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PUBLIC VERSION IRECFtVZLo APR 10 2007 COPYRIGHT ROYALTY JUDGES LIBRARY OF CONGRESS Washington, D.C. In the Matter of Docket No. 2006-3 CRB DPRA Mechanical and Digital Phonorecord Delivery Rate Adjustment Proceedings WRITTEN DIRECT STATEMENT OF THE RECORDING INDUSTRY ASSOCIATION OF AMERICA, INC. Volume 3 Charles D. Ossola (DC Bar No. 295022) Steven R. Englnnd (DC Bar No. 425613) James L. Cooper (DC Bar No. 442475) Michele J. Woods (DC Bar No. 426137) ARNOLD 4 PORTER LLP 555 Twelfth Street, N.W. Washington, D.C. 20004 (202) 942-5000 (Telephone) (202) 942-5999 (Facsimile) michele [email protected] (Email) Counselfor the Recording Industry Association ofAmerica, Inc. Amended Filing April 10, 2007 (Original Filing Date November 30, 2006) PUBLIC Before the COPYRIGHT ROYALTY JUDGES LIBRARY OF CONGRESS Washington, D.C. Aj'R18 m07 00PP~9ht Roy@y 8)are ) In the Matter of ) Docket No. 2006-3 CRB DPRA ) Mechanical and Digital Phonorecord Delivery Rate ) Adjustment Proceeding ) ) TESTIMONY OF PROFESSOR DAVID J. TEECE Mitsubishi Bank Professor, Haas School ofBusiness, and Director, Institute ofManagement, Innovation and Organization, at the University of California at Berkeley, Chairman, LECG, LLC NOVEMBER 30, 2006 PUBLIC TABLE OF CONTENTS Section ~Pa e INTRODUCTION AND SUMMARY ~ ooi ~ 0 ~ 1 A. Background and Qualifications. 1. B. Background on Matter 2 C. Summary of Conclusions 1. The royalty rate structure should be changed to a percentage basis........ 2. Rates should be lowered significantly — to 7;8% or less of wholesale revenues. 3. Rates recommendation................................................................., ......... II. THE ECONOMIC THEORY OF VALUING INNOVATION AND CREATIVE ACTIVITY oooo ~ ~ erie trooo ~ reer recit error to ~ ~ r rerit torero ~ eerie ~ oooro 9 III. THE MUSIC INDUSTRY: 1970 TO THE PRESENT ................. ~ to ~ *ooreiooo it 15 A. The Recording Industry's Performance Has Declined 15 1. Record Companies'evenues Have Dropped, 15 2. Unit Shipments of Albums and Spending on Music at Retail List Prices. 16 3. Unit Shipments of Recorded Music By Delivery Format.....„,....,....,. 19 4. Sales of the "Hits" Have Dropped Dramatically Since the Late 1990s ..... B, The Mechanical Royalty Rate.....,..„......„...............,.„...„..........„........... 1. Statutory Rate History. 2. Since 1997, the Mechanical Royalty Rate Has Risen Substantially While Wholesale CD Prices Have Fallen Substantially. 3. The "Effective" Mechanical Royalty Rate Has Likewise Risen, Taking an Increasing Percentage of Recording Industry Revenue ........................ 28 C. Causes of Industry Business Declines. 32 1. Piracy is a Primary Cause of the Drop in Record Company Revenues Since 1999 33 a. Music Piracy Explodes in 1999 33 b. Economic Effects of Piracy 35 2. Record Company Business Partners ...,.............................................;.. 4] D. Industry Responses To the Post-1999 Business Challenges. 42 1. Reduction in New Releases and New Artists... 43 2. Industry Response to Piracy...........................................,...........,....... 45 a. Record Company Staffing Reductions: 1999 Through 2005.............. 46 b. Publicly Available EMI Data on Employment and Costs ................... 47 c. Publicly-Available EMI Data on the Outlays By Its Music Publisher and Record Company Segments 49 d. Publicly Available Information from Warner 51 E. The Outlook for the Recording Industry's Sales and Revenues 51 TABLE OF CONTENTS PUBLIC (Cont.) Section ~Pa e F. The Music Publishers Have Prospered. 58 1. Music Publishers'oyalty Revenue Has Grown Significantly While the Recording Industry's Revenue Has Declined 2. Music Publisher Profitability Significantly Exceeds That Of Record Companies. 63 3. Music Publishing Is A Low Risk, High Margin Business ................... 63 IV. ANALYSIS AND RATE RECOMMENDATION.......................................................... ... 69 A. The Rate Structure Should Be Changed To a Percentage. 69 1. Percentage Structure ...................................,.................„......,.......,................ 69 2. The Appropriate Royalty Base....................................................................... 74 B. 1981 CRT Decision and Changed Circumstances Show the Rate Should Be 7.8% Or Less. 76 1. 1981 CRT Decision — The Last Mechanical Rate Proceeding...................... 76 2. 1981 CRT Decision Implies a Current Rate of 7.8 Percent Or Less of Wholesale Revenues. 79 3. The Section 801(b) Objectives and Changed Circumstances ........................ 81 a. Objective One: Maximize the availability of creative works to the public......... 82 (1) Economics of Maximizing Availability 82 (2) Trends in Availability of Creative Works Today 83 b. Objective Two: Afford the copyright owner a fair return and the copyright user fair income under existing economic conditions............. 85 (1) Economics of Comparative Returns. 86 (2) . The Current Balance of Return to Copyright Owners and Income to Copyright Users 89 c. Objective Three: Reflect the relative roles of the copyright owner and the copyright user in the product made available to the public with respect to relative creative contribution, technological contribution, capital investment, cost, risk, and contribution to opening new markets for creative expression and media for their communication 91 (1,) Economics of Relative Roles . 92 (a) Record Company Contributions. .93 (b) Record Company and Publisher Risk. 100 (c) Record Company Efforts to Develop New Markets.................... 101 (d) The Music Publisher's Contribution . 105 d. Objective Four: Minimize any disruptive impact on the structure of the industries involved and on generally prevailing industry practices. 108 e. Conclusion: The 801(b) Objectives Support a Percentage Rate and a Substantial Decrease in the Rate................................ 110 PUBLIC TABLE OF CONTENTS (Cont.) Section ~Pa e C. Other Benchmarks 111 1. Implications of the 1997 Settlement and Its Aftermath. 111 2. Mechanical Royalty Rates in the U.K 114 a. The U.K. Uses a Percentage-Based System. 114 b, The UK Mechanical Royalty Rate for Physical Products.... .....115 c. Current U.K. Mechanical Rates for On-line Products, 116 D. Rate Recommendation . 117 PUBLIC Value Creation, Value Capture, And Appropriate Royalties In The Recorded Music Industry I. INTRODUCTION AND SUMMARY A.. Background and Qualifications My name is David J. Teece. I received my Ph.D. in Economics from the University of Pennsylvania in 1975. I am currently the Mitsubishi Bank Professor in the Haas School of Business and Director of the Institute of Management, Innovation and Organization at the University of California at Berkeley, and Director and Chairman of LECG, LLC (an international consulting firm). I also have taught at Stanford University and Oxford University. I have published over 200 scholarly books and articles in the fields of industrial organization, technology management, the valuation and management of intellectual property, and public policy. Several of my academic papers have involved studies of the distribution of the rewards from innovative and other creative activity. According to Science Watch (Nov/Dec 2005), I was the tenth most cited author world-wide in economics and business for the decade 1995-2005. I am the co-editor and co-founder of Industrial and Corporate Change, an academic journal published by Oxford University Press that concentrates on issues surrounding technological change and business organization. I also have extensive experience in consulting in a wide range of industries. I have studied licensing in a variety of contexts, and have been a member of the Licensing Executive Society for many years. The analytical frameworks that I have developed for determining the ways in which innovations can be combined with other assets and capabilities to create value, and for determining the distribution of returns to innovation are widely referenced, and can usefully be applied to creative industries, such as the music industry. PUBLIC A copy of my curriculum vitae, containing my list of publications, is attached hereto as Appendix A. I have testified as an expert witness before courts and tribunals in the U.S., Canada, Australia, New Zealand, and Europe. A discussion of material considered in preparing this Report is attached at Appendix B. B. Background on Matter Section 115 of the U.S. Copyright Act (17 U.S.C. $ 115) provides a compulsory license for making and distributing phonorecords of a musical work. This right is colloquially referred to in the music industry as a "mechanical" license. The license covers traditional "phonorecords"' i.e., physical forms of sound recordings such as compact discs ("CDs") — as well as "digital phonorecord deliveries" or "'DPDs," such as digital downloads of sound recordings.'ompliance with the statutory terms permits use of a musical work upon payment of the statutory rate for each copy of the musical work distributed. For the first 70 years of the mechanical compulsory license, Congress set the rate directly. In the Copyright Act of 1976, however, Congress delegated the task of setting a specific rate to a Copyright Royalty Tribunal ('"CRT") which was empowered to hold hearings in support of its rate setting. Congress directed the CRT to set "reasonable terms and rates of royalty payments" in accordance with four "objectives" (the "Section 801(b) objectives"). Although there have been some intervening changes, the Copyright Royalty Judges in this proceeding must also set a "reasonable