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Bertelsmann: Making music with Napster

The German music giant has a plan for Napster. Now it has to sell customers--and the other big recording studios to buy in.

On Halloween 2000, German media giant Bertelsmann horrified the record industry.

The company, which owns the major record label BMG Entertainment, announced plans to invest in Napster--even while BMG and the other four major labels were suing the controversial file-sharing service for copyright infringement.

The investment was hinged on Napster's completion of an ambitious project to create a paid version of its immensely popular service--one that would not only charge consumers a subscription fee, but also pay labels, artists and publishers a cut while ensuring songs would not be distributed illegally.

On top of that, Napster and Bertelsmann executives confidently promised it would work with the record industry to achieve this goal.

Andreas Schmidt, the CEO of Bertelsmann E-Commerce group, emerged as the central figure behind constructing the Napster deal. Fresh from a two-and-a-half year stint as head of AOL Europe, Schmidt appeared out of thin air as the man appointed to see this deal through.

Schmidt has quite a task ahead.

For Bertelsmann, the risk in dealing with Napster has come at a cost. Top executives in its record label BMG Entertainment, including former CEO Strauss Zelnick and chairman Michael Dornemann, have quit. And other major labels, ranging from Universal Music Group and AOL Time Warner's Warner Music Group have openly voiced skepticism over Bertelsmann's participation terms.

Three months later, Bertelsmann continues to insist that a paid version of Napster is on track. But little is known about how it will look, or whether Bertelsmann will succeed in the daunting task of courting record executives to work peacefully together in creating the new Napster.

In a recent interview in his office towering 42 floors over Times Square, Bertelsmann's Schmidt sat down with CNET News.com's Jim Hu, laying out the company's plans for Napster as he provided a glimpse of what's in store for the German media giant.

What is the Bertelsmann E-Commerce trying to do?
The task of the Bertelsmann E-Commerce group is very simple. We took all the various aspects that we had related to e-commerce, related to broadband, related to mobile--whether they were stakes that we owned like Barnesandnoble.com or other subsidiaries--and grouped it under the holding company. The strategic job that we have to do is twofold. No. 1: identify the platforms and future business models to drive across mobile and broadband Internet. No. 2: build new business models out of the existing businesses that we have, or create new ones to help the content that we have to be a viable business in the future.

The announcement with Napster definitely shocked a lot of people in the media and music industry. What was it that sparked this leap of faith? You own a record label that's suing Napster.
Let me put it this way. A couple PULLQUOTE of assumptions that we had in this entire music space. No. 1: Music is the only true digital product today. It's digitized, and it's already flying across the various platforms, even on mobile platforms and so forth. No. 2: The traditional music majors.

You mean the Big Five (BMG Entertainment, Universal Music Group, Sony Music Entertainment Group, EMI Recorded Music and Warner Music Group)?
The Big Five--even the independents--were not able to manage consumer needs. Consumers clearly stated that they want to have access to music. And the various business models, including the rights management technologies, subscription offers, just didn't catch up with the consumer. Even today, only a couple thousand of songs are legally available at a point in time when we've been talking for three years about initiative-wide common standards around SDMI and rights management. Nothing happened in that space. So that left the door open for new services to be established. And then, obviously, Napster brought a technology which really goes back to the heart of what the Internet is all about--direct communication between people with different interests.

But at the same time, you're saying there are only a few thousand legal songs...
Right.

So is that an admission that you may be investing in a service that might not be legal?
No, it has nothing to do with what we do or what Napster is doing is legal or not.

What I'm saying is the offer which is out there today, whether it's from Universal, whether it's from BMG, whether it's from Warner Music, doesn't help the customer right now to get what he wants and what he deserves. (The customer wants) easy, simple access to music. If you install the various download tools, whether it's (Universal Music Group's) Bluematter or whether it's the Sony system or it's the various (initiatives) at BMG--your computer crashes. It's a complete mess-up in terms of technology; it's a complete mess-up in terms of ease of use. I think we have to do some thing about it.

How are you going to make it "legal" and secure?
That's what the lawsuit is all about. I don't think Napster has done anything wrong under the current law. I think they have a very good case with the court and they're making their arguments.

But while they're making their arguments, we have to take the opportunity to create something bigger than just to settle our legal terms from the past. This is the largest community of music lovers on the globe. If we can manage a way to deliver what the consumer clearly tells us he wants, in a way that is not destroying the entire music industry, then we are doing a good job.

Not destroying the music industry means artists have to be paid. That's the fundamental that Napster has said all along, and basically our job is to help them in that process to build their systems.

You're saying that you think Napster has a very good chance in court?
They have a very good legal argument.

At the same time, people in the few floors down in this office are still out on a holy war against Napster.
No, I don't think that they are on a holy war. If you talk PULLQUOTE to anyone at BMG these days, there's no holy war against Napster. The tone of all (the record labels) in regards to Napster has changed dramatically in the last couple of weeks. Even the comments that (Time Warner president) Dick Parsons made are much more moderate. He's not saying, 'Napster never.' He's not saying, 'We don't believe in it.' He's saying, 'Well, there are open issues we need to resolve, like, for instance, the business model, the payment structure, the accounting overall for what the rights holders get.'
These are fair questions that we have to answer. And that's what we're doing. But we're not doing this in public. We're meeting constantly with them, we're trying to take them into the process, giving them input, giving them knowledge, and including them in establishing this business model.

What are you putting on the table? Parsons said they hadn't seen anything that made them think this plan could be put into reality. What's the incentive?
Well, I think the incentives are twofold and AOL Time Warner is a different partner in that context. If you look strategically, I think they clearly have the ability to build their own music subscription service in the future. That's what they said. There will be clearly some certain element of competition in there. But I believe there will be file-sharing services not only from them but from other big brands. In the future, maybe Yahoo, or AOL, will be natural competition, but Napster has the advantage of being the first mover in that field.

Now, talking about the business model and what we have to offer, it's rather simple. We offer access to this large community of music lovers. We offer the artists and the rights holders to get payments in the future for use of their intellectual property, and offer participation. That could be equity or can be just a pure commercial relationship. That varies from the different strategic interests, which the Big Five companies have. Clearly, an integrated company like AOL Time Warner will have a different strategic interest than a Sony or a pure-play music company like EMI.

If you talk to AOL Time Warner executives, if you talk to music executives, if you talk to online music executives, they all say the only way for something like a music subscription service to work is if you get widespread industry participation.
There are three ways to do this. One way is through the judicial system. That's the court case, which is ongoing and we'll see what the courts have to say about whether it's (fair use or not fair use), and how the arguments are taken by the judge. I think they are very strong.

The second is a legislative approach, meaning that file sharing is a reality, it will not stop just with music but will expand on the business-to-business side throughout companies, it will expand over new formats or other formats of media. So I think in the long run there also should be a legal framework--I think under the (Digital Millennium Copyright Act) probably--for how to deal with file sharing in the future. To establish certain standards and rules, everybody, not just Napster, who wants to operate in that environment, can use and take forward. I think we've pioneered this right now. Napster just hired (Manus Cooney) who was the general counsel of the Senate Judiciary Committee. The third way to sell it is the commercial relationships that we have to establish. But we're moving on all three fronts right now.

There are reports where you are quoted as saying you will wrap up talks with music rivals within the next two weeks.
I think we are on a very good path right now. Obviously, the discussions with some partners are more intense than with others, and I'm very optimistic about this--otherwise, I wouldn't have made those comments. It might be two or it might be three weeks. What I'm saying is that the message is that for some major issues, we have the right emphasis right now, but they seem to be very receptive right now. And it's now about nailing down how it's going to look like in detail.

Vivendi Universal's CEO Jean-Marie Messier said they are not going to settle the Napster case until after the court decides because they learned from MP3.com that they can squeeze a lot of juice a lot out of this.
He made different comments at Davos (Switzerland), at the World Economic Forum. You have to take a look at the quotes. About two weeks ago, he gave a Business Week interview where he said, well, 'We think Bertelsmann was maybe a little bit too early.'

Too early in what?
Too early in cutting a deal with Napster. He said we really have to look at this and figure out how to make it work. And that's what you see over various comments taken from the announcement we made until today. You see a lot of progress. Obviously we'd like to see the progress go faster, but we have to take into account that it also means that entire corporations have to move their mindsets.

So you're saying that within 2 to 3 weeks we can expect to see other major labels signing on with you?
I haven't said major labels; I said more settlements, as we have already delivered. TVT, which Napster settled, even if it's independent, shouldn't be underestimated because they completely went out of the lawsuit, they completely settled. I think that's a very good indication that the model we have developed and put on the table in the private discussions that Napster's pursuing is really working.

How far are you on the negotiations with the major labels? Are you guys coming out with equity terms?
There is a complete package with all the elements: that includes equity, the transfer management with regards to the security and the accounting, to the payment for the artists. So everything is tied together now.

A big question mark is security. What sort of technology are you using to secure these files, to ensure payment, and to make sure these files are not traded illegally?
I don't want to be too specific about it, only to the extent that I say our number one goal is that the user experience that a Napster user has today is not tampered with. I know that Napster looked at all different technologies out there. Very few of them have proven to be sufficient when it comes to the elements of ease of use. They're all highly, highly secure, but secure to the way that users can't handle. And we don't think this is the right approach.

This is not about the national secrets of the United States, which have to be secured from the Soviet Union. This is about music. There always has been a certain element about piracy around music, as of today even in the physical format. We believe that even in the future there will be some piracy around music, there's no question about it. And this will continue. That's true for all media.

The point is, again, how to adapt the current copyright situation and the current copyright law, which is not adjusted to the technology, to make sure that we build a structure for the new services as they evolve without depriving artists of their rights. That's critical. And what's also critical with regards to security is that we develop common standards for delivering content in a way that is convenient to the user but also ensuring payments to the rights holders.

(Bertelsmann CEO) Thomas Middelhoff also gave a June or July timeframe for a Napster subscription service. Are you confident in that estimate?
I think we do what is in our ability to keep up with the timeframe, and we will see if we match it or not. But this is not just about a date. This is a very complex, very complicated build-out. As I said, it's legal, it's commercial, it's about legislation, it's about the business model itself, it's about defining new technologies.

Is there a subscription version of Napster right now that is being tested and could be introduced during that timeframe?
I will not comment on what is internally done right now. I just want to tell you there's a lot of complexity associated with it because we have to work on all fronts. That's certainly much, much more than what you have to do when you normally develop a business model and start a new service.

(Former antitrust chief for the Justice Department) Joel Klein and (Napster attorney) David Boies--are you creating your own antitrust team to take down the next monopoly?
Well, I don't see a monopoly right now. Bertelsmann has done this consistently, where we try to get the best people available on the team, and Joel will be a tremendous help for us in that process.

How will you work with Klein? Will he be involved in the processes in terms of negotiating with the labels?
He will be closely involved, working with me on strategic issues as well as on legal matters. He's got a great deal of experience, and we're looking forward to working with somebody who knows the U.S. legal system inside-out and who has a great deal of experience dealing with difficult situations.

AOL Time Warner doesn't want to say they are a media company, they don't want to say they are an Internet company. But yet many people have expressed concerns over the company that has been created in terms of future revenues that they want to tap television, broadband, and all media outlets. Is Bertelsmann driving toward the same goal?
We don't believe we need to control all the access. We don't need the pipes. We have strategic partnerships that guarantee access to the consumers, but what we believe is that we're going to create new products and new media formats across the various platforms. We will focus on media, the content production and delivery of this content across the platforms in the new formats.