The U.S. Department of Justice’s Antitrust Division (“DOJ”) recently closed a two-year investigation into Pressplay and MusicNet, the joint online music stores run by the five major record labels (the “Big Five” or “Majors”). The DOJ’s antitrust investigation focused on two questions. First, whether the Majors restrained competition by collectively establishing the terms upon which they would license their music to third-party music services seeking to compete with Pressplay and MusicNet. Second, whether the Majors used Pressplay and MusicNet to stifle competition in the burgeoning Internet music marketplace and to solidify the Majors’ central role in the existing physical music market. The DOJ found “no evidence” supporting either claim.
This article surveys the history of the online music marketplace, the role the DOJ’s antitrust investigation played in the development of that marketplace, and the present structure of the online music industry from an antitrust perspective. Part I provides a history of online music distribution and the DOJ’s investigation. Part II examines the DOJ’s antitrust analysis and its conclusions. Part III evaluates how current antitrust and copyright jurisprudence permitted the Majors to control the growth of the online music marketplace without any overt monopolistic acts.
I. History of Online Music Distribution
In 1999, there were five major record labels – Warner Music Group, BMG Music, EMI Group, Universal Music Group, and Sony Music Entertainment. These “Big Five” owned copyrights to more than 80% of recorded music sold in the United States. As copyright holders, the Big Five had the exclusive right to manufacture, sell or otherwise distribute copies of that music in any form. Generally, the Big Five’s independent distributors and retailers distributed and sold that music to consumers. That is, until Napster came along.
Napster, FastTrack and P2P
From 1999-2001, the name “Napster” became synonymous with online music distribution. A deceptively-simple software program using revolutionary “peer-to-peer” file sharing architecture (“P2P”) allowed Napster users to open their computer’s music library to the world. Napster served as a central directory to every users’ hard drive, but permitted the uploading and downloading of music directly from user to user, rather than storing or routing the songs through Napster’s central servers. Users seeking to obtain audio files from other users would transmit requests through the Napster server, which would perform a search of indexes of its users’ music for matching files, and then transfer the resulting list to the requestor. The requestor would then connect directly to the other user’s hard drive and download the file.
In its first year alone, Napster had twenty million users. By the time Napster shut down in 2001, an estimated sixty million users had shared over one billion songs in a new “MP3” format. At its peak, during a one-hour period, three million people exchanged over three hundred and fifty million songs. During the summer of 2000, Napster was one of the most visited sites on the Internet, and its teenage creator, Shawn Fanning, made the cover of Time Magazine. But Napster’s greatest strength – a central indexing system guiding its users to downloadable music – became its fatal legal flaw. Napster, at all times, held the keys to the indexes of the files stored by its users, and thus had the power to stop the downloading.
In 2001, a second generation of P2P software programs carried on the torch of file sharing. Gnutella and Freenet eliminated the central server that was Napster’s legal downfall, allowing a more “pure” P2P file sharing experience with decentralized networks and anonymity for file sharers. The interfaces were clunky, however, and were quickly followed by sites such as Audiogalaxy and Aimster that emulated the clean Napster interface, yet eliminated the necessity of a central server.
The year 2001 also saw the advent of the most significant advancement on Napster’s original technology – FastTrack software commonly used by services such as KaZaA, Grokster and Morpheus. These software systems used a “supernode” model of P2P distribution developed by KaZaA, in which a number of computers on the network are designated as indexing servers. A user searching for a file connects with one of the supernodes, which then conducts a search of an index and supplies the results; the user then downloads the song directly from the other user’s hard drive. This supernode technology allowed these second generation P2P systems to surpass the success of Napster; according to one estimate, in June 2004, an average of 8 million users were online sharing 10 million gigabytes of data at any given time.
The Music Industry Goes on the P2P Attack
Compared to the rapid development of the popular forms of P2P technology from 1999-2001, the music industry responded as if it were struggling to free itself of quicksand. Bloated and deeply entrenched in its existing physical distribution model, the music industry’s first experience with mass online music distribution was, like everyone else, Napster. But what consumers embraced, the industry attacked. Beginning in 2000, the music industry (represented by the Recording Industry Association of America (RIAA)) embarked on a three-pronged attack against Napster and P2P file sharing. First, take down Napster and its P2P progeny through the courts; second, obtain government support for the industry’s battle against illegal online distribution of music; and third, sue the file sharers. The unwritten corollary to this strategy was the one that raised the monopolistic red flag – the music industry’s initial refusal to authorize third parties to legally sell and distribute online music.
The Majors’ attacks on P2P were initially successful. In 2001, the Ninth Circuit in A&M Records v. Napster upheld a lower court’s ruling that Napster was likely, at trial, to be held liable for contributory and vicarious copyright infringement, due to its knowledge of its users’ direct copyright infringement, and Napster’s failure to do anything about that alleged infringement. The court concluded that, upon notice, Napster had to remove any copyrighted material currently traded by its users, and had to police its system to prevent future users from sharing infringing copyrighted materials. Because Napster’s centralized server held the keys to the file indexing system, the Ninth Circuit concluded that Napster provided both the “sites and facilities for direct infringement.” Napster eventually buckled under its own inability to patrol what it had created.
The RIAA’s parallel attack on the second-generation P2P systems in 2001 was not as successful. Unlike Napster, the second-generation P2P systems had a legal loophole – the software providers no longer provided the “site and facilities” for infringement, or “keys” to the online file sharing kingdom. Because these second-generation services had substantially non-infringing uses (i.e., uses other than copyright infringement), and the software companies no longer had access to the file indexes, the Ninth Circuit recently held in Metro-Goldwyn Mayer v. Grokster that this new generation of file-sharing technology could not be held liable for contributory or vicarious copyright infringement.
The RIAA’s pleas for government intervention were also unsuccessful. When the RIAA initially approached the United States Congress for a legislative solution, Senator Orrin Hatch and others in Congress pressed the music industry to either develop viable alternative legitimate download services or face an antitrust investigation. Lawmakers hinted that a possible resolution would be the RIAA’s worst nightmare – forced licensing to third party digital music stores. In late July 2001, Congress went as far as to introduce a bill seeking to force the Big Five to license their music to others. Representative Rick Boucher (D-Va.), who introduced the Music Online Competition Act (eventually unsuccessful legislation designed to force non-discriminatory music licensing) said at the time that “[t]he Justice Department is concerned about . . . the anti-competitive effect of the labels that own 80% of the world’s music creating the sites that, by and large, have virtually exclusive licenses to distribute that music.” The government’s skeptical attitude towards the RIAA at the time was deserved.
In May 2000, for example, the Federal Trade Commission (“FTC”) found that the Big Five had collectively adopted pricing policies designed to squelch retailers’ discounting of compact discs (“CDs”) to as low as $9.99 in the mid-1990s. These pricing policies, the DOJ found, constituted antitrust violations. The RIAA’s actions in a corollary music market – interactive “webcasting” (or “streaming”) of music over the Internet – also raised antitrust concerns. The RIAA had, from the beginning of that burgeoning market, demanded utter control over the means and method of online webcasting, and the similarities between their attempts to gain control over webcasting paralleled their perceived attempt to control online music distribution. With webcasting, as in online music distribution, the RIAA went to battle with third parties regarding the terms of licenses and what royalty rates should be paid to the Big Five.
In briefs submitted to the Ninth Circuit in A&M v. Napster early in 2001, however, the RIAA stated that the Big Five had too been working on online music distribution. Then, faced with an imminent Senate Judiciary Committee hearing on access to digital music, the music industry dropped an antitrust bombshell: they had entered into two joint ventures to create online subscription music services collectively owned by the Majors – MusicNet and Pressplay.
MusicNet and Pressplay
Sony and Universal had teamed up to form Pressplay, and Warner, EMI and BMG had teamed up with RealNetworks to form MusicNet, both launched in December 2001. MusicNet was a distribution service, through which other online music services would be able to determine their own prices and terms. Pressplay was a full-service subscription model, setting its own prices and subscription terms.
These joint ventures had antitrust problems written all over them from the beginning. Strike one against the joint ventures was the Big Five’s near complete ownership of all recorded music. In the physical music marketplace, wholesalers and retailers had some check over the prices charged by the Big Five for that music. In the digital marketplace, all bets were off. The Big Five would be licensing their music to digital distribution companies they ran, thus controlling the manner and pricing of music distribution over the Internet. Strike two was the Majors’ perceived attempt to litigate competing services out of existence or purchase their competitors. Strike three was the Big Five’s concurrent refusal to authorize any company to sell and distribute online music, essentially forcing consumers onto Pressplay and MusicNet if they wanted to download music legally.
Adding insult to injury was the quality of Pressplay and MusicNet. The systems were riddled with restrictions, and wildly unpopular with music consumers. The services were not legitimate alternatives to Napster or other P2P systems – they were substandard. They used competing audio formats, and MusicNet initially allowed only restrictive “streams” or “tethered downloads.” Pressplay allowed only its high-end subscribers an opportunity to download a limited number of songs that could be transferred to CDs and MP3s, while most users of its base subscription package could only “rent” their music, thus locking these users into a lifetime subscription if they wanted to keep up their digital access to Pressplay’s music. Neither service possessed content from all of the Big Five, thus requiring consumers to subscribe to both services if they wanted content from all the Big Five record labels.
Even the DOJ noted in its Statement regarding the closing of its digital music investigation that when Pressplay and MusicNet first came online, the “poor quality and restrictive nature” of the services “provided some support” for the theory that the Majors were attempting to “impede the grown of the Internet” for music distribution. Simply put, it appeared that the services had been poorly designed in order to steer users back towards the “bread and butter of the music industry” – CD purchases.
Trade groups and legislators criticized the Big Five’s refusal to license their music and unfettered control of prices charged to download music. Those same critics argued that independent record labels or other entities could have promoted and distributed new music as effectively as the Majors, but at a significantly lower cost, making them more attractive to artists than Pressplay or MusicNet. Of course, the Big Five had no built-in incentive to allow that to happen.
In October 2001, Napster’s attorneys brought these criticisms to a head before U.S. District Judge Marilyn Hall Patel, the judge who first effectively shut Napster down. After the Ninth Circuit remanded A&M v. Napster to Judge Patel, the RIAA moved for summary judgment on several alleged infringements of their copyrights – a decision that could have set the computation of damages against Napster for each instance of infringement.
At the hearing on the RIAA’s request for summary judgment, Napster argued that the MusicNet/Pressplay arrangement constituted both horizontal price fixing by setting prices in the online music marketplace, and vertical foreclosures of the digital marketplace by refusing to enter into reasonable licensing and distribution arrangements with competitors (and possibly licensing each others’ services on better terms). Napster introduced evidence that the Big Five’s actions in the online marketplace would effectively exclude independent wholesale and retail competitors, thus raising prices and harming artists by reducing competition for the rights to distribute artists’ music.
At the same time, the Big Five reportedly sought onerous distribution terms from potential distributors. Some critics argued that the Big Five were demanding exclusive distribution deals and tying in webcasting licenses at a set rate with the RIAA. It appeared that the Big Five were preventing webcasters from offering the same type of interactive services then offered exclusively by Pressplay and MusicNet.
Competing online music companies complained that the Big Five either simply refused to negotiate the licenses, or offered licenses at royalty rates that would ensure bankruptcy. One source reported that MusicNet refused to license to small entities, and in certain cases, required companies to make advance payments of as much as $750,000 before even entering into talks to license their music. Napster itself argued that it had reached an agreement earlier in 2001 to carry MusicNet songs in the new legal version of Napster (Napster 2.0). But, an exclusivity provision essentially forbid Napster from signing a similar deal for Pressplay. Napster contended that this was a “misuse of copyright,” stating that “what you have here is an attempt (to use copyrights) to control Napster’s ability to enter into an agreement with anyone else.”
Judge Patel remarked about the Big Five’s licensing tactics: “I’m really confused as to why the plaintiffs came upon this way of getting together in a joint venture. Even if it passes antitrust analysis, it looks bad, sounds bad, and smells bad.” The Department of Justice apparently agreed.
The DOJ’s Investigation & the “iTunes Effect”
The Department of Justice’s Antitrust Division announced its investigation into MusicNet and Pressplay in March 2001. The DOJ investigation followed shortly on the heels of a similar inquiry into the joint ventures by the European Commission (the executive body of the European Union). Beginning with interviews of major players at the Big Five, the investigation continued through the summer at a slow pace. Following the October 10, 2001 hearing before Judge Patel, the DOJ intensified its investigation by calling for behind-closed-door meetings with industry executives, and by sending out civil investigative demands (“CIDs”) to the RIAA, MusicNet and Pressplay. The CIDs sought, among other things: documents regarding the Majors’ Internet music services; terms proposed by the record companies and music publishers for their licenses; lawsuits the Majors had threatened, filed, or settled regarding online music; proposed and final licenses, analyses of the terms; and documents discussing the quantity of music needed to launch a successful online music business.
And then came iTunes. One word describes Apple Computer’s revolutionary iTunes software, iTunes Music Store (“ITMS”) and iPod: phenomenon. The iTunes software program for Apple users debuted in early 2001 to little fanfare, but was quickly acknowledged as the industry leader and preferred music player for Apple users. When Apple debuted its now-industry dominant iPod in November 2001, no one saw what was coming around the bend. In April 2003, Apple’s CEO Steve Jobs revealed that he spent 2002 negotiating what no other company had been able to negotiate – music licensing deals with the Big Five and thousands of independents. Hidden in the innocuous iTunes software was a gateway to the ITMS, where consumers could finally get a “Napster-like” online music experience – songs that could be quickly and easily downloaded, no subscription required, for 99¢ per song or $9.99 for an album.
iTunes was the Trojan horse of the music industry. Where competitors failed, Jobs succeeded. Apple’s three percent (3%) computer market share served as a perfect testing ground for legal online music distribution. ITMS users quickly racked up 1 million sales in the iTunes Music Store’s first week of business. By October 2003, Apple had sold 14 million legal downloads, making it the most successful legal online music store in the world.
And then Jobs revealed a bigger coup: ITMS for Windows. Apple, announcing that “Hell froze over,” did something it had never done: built a software platform for Windows. Opening its doors in October 2003, Apple repeated its success with ITMS for Apple in the Windows PC market. As of August 2004, iTunes offered over one million songs available for download in the United States, including music from the Big Five and over 600 leading independent music labels, 100 million downloads and a seventy percent (70%) market share.
With the proven success of Apple, the digital download gold rush began. The Big Five began licensing their content to a wide number of entities in the United States and abroad, removing many restrictive music licensing terms from their agreements with online music stores, and allowing online stores to deliver the music in a number of different formats and terms. A vast array of companies including Amazon, BuyMusic.com, MTV, Wal-Mart, Coke, Dell, Microsoft, Musicmatch, Woolworth’s, Virgin Music, Yahoo, Starbucks, and even Oxfam now boast digital music download services for PCs.
And, as the download stores exploded, Sony and Universal Music Group sold Pressplay to Roxio, an independent software company that absorbed Pressplay into its legal version of Napster, Napster 2.0. Napster 2.0 improved on Pressplay, and MusicNet changed the nature of its services. More importantly, this divestiture of Pressplay removed any possible allegations of conspiracy amongst the Big Five to control music licensing terms.
II. The DOJ’s Antitrust Analysis
Close on the heels of ITMS for Windows, the DOJ announced the closing of its investigation into Pressplay and MusicNet. Issuing a press release on December 23, 2003, the DOJ provided a window of insight into the logic behind that decision. The DOJ’s investigation focused on two questions. First, whether the Big Five’s ownership of Pressplay and MusicNet led them to restrain competition by limiting licensing terms for their music to unaffiliated music distributors. Second, whether ownership of Pressplay and MusicNet allowed the Big Five to “impede the growth of the Internet as a channel for the authorized promotion and distribution of music, and thereby help the major labels solidify their central roles in the existing music market.” Both questions were answered with an emphatic “no.”
Limitations on Licensing Agreements
The DOJ first examined the terms of the Majors’ licensing agreements to third-party music services attempting to compete with Pressplay and MusicNet. The DOJ’s concern was that the Big Five would collectively establish the terms on which they would license their content to third party providers of online music, using Pressplay and MusicNet to exchange “inside” information regarding licensing terms and conditions. By exchanging this information, the Big Five could control the manner and means of licensing and set a standard arrangement, to the detriment of the third party music services.
The DOJ’s investigation, however, found that the terms of the Big Five’s music licenses to third party services “var[ied] significantly,” and that each label “adopted its own approach” toward Internet distribution of their music to other companies. Pressplay and MusicNet had themselves apparently adopted safeguards designed to prevent the inappropriate exchange of such information between their Big Five owners. The DOJ thus found that the “major labels licensed their music to a broader array of third-party music services that compete on price and features [than when the investigation first started].” Moreover, the private company Roxio’s acquisition of Pressplay completely eliminated the possibility of information sharing and the prospect of diminished competition between Sony and Universal, thus taking some major steam out of the DOJ’s initial concerns about those labels’ ability to control pricing and features of the third party services.
Impeding Growth and Solidifying The Existing Market
The DOJ also investigated whether the Majors suppressed the growth of the Internet as a means of promoting and distributing music in order to protect their present marketplace position in the distribution of music on physical media such as CDs. In essence, the DOJ’s concern was that the Majors would use Pressplay and MusicNet to control the pace and direction of the online music market, rather than letting the marketplace control that growth.
The DOJ’s stated rationale for concluding that the Majors did not collude to suppress the growth of the online music marketplace was based on the realities of the online music marketplace in late 2003. R. Hewitt Pate, the Antitrust Division’s Assistant Attorney General, stated that the inquiry “has uncovered no evidence that the major record labels’ joint ventures have harmed competition or consumers of digital music,” because “[c]onsumers now have available to them an increasing variety of authorized outlets from which they can purchase digital music and . . . are using those services in growing numbers.” The DOJ found that:
Consumers can now download individual songs from a growing number of competing digital music suppliers, each of which offers songs from the music catalogs of all five of the major record labels. Consumers also have their choice of subscription-based music services that, for a monthly fee, allow subscribers to browse hundreds of thousands of songs, to listen to “streams” of an unlimited number of songs of their choice, and to download the particular songs they want to “burn” to compact discs or transfer to portable devices.
The existence of such choices greatly alleviated the DOJ’s concern about the Majors’ use of the joint ventures to suppress competition. Roxio’s acquisition of Pressplay from Sony and Universal provided even greater antitrust relief because it “eliminated the possibility of . . . diminished competition between those two labels that might have been facilitated by their continued involvement in Pressplay.” Moreover, Pressplay and MusicNet vastly improved their services, and “[c]onsumers can now download individual songs from broad music collections offered by at least five such services, and might soon be able to choose among a dozen suppliers.” From this, the DOJ concluded, “the major labels are not impeding the promotion and distribution of music over the Internet.”
So, the DOJ held that the growing number of legitimate online music sources for consumers proved that the Big Five did not suppress competition by forming MusicNet and Pressplay.
III. Monopolistic Effects Without Antitrust Hassles
A 99¢ per download price gives the labels about the same profit they make on the average sale of a CD. How did the music industry arrive at a collective 99¢ price point for legal music downloads that guarantees at least the same profit as from CDs, despite the differences in costs between CD distribution and digital distribution? The Majors, without any overt monopolistic acts, were able to use their collective powers in the licensing market to slow the growth of the legitimate online music marketplace until the market would bear such a price. What the Majors could not obtain by overt monopolistic acts, they could obtain from copyrights.
Copyrights as Limited Monopolies
Copyrights are limited monopolies by definition. The U.S. Constitution provides that “The Congress shall have the Power . . . To promote the Progress of . . . useful Arts, by securing for limited Times to Authors . . . the exclusive Right to their respective Writings.” Authors of copyrighted materials such as musical works have the exclusive right to make copies of their music, sell or otherwise distribute copies of their music, to perform their musical works in public and to prepare derivative works.
When analyzing the legality of distributional restraints on copyrighted materials, therefore, courts generally take into account the relationship between the restraint and the statutory right to control the methods and means of distribution of the copyrighted materials. In other non-intellectual property contexts, distributional restraints imposed by a limited number of owners of goods working collectively would likely be seen as per se violations of the Sherman Act. With copyrights, however, such a monopoly is condoned. As stated by the United States Supreme Court in Broadcast Music, Inc. v. Columbia Broadcasting System, Inc.:
Although the copyright laws confer no rights on copyright owners to fix prices among themselves or otherwise to violate the antitrust laws, we would not expect that any market arrangements reasonably necessary to effectuate the rights that are granted would be deemed a per se violation of the Sherman Act. Otherwise, the commerce anticipated by the Copyright Act and protected against restraints by the Sherman Act would not exist at all or would exist only as a pale reminder of what Congress envisioned.
Copyrights alone, however, will not shield overt price-fixing violations. Agreements to fix prices for copyrighted materials are treated – absent some legitimate copyright purpose – just like any other horizontal price fixing combination and held per se illegal under the Sherman Act. Similarly, vertical restraints on trade in the distribution hierarchy through price fixing are also generally per se illegal. However, current antitrust jurisprudence in the copyright context demonstrates that unless there is a naked restraint on competition, the governing legal standard is the rule of reason, such that a copyright owner’s ability to exclude and control use of the work is given deference.
Using Copyrights to Maintain Profits
During the DOJ’s investigation, critics commonly asserted that the Big Five were colluding to impede the growth of the online music marketplace, leveraging copyrights to protect the Majors’ position and profits in the physical music marketplace. Larry Lessig, a Stanford University law professor and chair of the Creative Commons copyright project, stated at the time that “it’s the intent of the music industry to stifle and slow innovation to better protect existing market positions. Whenever there is a model created they don’t like, they sue and get it pretty much stopped.” A review of the Majors’ actions over the past three years supports such a criticism.
The Big Five had near-total control over the intellectual property (the Majors’ music catalog) and initially used their copyrights to bar competitors’ access to that property by refusing to license their music to competitors on reasonable terms. At the same time, the Majors sued Napster and its progeny P2P networks out of existence, thus forcing consumers to obtain that property through substandard online music stores run by the intellectual property holders, a.k.a. the Majors. Such actions would likely have been seen as antitrust violations in a non-intellectual property context, as all the conditions for traditional horizontal and vertical price-fixing arrangements were in place.
In the copyright context, however, such licensing tactics are often permitted, as deference is given to the copyright holders’ exercise of control over their work. There were also legitimate business reasons for every step the Big Five took: joint music ventures allowed the Big Five to initially experiment with a form of music distribution previously uncharted by anyone but Napster (thus some leeway had to be allowed); restrictions on licensing were permissible under copyright law; and initial price setting at various levels based on both subscriptions and downloading allowed the Majors room to determine the appropriate “real” cost in this new marketplace. And eventually, the Majors licensed their catalogs to third parties.
But by using restrictive licensing practices to initially halt competitors’ entrance into the digital music marketplace, the Big Five changed the course of online music distribution. They slowly controlled the growth of the marketplace, testing it with Pressplay and MusicNet. By 2003, with successes against Napster and lawsuits against file sharers in their pocket, the Big Five settled on a 99¢ pricing model that equaled, or even exceeded, their existing CD profit structure. The Majors’ delay in the development of the online marketplace, although insufficient to rise to a level engendering antitrust action by the DOJ, eventually resulted in a price point for downloads that would likely have resulted had the Majors expressly colluded to control the online music marketplace in the first place.
Like the heady days of the booming Internet economy, we are in the midst of a paradigm-shifting change in the way music is distributed and purchased. The DOJ’s watchful eye can partly be credited for the Big Five’s gradual loosening of its licensing reins in the online music marketplace. But Apple’s iTunes also proved the market for online music distribution, a bandwagon upon which a host of other online retailers across the world have now jumped, partly fueled by the Majors’ willingness to license their music when they saw the ability to maintain their profit in that market.
It could be true, as recently stated by the court in Grokster, that time and market forces result in an equilibrium between the music industry’s interest in controlling its mechanisms of distribution and the consumer’s interest in innovation and access to copyrighted materials. But it could also be true that the Majors delayed the development of the online music marketplace in order to control the pace and manner of that development, while at the same time raising the market value for their intellectual property. The DOJ could do little, if anything, about such delay absent evidence of overt collusion between the joint ventures. In a marketplace where a limited group of intellectual property owners control access to the majority of that property, that is the risk consumers must bear.
 In August 2004, Sony Music Entertainment and Bertelsmann Music Group, the world’s second and fifth largest record labels, merged into the world’s largest record label, Sony BMG Music Entertainment. Barry Willis, Done Deal: Sony BMG, stereophile.com at <http://www.stereophile.com/news/080904sonybmg/> (Aug. 9, 2004).
Roxio recently divested itself of its software business to focus on Napster 2.0. Barry Willis, Roxio Pouring All into Napster, Stereophile.com, at <http://www.stereophile.com/news/081604roxio/> (Aug. 16, 2004).