Pandora Music Inc., iHeartMedia Inc., and other digital music services pay songwriters too little—a government-set rate that falls below what the composers would get on the open market—a royalty organization will tell a federal appeals court Feb. 8.

The U.S. Court of Appeals for the District of Columbia Circuit will hear arguments on whether rates set by the Copyright Royalty Board are based on what the digital music services would pay to play the music in a free market.

SoundExchange Inc., an organization that collects royalties for copyright owners from digital music services, is prepared to argue that licensing deals used by the board to set statutory rates are artificially low because the deals aren’t reached under true market conditions. The board will counter that it established reasonable rates supported by substantial evidence.

The question of how high the government sets rates will impact when services like Pandora—critical to the music industry’s attempts to recover from plummeting sales of CDs and other physical music formats—will reach profitability.

Pandora, launched in 2000, has yet to become profitable, reporting an operating loss in 2016 of $319 million on $1.38 billion revenue. And market-based royalties set by the government are important to the music industry, which operates under several different kinds of licensing systems.

In Congress, the Music Modernization Act (H.R. 4706 and S. 2334), recently introduced to address music licensing issues, would allow the court that oversees other types of negotiated music licenses to consider a wider range of existing rates, including market-based deals, when resolving rate-setting questions.

The board sets the rates under Section 114 of the Copyright Act, 17 U.S.C. §114, which creates a statutory license for noninteractive satellite and internet radio services. Noninteractive services, such as those offered by Pandora and iHeartMedia, don’t let users choose which songs they hear.

The law requires the board to set rates according to the “willing buyer/willing seller” standard—meaning it should replicate what the parties would have agreed to in a market without a statutory license.

In May 2016, the board set rates for subscription-based commercial noninteractive services from 2016 to 2020 at 22 cents for 100 plays, and for advertising-based services at 17 cents for 100 plays. The subscription service rate went down from 25 cents and the non-subscription rate was up from 14 cents. Pandora said the rate was acceptable. SoundExchange disagreed.

The National Association of Broadcasters, Pandora, and iHeart, which have intervened in the case, urged the court in a joint brief to affirm the board’s decision. Sirius XM, which is also subject to the rates, didn’t intervene in this proceeding.

Market-Based Standard

Section 114 allows streaming services to play music as long as they comply with the board’s terms, including payment of royalties to SoundExchange Inc., which distributes payments for performance of musical works to copyright owners.

SoundExchange is disputing how the board used existing licenses negotiated between copyright owners and music services to set the most recent rates.

Specifically, the board considered a 2014 deal between Pandora and independent music rights agency Merlin Network BV, and a 2013 deal between iHeartMedia and Warner Music Group.

SoundExchange, in its briefs to the court, said the board failed to consider that the negotiations that resulted in the Pandora-Merlin and iHeart-Warner deals were influenced by the fact that the statutory license exists in the first place. That is, if parties fail to reach agreement, the statutory license process means that a streaming service could just go to the government to get a rate, taking away some of the copyright owner’s leverage.

“The very existence of the statutory license distorts—or casts a ‘shadow’ on—privately negotiated agreements,” SoundExchange said. In a truly free market, the negotiated rates would be higher, it said.

SoundExchange also objected to the board’s discounting of rates by applying a concept of “effective competition,” or imagining a situation in which the licensing fees were being negotiated in a market in which the participants had effective competitors. That method is not authorized by the Copyright Act, SoundExchange said.

However, Congress explicitly authorized its reliance on existing licenses as evidence of market-based rates, the board said in its briefs, regarding SoundExchange’s “shadow” argument.

The case is SoundExchange, Inc. v. Copyright Royalty Bd., (Webcasting IV), D.C. Cir., No. 16-1159, argument scheduled 2/8/18.