The Recording Industry Practice of Recoupment - Assignment Example

Topic: The Recording Industry Practice of Recoupment: An Economic Analysis Recoupment in recording industry is a controversial practice, in which a record label provides an artist money to bear the production and marketing cost of an album. The record company gets rights over the royalty of an album to cover its costs until all the costs are recouped. Artists blame the record companies of using unfair accounting practices to cheat them on royalties. On the other hand, recording industry advocates recoupment on the ground that it facilitates the industry to introduce new music and get compensation in the form of recoupment against the huge financial risks involved in bringing new faces to limelight. But actually, “cheats” by labels decrease royalty rates by 25 percent and most of the albums fail to reach the target sales, creating an irony of situation, as royalties are based on sales (Mike Wiser, 2004). Legal Background Senator Kevin Murray, Senate Select Committee on the Entertainment Industry, 26th District Chair, State of California has elaborated on the malpractices of recording industry -- of bringing amendments via bankruptcy bill, which were thwarted. These amendments would have negatively affected artists’ interests, had they been passed into law. Such back door attempts by the recording industry have soured the relationship between artists and record companies. Artists have got united under the umberella of American Federation of Television and Radio Artists (AFTRA) and the American Federation of Musicians (AFM). The bone of contention between the artists and recording companies is the accounting practice with many sub sections like structure of contracts, recoupment, absence of penalties for underpayment, limitations on the right to accounting and royalty terms, which are not clear and straightforward (Kevin Murray, 2002). The practice of recoupment is the most debatable issue, in which a record company recovers a list of expenditures from the royalties of artists, incurred on producing the master recording. The contract’s terms and conditions are settled on the comparative strength of the two parties’ bargaining power. There have been many examples of corporate cheating on artists, the example of famous blues artist Muddy Waters, under debt of about $56,000 in unrecouped expenses in 1985, although producing many best-selling hit records. Most probably, keeping this inequity in view, the record company paid his estate $25,000 in royalties the same year, freeing Muddy Waters from debt Holland, 1995. This was a rare case where the behavior of the label was supportive otherwise, innocent young musicians are entrapped by the compelling logic of the terms of the contract. The contracts are totally unfair in the moral sense of the word; they are only legal documents, empowering the labels to be gatekeepers and getting ridiculous favors from musicians in a legitimate way (Papadopoulos, 2004).  According to Caves (2000) “artists of all types engage in creative processes and tasks that come to completion only with the collaboration of ‘humdrum’ (or ‘ordinary’) partners”, and recording contracts “reflect the uncertainty of success and the inability of young performers to supply inputs other than their time and talents.” Professor Theo Papadopoulos of Victoria University in Australia has thoroughly researched like issues in his research paper “Are Music Recording Contracts Equitable? An Economic Analysis of the Practice of Recoupment”.1 According to Papadopoulos, labels’ fixed or ‘establishment’ cost per record includes the recording advance, the calculated marketing campaign, music videos, payment to independent promoters, retail product placement and tour support. The variable cost per record depends on the marginal cost. Table 1. Cost of Production: Sample Sound Recording Title. Hypothetical values entered for explanation Taking an example, assuming that recording advance, through a contract, covers costs amounting to $75,000, which is recouped later from future record sales by subtracting from artist’s royalties. The recording company invests $2 million in the marketing campaign for 1. MEIEA Journal, IV:I, 2004, 83-103. the album, $1.2 million on retail product placement, tour support, and such related advertising purposes for atleast a period of six months, succeeded by the release of the album to increase its sales Philips, 2001. It is common knowledge that radio airplay is a major factor of increasing sales. That’s why $800,000 was spent on independent promoting by way of impressing upon radio programmers to add the song from the new album on the radio station’s play list. Most recording contracts include not only recording costs to be recouped but other costs like promotion, tour support, video production, and independent promotion as well in the range of 50 to 100 percent of individual items expended. Artists contend that the recoupment of marketing and promotion expenditure is a means to transfer cost and risk of the investment of these two items on them. It is debated that owning the master recording becomes the artist’s right, as copyright law imparts owning rights to the party that pays for the recording and as the cost of recording is subtracted from an artist’s royalties, artist is the party who pays the recording cost, hence entitled to having master recording. Singer-songwriter Courtney Love has expressed anguish over what she thinks as absolutely biased recording contract, which highly favors labels and is detrimental to causing financial loss to the artist and band members. On the other hand, record companies argue that the practice of recoupment under the contract is must to compensate lack of surity of success of an album and followed risk related with investing in a new artist and the album. Not all albums click; majority titles fail to break even. Record companies argue that only ten percent titles are financially successful and profits earned on them are necessary to compensate huge losses incurred on most of the titles that don’t break even Philips, 2001. The expenditure data of hypothetical values in table 1 examines a record company’s cost structure and sales necessary to break even on an artist’s sound recording title. According to Papadopoulos, the variable cost per release is determined by the marginal cost, which could be simplified thus: A label’s total cost function for that release is: Total Cost =Total Fixed Cost (TFC) + Total Variable Cost (TVC) (1) Here, TC is the total cost, TFC is total fixed cost, and TVC is total variable cost. For a record company, TVC has a number of parts, which are taken as: TVC = MPC.Q + DIST.Q + RA.Q + RP.Q (2) Here, MPC is the marginal physical cost, DIST is the distribution cost, RA is the artist royalty, R is the publishing (or mechanical) royalty and Q is the quantity of sound recordings manufactured. Dividing equation (2) from (1) we get: TC = TFC + MPC.Q + DIST.Q + RA.Q + RP.Q (3) Differentiating equation (3) with respect to Q we obtain: dTC/dQ = MPC + DIST + RA + R= MC (4) Equation 4 shows the record company’s marginal cost of production, which matches with the table 1 and it is dTC/dQ, which is represented with the symbol MC and clearly describes the physical component (MPC + DIST, hereafter represented by the symbol MPC) and intellectual property component (R + RP) of the sound recording. These components of MC are presented in Figure 1 below (Papadopoulos, 2004).  Figure 1. Marginal cost of production. Peter Alhadeff and Barry Sosnic in “A Contribution to the Economic Analysis of Costs and the Equity of Recoupment Practices in the Music Industry”2 have analyzed Papadopoulos scenarios of settlements over artists’ royalties by taking up the issue of contractual equity. Papadopoulos questions the point in the product cycle at which a label should consider advance to the artist as paid from the artist’s royalties. Papadopoulos’s analysis borders on the definition of total cost and because of that fixed cost. According to Alhadeff and Sosnic, in his analysis of the recording advance, a major factor in Papadopoulos analysis, he has undervalued a label’s break-even point. Aalhadeff and Sosnick agree that recording advance is a fixed cost but deem it wrong to take the sum at its face value, which is given to the artist. The recording company would have earned a fixed sum of interest on the amount had it invested it somewhere else. At the time of signing the artist, this opportunity cost of lending money to the artist is real and needs to be taken as an extra item of fixed cost. If for example, a label pays recording advance P, it can earn in future A sum of money, which is greater than P and if that money is invested in some venture giving fixed returns at yearly rate I for N years, then, A= P(1+i) N and I= A−P, where I is interest earned. A label foregoes the interest I that would have accrued on P on another investment at the rate i. For artists, whose records are not going to break-even, the cost to the label is nearer to P + I. Most of the artists, the value P + I is included in a label’s total fixed cost. 3 Thus, the fixed cost for artists that will break-even, on the contrary, should include the loss of at the minimum one period of unearned interest on the recording advance. 2 Peter Alhadeff is an Associate Professor at Berklee College of Music and Barry Sosnick is the President of Earful.info. 3 In practice, labels do not give the artist the full advance up-front. The equivalent treatment would be to consider the loan as an annuity, and the relevant cost would be then be the future value of that annuity. The reasoning given by Alhadeff and Sosnick, according to both, is standard in financial break-even analysis, which is a better break-even method to show label-artist relation than accounting break-even method. 4 The important question, here, is equity of contracts in the record music business, which needs attention. There is a premium tagged to liquidity; it’s not free. Assume if artists are financially well to bear the financial responsibility of their musical projects, they would have to forego interest, if they withdraw money from their own funds and it would have been a permanent decrease in their bank balance. In fact, actual valuation of the recording advance in the cost equation of a recording company for a particular artist hints on reaching the break-even point later than expected by Papdopoulos with accounting break-even. When a recording company signs a new artist, it takes risk. The relation between artist and label is always doubtful. At the minimum, future earnings must even up with earlier spendings. To compensate the risk factor, Papadopoulos adds another independent factor to the artist’s total cost function. His argument that a label is a multiproduct firm and all the artists on its roll won’t get back their recording advance; a label will plan to compensate the loss, which he names λ, distributing its value among the artists on the roll of an album. In other words, according to Papadopoulos, the hit albums giving artists will bear the cost of financing the less selling artists, as break-even point for hit artists appears later than expected (Alhadeff and Sosnick, 2005). 4 See Harold Vogel for a comparative discussion of entertainment company buyouts: Entertainment Industry Economics(Cambridge University Press, 2001), pp. 27-29. There are many court cases pending related to music industry’s issues, which have come up with the advent of technology, like p2p file sharing, which is detriment to the creativity of the artist. The testimony of Ann Chaitovitz, the Director of Sound Recordings for the American Federation of Television and Radio Artists (AFTRA), from a hearing in front of the California State Senate Select Committee on the Entertainment Industry, in which she states “… royalty artists generally receive between $0.80 and $2.40 for each recording sold, depending on the level of success of the artists when the royalty contract is signed…”(Testimony of Ann Chaitovitz, Director of Sound Recordings, AFTRA). No doubt, technology is changing the perspective of record companies and artists but contracts serve a purpose – to stop opportunistic behavior and it is implicit in deriving the meaning not to take benefit of the susceptible situation. A contract serves five different economic objectives: 1. Keeping opportunism away 2. Extrapolating effective terms 3. To prevent avertible mistakes in the contracting process 4. To leave risk element to be taken care of by the better risk bearer 5. To minimize the cost of settling contract issues. Posner 1998 feels that courts are not well equipped to settle such disputes as the element of consideration is quite important in a contract and courts don’t see through the ‘adequacy of the consideration of a promise; judicial wisdom lies in using the doctrine of duress in comparison to the doctrine of consideration in effectively altering a contract. Contracts are offered either on fixed price basis or take-it-or-leave-it basis. The seller, (here, it is the record company) always has upper hand and purchaser (the artist) has no choice as the market is not competitive (Blanchette, 2004). The royalties payments are settled on the basis of assumed legal statute and as such two distinct channels are used: royalties for the public performance of a work and manual royalties taken from the use of a song for records, tapes and CD sales where the royalties are paid by the record companies. Generally, an artist gets in the range of 8-25% of the expected retail price of a recording. It is not net payment in the hands of an artist. There are three other isues affecting the royalty payments. An artist doesn’t earn royalty on “free goods” offered to radio stations and records sold through record clubs. In music industry, CD and cassette recordings bear 100% “return privilege”; not sold items are returned to the recording company, as a result, it has to hold back 35% royalty for reserves given back by record stores. Further, breakage of albums in shipments reduces 10% royalty (0bringer, 2003). The mechanical royalties in America are based on a “statutory rate” fixed by the U.S. Congress. This statutory rate functions according to the Consumer Price Index, which varies. Presently, the statutory rate for songs of five minutes or less in length carries a rate of $.08 and songs beyond five minutes length are offered royalty $.0155 per minute. Taking an example for a song of eight minutes duration, it would earn an artist $.124 per recording sold. Rules are not hard and fast; there is always bargaining. Record companies mostly settle on a rate, which is nearer to 75% of the statutory rate and that too, when the writer is also the recording artist. The statutory rates don’t come in the way of settling a deal at a lower rate. It is observed that sometimes, it is in the best interests of all parties concerned to settle on a lower rate (0bringer, 2003). The results of online digital music distribution are favorable for artist’s royalties. The RIAA’S Consumer Profile analysis projects a rosy picture of future digital downloads overtaking that of CDs. Companies like Apple iTunes are frontrunners, expecting good competition from Napster and MusicMatch in near future. The structure of online music distribution industry may, most probably, encourage the Big Five to set up their own ventures in collaboration with the labels. According to reports of The Wall Street Journal, Microsoft Corporation is in the process od starting a song downloading service. Wal Mart Stores Inc is not far behind. There is sound potential of new opportunities for artists to outsmart and dodge recording companies by distributing music straightway to consumers, as digital distribution of sound recording over the Internet has opened new doors -- the catalyst of change (Blanchette, Kasie 2004) Otherwise, there is great need for recording companies to be transparent and open-minded in signing contracts with artists. A new model approach is the need of the hour, where the record companies and the artists share the profit that comes after the break-even sales. In the traditional approach to the contractual relationship, artists’ royalty is seen as a cost to the recording company and it strives to decrease this cost; this outlook needs to be changed. Instead, the artist should be a partner in the recording business, creating saleable products. It is worth experimenting to invite artists in the executing of production and marketing plans of an album and they should be taken into confidence about the related costs of albums. The record companies can continue with the practice of recouping a percentage of set costs against artists royalties at the rate of 100% till the break-even point is achieved and beyond the break-even point to the volume of total sales, both parties can reach at a percentage to be decided mutually at which the artist is ultimately recouped. It might result in minimizing profit on successful titles and as a result, record companies might not practice the new model by walking on the beaten path. The record companies would decrease the speculative investments on the release of new sound recording albums. Certainly, it won’t be bad news for established artists but minimize the variety in music, as artists performing in non-mainstream music genres won’t find it easy to get a contract offer from a recording company (Papadopoulos, 2004).  The music industry is full of creativity. Demand is an economic property, which is never certain; there are certain fixed costs, production is multi-channeled. Artists are creative people who practice their art for art’s sake; they don’t have a commercial bend of mind. That’s why they earn less. There is diversity in creativity; musical products have infinite variety; they could be creatively different and have distinct qualities. Time plays a very important role, affecting the economy of recording industry, as is seen by the advent of technology, bringing digital revolution. Because musical products are durable and carry rent, small revenues collected over a long period of time change into substantial amounts. Artists need agents to keep their works, track and collect fees. The heralding of a new time with the pogress in technology might change the winds in favor of artists against recording companies. Time will tell what role the recording companies play in future; whether they remain in the market as players or find themselves nowhere, as the ways of recording, preserving and buying music on the Internet have revolutionized. It has changed the very face of the music industry and will also decide on the recording industry’s practice of recoupment (Caves, R. E. (2000). Works cited list Alhadeff & Sosnick.“Record Labels, Artists, and Finance: A Contribution to the Economic Analysis of Costs and the Equity of Recoupment Practices in the Music Industry.” Blanchette, Kasie. “Effects of MP3 technology on the music industry: An examination of market structure and Apple iTunes.” April 2004. < http://www.holycross.edu/departments/economics/website/honors/blanchette_thesis.pdf> Caves, R. E. 2000. “Creative Industries: Contracts Between Art and Commerce” Harvard University Press Murray, Kevin. Senator: Senate Select Committee on the Entertainment Industry. “Recording Industry Practices.” March 12 2002. Obringer, Lee Ann. How Stuff Works: “How Music Royalties Work.”. 9 October 2006. < http://entertainment.howstuffworks.com/music-royalties6.htm> Papadopoulos, Theo. “Are Music Recording Contracts Equitable? An Economic Analysis of the Practice of Recoupment” MEIEA Journal Vol 4 No 1(2004) pp 83-104.< http://www.meiea.org/Journal/html_ver/Vol04_No01/Vol_4_No_1_A5.html> Regan, Keith, E-Commerce Times. “Apple: iTunes for Windows Off to Roaring Start” Time 21 Oct. 2003: 9:30 “Whom does copyright law really protect?” Filed under: General— mdaly Time 5 March 2005: 4:44 pm Wiser, Mike.“The Way the Music Died: What is recoupment?” May 27 2004. Read More