The National Association of Broadcasters went even further in the recent Web IV proceeding with the full-throated support of Pandora’s CFO Michael Herring–under the CRJ’s new rules not only must a compulsory license audit be conducted by a certified public accountant, that CPA must also be licensed in the jurisdiction where the audit is conducted.  This is another one of the real howlers enunciated with a straight face by the Copyright Royalty Judges in their Web IV determination recently published.  (See the final determination paragraph G6.)

Not even the evil record companies ever tried to get away with this licensing requirement under the audit clauses of record deals, probably because they would have been laughed out of the room.  Unfortunately, that’s not possible with the government’s boot on your throat in the form of the Copyright Royalty Judges.

Warner Music Group executive Ron Wilcox gave an excellent summary of this issue in his Web IV testimony (at p. 15):

WMG’s agreements generally do not require that a certified public accountant (“CPA”) perform royalty audits with its digital partners. Auditors who conduct royalty audits of digital services generally do not draw on the set of skills required to pass the CPA exam.

Rather, royalty auditors must be able to understand the technical systems that WMG’s partners use, to interpret data those systems maintain and generate, and the like. For example, a royalty auditor may have to examine a streaming service’s server logs and content databases to determine the accuracy of the service’s statement of performances and royalty payments.

This could require understanding how the service’s systems record digital performances, how those records are retained, and how those records are used to generate royalty statements. In addition, royalty auditors must be familiar with some of the unique conventions and jargon in the music industry as well as the royalty terms applicable to each service provider.

For instance, auditors need to understand how to calculate a pro-rata share from a label pool, how performances are defined in the relevant contracts, and how to account for non-royalty-bearing plays.

Because royalty audits require extensive technical and industry-specific expertise, in WMG’s experience a CPA certification is not generally a requirement for conducting such audits. To my knowledge, some of the most experienced and knowledgeable royalty auditors in the music industry are not CPAs.

For some unknown reason, the Copyright Royalty Judges chose to disregard this testimony from one of the most experienced and knowledgeable executives in the music business.  Who happened to get the issue exactly right, by the way.

So the CRJ’s disconnected ruling on this issue was unfortunate.  Especially so because this ruling affects all SoundExchange audits–conducted on behalf of artists, musicians, vocalists and record companies.  The CRJ’s ruling makes an already difficult practice Jesuitical in the extreme and adds untold expense and inefficiency to an already cumbersome process.

But good news has come to light–actually great news.  Pandora has seen the error of their ways on this issue and has dropped both the CPA requirement and the licensing requirement in its most recent push for direct licensing conducted by MRI.  This is truly great news and indicates a welcome change of heart at Pandora.

Here’s the new language in Pandora’s announced streaming service:

Audit: In order to enable PUBLISHER to be satisfied that it is being accounted to on an accurate and timely basis in connection with the Pandora Services (including by verifying that the calculation of all financial information is correct), PUBLISHER may appoint an independent third-party auditor (“Auditor”) to examine and make copies and extracts of Pandora’s books, records and server logs related to the use of PUBLISHER Compositions and fulfillment of Pandora’s obligations under this Agreement (collectively, the “Accounting Materials”), such audit to occur at Pandora’s offices and at PUBLISHER’s expense.

This is a triumph of reason over the absurdly out of touch positions taken during Web IV by Pandora, NAB and others, and should immediately be brought to the attention of the appeals court to conform the audit regulations in line with the Pandora commercial benchmark.

 

What is Texas Pacific Group Up To with Pandora and Spotify? Something? Anything?

by Chris Castle

As I’ve noted a couple times, convertible debt financing is all the rage with digital music service these days.  Deezer turned to it after a busted IPO in France, and now both Pandora and Spotify went there.  What’s attractive about debt?  Different reasons depending on the company’s situation.

Convertible debt is a special form of (usually) secured or collateralized loan that looks like any other loan except that it is convertible into the shares of the company.  The amount of time between the funding of the notes and the call on the debt gives the company some running room.  Given that the shares of the company may be worth less (or worthless) at the time the note converts, there’s usually some equity kickers in there along with a pretty bullet proof “event of default” clause.

Depending on how much money is involved and the negotiating position of the lender (usually near infinite leverage at this point), it’s possible for the lenders to effectively take over the company.  If you’re in the management team, that kind of thing can ruin your whole day.

When a company has already been to the well  in the public equity market like Pandora, sometimes going a third time is just not in the cards.  This is particularly true when the company’s share price is going the wrong direction, like Pandora.

Pandora 4-4-16

For Spotify, I’ve already speculated that the main reason Spotify would like converts is because it avoids establishing a valuation for the company.  This can either be a clever move or a desperation hail Mary.  Since both Pandora and Spotify are suddenly in the debt business in a big way (Pandora $300,000,000 and Spotify $1 billion) something common to both caught my eye and that is Texas Pacific Group (or “TPG”).

According to the Wall Street Journal and Bloomberg, TPG is a lender in Spotify’s $1 billion line of convertible debt.  As Spotify is not publicly traded (and I presume these are not publicly traded bonds), we don’t have all the details you’d get in a public offering.  But it looks to be a pretty rich deal for the lenders as you would expect.

According to the WSJ:

Private-equity firm TPG, hedge fund Dragoneer Investment Group and clients of Goldman Sachs Group Inc. [which probably means Sean Parker] participated in the deal, which has been signed and is expected to close at the end of this week, these people said.

But wait, there’s more:

In return for the financing, Spotify promised its new investors strict guarantees tied to an IPO. If Spotify holds a public offering in the next year, TPG and Dragoneer will be able to convert the debt into equity at a 20% discount to the share price of the public offering, according to two people briefed on the deal. After a year, that discount increases by 2.5 percentage points every six months, the people said.

Spotify also agreed to pay annual interest on the debt that starts at 5% and increases by 1 percentage point every six months until the company goes public, or until it hits 10%, the people said. This interest—also called a “coupon” and in this case paid in the form of additional debt, rather than cash—is commonly used in private-equity deals but rarely seen in venture funding.

In addition, TPG and Dragoneer are permitted to cash out their shares as soon as 90 days after an IPO, instead of the 180-day period “lockup” employees and other shareholders are forced to wait before selling shares, the people said.

TPG and Dragoneer will buy $750 million worth of the deal, with the remainder going to clients of Goldman Sachs Group Inc., which advised on the financing, according to people familiar with the deal.

Spotify indicated to new investors it plans to go public in the next two years, people familiar with the matter said.

It’s possible to get more expensive money, but that would involve credit cards.  One thing I feel confident in guaranteeing about TPG, they got their pound of flesh.  And for Spotify–this deal looks pretty desperate.

As an aside, the Bloomberg reporting continued the thoughtless canard:

[L]ike other streamers, Spotify makes losses because it has to pay high fees to the music labels. On about 1 billion euros ($1.1 billion) of revenue in 2014, Spotify suffered an operating loss of 165 million euros, with some 70 percent of costs going to pay labels.

Wrong–the reason that Spotify loses money is because it is trying to maintain a near vertical growth curve.  Remember “get big fast”?  The mantra of the Dot Bomb Collapse?  And then there’s that nasty bit of not actually paying songwriters or bothering to get a license.

But TPG also turned up at Pandora where they got a board seat.  According to a Pandora press release:

[Pandora] is expanding the size of Pandora’s board from nine seats to 10 seats with the addition of Anthony J. “Tony” Vinciquerra, a technology, media and telecom expert with over 30 years of industry experience. Vinciquerra will join the board as a Class III Director and will be included in Pandora’s proxy statement for election at the 2017 Annual Meeting of Stockholders.

Mr. Vinciquerra has a background working very successfully for that well-known milktoast, Rupert Murdoch.  I find it interesting that within a month of Mr. Vinciquerra joining the board Brian McAndrews is out and Pandora is reportedly selling the radio station it bought for the sole purpose of sticking it to songwriters.  Hard to say if Mr. Vinciquerra is kicking ass and taking names, but ousting the guy who championed dropping $450 million on Ticketfly, antagonizing creators to the point of rank hostility and did not understand the definition of payola might be a step in the right direction.

Whether he can do the same for Spotify is an open question.

pandora_500_billboard_cover

Who knows?  Peace could be breaking out all over.  And that would be nice for all of us.

 

What’s Next for Pandora?

Tim Westergren has returned to Pandora as the company’s CEO.  He’s got a golden opportunity to change how Pandora is viewed–we all want Pandora to succeed, but there’s little support for the path the company has been on for years now.  The 42% decline in Pandora’s stock price over the last 12 months hasn’t been helped by the company’s rocky relationship with the vendors of their main product: music.

pandora stock price

With some analysts giving Pandora a fair value stock price of $7, here’s a little unsolicited advice.

Overhead:  Pandora’s overhead is out of control.  They will blame it on royalties, but a closer look shows that the company has a problem with its operating costs that they would like you to ignore (hence the $7 fair value price target).

Pandora 2015 YOY

Integrity:  Westergren arrives at Pandora in a much different point in the zeitgeist than when he founded the company in terms of artist relations.  He made a huge misstep by associating himself with a string of attempts to lower Pandora’s royalty payment to artists and songwriters all of which have either outright failed or created more hostility than they ever would be worth.  In an atmosphere where artists are increasingly suspecting digital music services of cooking the books or operating without licenses, Pandora needs to be doing it better than the next guy.  Westergren doesn’t want to get stuck with Pandora’s “Enron moment”.

Legislation: Pandora backed the failed Internet Radio Fairness Act that was designed to lower artist royalties and created a huge backlash from the artist community.  Some refer to its spectacular failure as “lobbying malpractice.”  One time can be chalked up to bad advice. Don’t make it twice.

Litigation Against Compensating Artists: Pandora became the poster child for refusing to pay royalties on recordings made prior to February 15, 1972 which has come to be known as the “Pandora loophole”.  This would mean that if you were to record “Sophisticated Lady” or “Hello Dolly” tomorrow, Pandora would pay you but not the estates of Duke Ellington or Louis Armstrong.  In a move reminiscent of Spotify’s settlement with the NMPA, Pandora settled with just the major labels and is continuing to litigate against the class lead by The Turtles.  Westergren should settle Pandora’s case and treat all artists fairly.  Again, bad advice can get forgiven if the company does the right thing.  Avoid having loopholes named after your company on a go forward basis.

Litigation Against Compensating Songwriters:  Pandora has lead the way in using the rate courts against songwriters at great expense to ASCAP and BMI.  While Pandora is reportedly trying to make direct agreements with publishers, the company is using the rate courts to drag songwriters through the muck.  Westergren should stop trying to litigate royalty rates and ask yourself if you really saved that much money compared to your own legal fees and brand damage.

Lobbying With MIC Coalition:  Pandora is a member of the MIC Coalition, an alliance of companies against songwriters and artists—companies with a combined market capitalization of over $2 trillion.  (I stopped counting at $2 trillion dollars as I get confused by that many zeros to the left of the decimal place like I get confused by zeros to the right of the decimal place on Pandora’s royalty payments.)  There’s no good reason for Pandora to be in the MIC Coalition–whose first official act was to file an antitrust complaint against SESAC.  That’s right–because Google, Clear Channel (iHeart) and all the rest need protection from songwriters.  (The MIC Coalition even had a fake panel at SXSW moderated by their lobbyist who failed to identify her connection to the “McCoalition”.)

MIC Coalition

Tim Westergren built the better mousetrap, but it’s managed to catch a rat.   By pursuing a path of high integrity and fair dealing with creators, Pandora might have a chance to make it.  It would be a shame to see it go under.  Westergren’s brief should be to do everything he can to get the creative community back on board instead of looking like a stock-rich bubble boy having breakfast at Buck’s.