- In the fall of 2000, former Bertelsmann Chief Executive Thomas Middelhoff thought he had devised a way to invest safely in Napster, positioning the media giant to reap billions of dollars if everything worked out and protecting Bertelsmann legally if Napster collapsed. In this excerpt from All the Rave: The Rise and Fall of Shawn Fanning’s Napster, author Joseph Menn explains how Bertelsmann wound up on the wrong end of a $17 billion lawsuit filed by songwriters and music publishers.*
A Halloween Day 2000 press conference in New York revealed an astonishing alliance between Napster Inc., on its knees in court, and the parent of one of its five archenemies. German publishing conglomerate Bertelsmann AG, owner of No. 3 record label BMG and the world's largest book publisher, Random House, had decided it was better to join together than to fight.
BMG had been bombing financially, and Bertelsmann thought that a Napster-like distribution system might give it an unbeatable advantage. As reporters gawked at Bertelsmann CEO Thomas Middelhoff hugging Napster author Shawn Fanning, they heard even more than the usual amount of hype. "There's no question that file-sharing will exist in the future as part of the media and entertainment industry," Middelhoff declared. "Now the show begins."
The alliance had begun coming together not long after Napster was crushed by U.S. District Judge Marilyn Patel's proposed injunction, now stayed during appeal. Napster CEO Hank Barry was trying to attract financing anywhere he could. In the meantime, Middelhoff's e-commerce chief, Andreas Schmidt, was spending time in Silicon Valley, chatting up digital-music firms and talking about Bertelsmann buying them. "He looked like Daddy Warbucks, with Bertelsmann's cash coming out of his ears and his breast pocket," said Gerry Kearby, head of Liquid Audio. "They were making overtures to purchase every company in the space."
It was also around then that Middelhoff and Schmidt discussed the potential for a Napster settlement with a discouraged Edgar Bronfman Jr. of Universal Music. Middelhoff and Schmidt left the meeting thinking there was some kind of deal possible, that Bronfman just wasn't seeing it. Schmidt called Barry, leaving the music people at BMG out of the loop.
Over the strenuous objections of BMG executives, Bertelsmann ultimately pledged to lend Napster $60 million, convertible into 58 percent ownership. Unlike Barry, Middelhoff wasn't sure Napster was legally defensible. "It is true that this private exchange of music via the Internet has thus far infringed upon the copyrights of artists and record companies," he wrote to colleagues. So instead of a direct stock investment, he was willing only to make the loan. The reasoning was spelled out in a September 2000 briefing for Bertelsmann executives by a consulting firm. In a slide identifying the major risks of Bertelsmann's involvement, the experts wrote: "How do we avoid liability for old and ongoing copyright infringements? [Bertelsmann] provides loan and thus does not become a shareholder."
In a worst-case scenario -- Napster losing in court and filing bankruptcy -- they predicted that Bertelsmann would emerge with Napster's valuable technology, since the loan would be secured by those assets. A separate task force of Bertelsmann executives assigned to "Project Thunderball" recommended that Napster's existing system stay operational until a copyright-friendly version was ready. That way, the maximum number of subscribers could be pitched to switch. "Otherwise the customer base will be disbursed [sic]," the task force told Middelhoff.
Bertelsmann's Halloween press conference was long on attendees and short on details. The company said Napster's system would continue as it was, that BMG wouldn't drop its suit, and that a new business model hadn't been worked out. The executives were carefully coached: if they were asked whether the loan would facilitate more illegal downloading, they were told to say neither yes nor no, just to parrot a line about the loan being used to develop the legitimate system. The companies revealed none of the investment terms. Rather than racing to sign up, competing record labels were aghast, since the deal gave Napster the financial means to keep fighting them.
After months went by without a new version of Napster, Bertelsmann's eCommerce Group met to discuss getting content from the other majors and getting management control of Napster, perhaps "by replacing HB [Hank Barry] with a Bertelsmann manager." The team wrote that it was "legally difficult, but doable" to get rid of Barry. After Patel's injunction was upheld, Napster was forced to go dark and stay dark until it could block 100 percent of the infringing material. Two weeks after that decision, Barry named his replacement CEO, Konrad Hilbers, who had worked for Bertelsmann's business-development team, as chief financial officer of its publisher Bantam Doubleday Dell, and as CFO of AOL Europe before a last stint at Bertelsmann's BMG.
A secure version of Napster took another six months, and it still lacked most major-label songs. Napster had one more card to play -- the threat of bankruptcy, which would likely leave the record labels with nothing, while Bertelsmann stood to walk away with the technology. Renewed talks between Hilbers and the record industry failed when Bertelsmann balked at the $250 million price tag. "With that, this whole strategy fell apart," Hilbers said.
Desperate for cash, Napster began firing staff in the spring of 2002 and returned to Bertelsmann asking for more money. Seeing Napster's weak position, Middelhoff suggested that Bertelsmann simply buy the company instead. He reasoned that Bertelsmann would have a better chance of striking a deal with the labels, and since Napster wasn't operational, Bertelsmann felt that it would have no liability even if Napster were hit with a massive judgment.
The talks between Bertelsmann and Napster foundered, and Napster filed for bankruptcy in June. Now Bertelsmann agreed to buy just Napster's technology, cleansed of liability from the pending copyright suits. Bertelsmann dismissed Middelhoff before the Napster deal could be consummated, but it was contractually obligated to continue with the $9 million purchase if Delaware U.S. Bankruptcy Judge Peter Walsh approved it by the Sept. 3 deadline.
The record labels and music publishers fought the deal and won access to documents and the right to interview Hilbers, Napster CFO Lyn Jensen, and Bertelsmann's Bill Sorenson. The music companies argued that Bertelsmann hadn't acted like a regular lender when it first gave Napster money, but as a disguised equity investor. In bankruptcy law, the distinction is critical. If Bertelsmann was really a secured lender, then it could count its $85 million in loans and have a giant head start on any other bidder for Napster's remains. If it was an equity investor, then the value of its holdings would be virtually wiped out, and everyone would start from the same place in the bidding.
The industry's lawyers turned up a raft of evidence that Bertelsmann's relationship with Napster was far different from that of a normal creditor. To begin with, Jensen testified that she couldn't get a bank loan at any interest rate before Bertelsmann stepped in. Bertelsmann not only made a massive loan, it did so at 6.1 percent -- more than three percentage points below the prime rate. The evidence also showed that Bertelsmann was thinking from the beginning that a bankruptcy would turn its low-risk loan into ownership.
More seriously, there was the matter of management control. Hilbers acted to the outside world like an independent thinker, but his e-mail was littered with direct orders from Middelhoff, his former boss. And despite the claims that the $60 million in initial funding was going toward the development of a legally sound system, Bertelsmann executive Sorenson conceded that much of it was used for regular operating expenses. Finally, Bertelsmann executives had written that they should keep the old service open so that they had the biggest potential audience when the system converted to a legitimate structure.
"Bertelsmann knew the money was being used to continue to run the infringing service until the legal service could be developed," music publishers' lawyer Andrew Rosenberg argued at a showdown hearing that began before the Labor Day weekend and concluded on the very day of Bertelsmann's deadline. Speaking for some of the record labels, attorney David Stratton went even further: Bertelsmann had such control of Napster, he said, that the labels were considering suing Bertelsmann itself. The case would be similar to the never-completed claim against Napster, that it knew about the infringement and had contributed to it. The prospect made Bertelsmann's new leadership nervous: a now-wasted $85 million was bad; a potential billion-dollar liability was a whole new ball game.
Judge Walsh assumed that if he ruled against the asset sale, Napster would be liquidated. But the facts were so egregious that he had no choice. There were a number of grounds to rule as he did, Walsh said, but he cited just one -- that Napster hadn't met its burden of showing that its negotiations with Bertelsmann had been at arm's length. "It seems abundantly clear that Mr. Hilbers had one foot in the Napster camp and one foot in the Bertelsmann camp, and was so fundamentally conflicted that I believe that the transaction was tainted," Walsh said from the bench.
Hours after Walsh ruled, Napster said it planned to liquidate. At auction, Silicon Valley software firm Roxio Inc. bought Napster's technology; it plans to relaunch a version of Napster this year. In February 2003, songwriters and music publishers sued Bertelsmann for $17 billion.
The above is an excerpt from All the Rave: The Rise and Fall of Shawn Fanning's Napster (Crown Business, April 2003) by Joseph Menn. Menn is a staff reporter for the Los Angeles Times and co-author of The People vs. Big Tobacco (Bloomberg Press, 1998).
