COLUMN: Johnny Mercer was Capitol’s first president. Glen Wallichs succeeded Mercer in 1947. Alan Livingston succeeded Wallichs in 1961. One of Livingston’s main accomplishments was creating the cartoon character Bozo the Clown. Livingston got fired in July 1968 and was succeeded by Stanley Gortikov. Gortikov also succeeded Wallichs as president of Capitol Industries in 1969. Sal Iannucci became president of Capitol Records. Iannucci was Capitol’s first “outside” executive. He had been vice president of National General Corp. and before that a vice president of CBS Television.

As the financial information accompanying my previous post on Capitol’s early history shows, both Gortikov and Iannucci did not perform according to expectations. EMI fired them in April 1971 and replaced them with Bhaskar Menon. In 1974 Menon appointed Brown Meggs as president of the Capitol label. He fired Meggs in 1976 and appointed Don Zimmermann. Meggs later went on to head Angel Records, EMI’s classical music label in the U.S. Steven Murphy, a book-publishing executive from Simon & Schuster, replaced him in February 1991. In July 1978 John Reed (then chairman of EMI) appointed Menon as head of EMI Music worldwide. [I will discuss the Menon regime in a subsequent post.]

Capitol’s early artist relations gaffes are well known. Two of the most famous are Frank Sinatra and The Beatles. Warner Brothers (films) formed its own record division in 1958. In the early 1960s it was able to lure Frank Sinatra from Capitol. Sinatra owned Reprise Records. He sold it to Warner Bros. Records for $1.5 million and one-third of the stock of the combined company, together with a new film deal, Bruck, C. (1994) Master of the Game (p. 50). The package was valued at some $22 million, Eliot, M. (1989) Rockonomics – The Money Behind the Music (p. 149); and Goodman, F. (1997) The Mansion on the Hill (p. 49). Sinatra’s deal even gave him veto power over any later sale of the label. Sinatra and Reprise later sued Capitol for restraint of trade in September 1962, alleging Capitol revengefully had dumped all of his old LPs in the market at half their wholesale price, Sanjek, R. (1996) Pennies from Heaven (p. 388).

Later, Capitol executive Dave Dexter famously rejected all four of the Beatle’s first singles (“Love Me Do,” “Please Please Me,” “She Loves You” and “I Want to Hold Your Hand”). As a result they were released on the independent label Vee Jay Records. Only by suing Vee Jay on a pretextual basis was Capitol able to get them back, Callahan, M. (May 1981) “The Vee-Jay Story,” which appeared in Goldmine Magazine; and Goodman op. cit. (p. 368); and Sanjek op. cit. (p. 381).

One of management’s major distractions in 1971 – 1978 was a class action lawsuit for securities fraud arising out of Capitol’s alleged overstatement of its financial condition in order to inflate the market price of its publicly-traded stock, Catena v. Capitol. I have posted a copy of the complaint here. Capitol’s stock had fallen from $60/share in November 1969 to $12/share in August 1970 to $6/share in November 1970. Catena alleged Capitol had engaged in a wide variety of illegal trade practices. These included giving advertising allowances to dealers, which never were used for advertising; distributing free goods to dealers as a sales inducement to buy more records, which then were returned for full credit against a price the dealer never paid; manipulating earnings by inducing dealers not to return records before key financial reporting dates; and failing to write-off obsolete inventory, Sanjek op. cit. (p. 557); Sanjek, R. & Sanjek, D. (1991) American Popular Music Business in the 20th Century (p. 219). The Catena case precipitated a grand jury investigation. Capitol eventually prevailed in the action because of a U.S. Supreme Court decision in a case called Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) requiring a higher standard of proof in actions for securities fraud.

At the time these practices were found throughout the record industry, though there is evidence they particularly were prevalent at Capitol; see, for example, the book by former Capitol executive Roger Karshner (1971) The Music Machine (p. 67). The Catena case did much to anneal Menon’s management team and unquestionably was a material factor precipitating EMI’s tender offer in October 1978 for all of Capitol’s publicly-traded shares then outstanding.

Arguably much of the conduct alleged in the Catena case continued to occur after EMI took over Capitol, the only difference being there were no public shareholders to complain. As Walter Yetnikoff of CBS Records candidly admitted in his book Howling at the Moon (2004), “The mystique of the music business is that, though profits are huge, accounting is incomprehensible … calculating profits requires decoding a system that defies normal scrutiny” (p. 207). [Yetnikoff’s use of the term “profits” is imprecise; what he really means is “free cash flow” generated by record company operations, which then can be deployed for other corporate purposes.]

Three later examples of this type of earnings manipulation at Capitol involved David Bowie, Tina Turner and Garth Brooks. In 1983 David Bowie released the album “Let’s Dance.” In order to induce Bowie to deliver his next record “Tonight” before the end of EMI’s 1984 fiscal year, Capitol paid Bowie an extra-contractual advance of $1 million. Tina Turner’s 1984 album “Private Dancer” was a surprise hit and Capitol paid her an extra-contractual advance of $1 million to deliver her next record “Break Every Rule” before the end of EMI’s 1986 fiscal year. Both “Tonight” and “Break Every Rule” were unsuccessful, particularly in comparison to their immediate predecessors. Neither artist ever again achieved the same level of sales.

The same thing happened later with Garth Brooks. When Brooks initially was signed to Capitol’s Nashville-based label he had a conventional recording contract. It paid him an advance, specified a modest royalty rate, and required him to deliver additional masters. In December 1990 following the success of his first two records Brooks renegotiated the royalty rate to 15%, with escalations based on future anticipated net sales. With his continuing success in January 1993 Brooks radically restructured the contract. He flipped the relationship between the record company and its artist, in effect retaining all net sales proceeds, while paying the label a distribution fee and an allowance for manufacturing and marketing costs. Capitol gave Brooks ownership of all of his previous masters. It also applied the new contractual terms retroactively. These concessions significantly contributed to Brooks’ estimated $300 million income for the first eight years of his career, Feiler, B. (1998), Dreaming Out Loud – Garth Brooks, Wynonna Judd, Wade Hayes, and the Changing Face of Nashville (p. 279). Brooks’ next record – “Fresh Horses” – dramatically under-performed in relationship to its predecessors.

Capitol was particularly vulnerable to these kinds of problems because of its historically low market share. It was, however, not the only label susceptible to this tendency. According to Hits magazine, of the forty most competitive bidding wars for artists in the early 1990s, the results produced: six hit records, nine ambiguous ones and 25 signings that did not make back their initial investment and were financial disasters, Haring, B. (1996) Off the Charts (p. 149).

Here are a few examples. At the height of the CBS – Warner Bros. wars in the late 1970s – early 1980s, CBS (then run by Walter Yetnikoff) chased after Warner Bros. artists such as James Taylor. CBS ended up signing Taylor for a $2.5 million advance and an additional $1 million/album, Dannen, F. (1990) Hit Men – Power Brokers and Fast Money Inside the Music Business (p. 125). Warner Brothers (then run by Mo Ostin) in turn pursued CBS artists such as Paul Simon. This prompted Yetnikoff to sign artists preemptively to prevent them from going to Warner Bros., such as Paul McCartney (formerly signed to EMI) and the Beach Boys. The McCartney deal was reported to be worth $20 million; CBS wanted it so badly it threw in the valuable CBS-owned Frank Loesser catalog of music as an extra incentive, Eliot op. cit. (p. 195). McCartney made five albums for CBS and only one of them (“Tug of War”) arguably was successful. McCartney later re-signed with EMI but the Loesser catalog was his to keep and CBS lost at least $9 million on the deal, Dannen op. cit. (p. 127).

In retaliation Ostin in turn pre-emptively signed artists to prevent them from going to CBS, such as Rod Stewart, whom he signed for 10 albums at $2 million apiece, Dannen op. cit. (p. 126). None of the newly-delivered records achieved the sales of their predecessors. [For an analysis of the CBS-Warner Bros. wars, see this post.] Even when he still was president of CBS Records, CBS Inc. sued Yetnikoff in May 1988 alleging he had improperly depressed profits of the records group in the fourth quarter of 1987 by (among other things) making large unjustified and improper advance payments to artists who hadn’t had a hit in years, Dannen op. cit. (p. 314).

Later, in 1990, Hollywood Records – then run by the lawyer Peter Paterno – paid $10 million to sign the band Queen and license the right to distribute its 15-album catalog in the U.S. At the time Paterno knew that Freddie Mercury had AIDS, Haring op. cit. (p. 173). Mercury passed in November 1991. It seems unlikely Hollywood Records ever recouped. During his tenure Paterno wrote a memo defending his performance, which particularly was critical of Capitol. This was ironic because Capitol was Queen’s immediately-previous label and Queen failed to deliver any significant records to Capitol. In other words one of Paterno’s most important management decisions emulated Capitol in almost every respect. In fact Capitol had gotten itself into litigation with Elektra Records, Queen’s label before Capitol, in order to secure the rights to Queen in the first place.

How can we account for this phenomenon? Most business organizations prefer to characterize themselves as “strategic.” This carries with it the implication the company envisions a future, which might be different than the present is today. It is planning ahead. This proposition is more difficult to accept with firms engaged in creative endeavors, morphing “art” into “commerce.” Artistic works by their very nature are intangible and ephemeral. They have no intrinsic worth. Properly understood making money out of them is a form of latter-day alchemy. The main economic problem with artistic works is there are no standards or criteria to assess their value in the marketplace in advance of their actual sale. Because of this it’s impossible to know what to do in advance. Market research and corporate planning are inefficacious. Anything can come out of left field and be a big hit. One can invest in big stars only to discover they’re past their prime.

The counterpart to this is one can invest a modest sum only to have the property explode and become incredibly successful. An example is Nirvana’s “Nevermind.” Released with few expectations in 1991 it went on to sell over 10 million copies and generate over $80 million for its label Geffen Records, Farr op. cit. (p. 43); Goodman op. cit. (p. 355). Label president Ed Rosenblatt was quoted as saying “We didn’t do anything. It was just one of those ‘get out of the way and duck’ records,” Azerrad, M. (1993) Come As You Are: the Story of Nirvana (p. 218). Because there is no clarity to this when viewed prospectively the most the record company can do is to develop a kind of defensive early-warning system, a network of tentacles and NORAD-like radars, which will pick up even the most sensitive vibrations. Once the record company senses something is happening it can reallocate resources and, like an ember, carefully conflagrate it to other markets, territories and media. In an environment of limited economic resources the only business strategy that works is triage. This is a reactive strategy, which is the precise antithesis of the forward-looking strategy most firms try to implement.

The transactions I’ve mentioned illustrate what I’ve come to call the “fading diva syndrome.” By this I mean that as a record company becomes more desperate for potential hit records it has a tendency to renegotiate its existing contracts (or enter into new ones) to over-pay established artists, in the hope they will be able to duplicate their previous success. Given the transient and volatile nature of consumer demand for recorded music, more often than not this is a mistake and the new record will be financially unsuccessful. Reciprocally the extent to which the artist demands prospective concessions is a measure of the artist’s lack of belief either in his/her own capacities to deliver a commercially-demanded record, or his/her lack of belief in the record company’s ability to market and promote it effectively once delivered. For example, when the band The Police signed with A&M in 1978 they took a lower advance but a larger back-end royalty because they thought they were going to be successful; as a result of doing so they made far more money than they ever would have, had they taken a larger advance with a lower back-end.

This complex of inter-reactions is what economists call a “moral hazard” problem. Moral hazard has nothing to do with “morals” in the sense of good v. bad or right v. wrong. Rather it occurs when parties to a contract attempt to insulate themselves from the risk of their own non-performance or inability to perform, mainly because they’re not sure whether they can.

There are many good reasons for artists to try and protect themselves by seeking large advances that don’t involve moral hazard. One of the main ones is record company chicanery. Recording artists (particularly new ones) historically have been disadvantaged by artist contracts. Plenty of books explain the nuances of how and why this occurs and ways to try and negotiate around it, see, e.g., Passman, D. (1991) All You Need to Know about the Music Business (and its many subsequent editions); Owens, J. (1992) Welcome to the Jungle; and Avalon M. (1998) Confessions of a Record Producer.

Even with a good contract, though, there are a variety of ways in which the physical number of records sold gets manipulated. As a result, what should count as net sales turn into non-royalty-bearing transactions. These include: (1) the use of “free goods,” which are records given away to retailers as a sales inducement. Records by popular artists often are given away to support sales of records by less-popular ones. (2) provisions involving the use of free goods by record clubs (when they still were around), for example, “buy two, get one free.” For example, back when he was popular, the EMI recording artist Richard Marx discovered his albums comprised almost 50% of the frees given away by record clubs, Haring op. cit. (p. 124). (3) Large dumps of “obsolete” records, which dramatically depreciate the economic value of the artist’s records still in the marketplace, and the artist’s future sales potential. Capitol in particular was guilty of engaging in these practices, especially with The Beatles. Although the Beatles ceased recording in 1969, in the early 1980s they still comprised some 30% of Capitol’s sales. Over an 11-year period Capitol continually “scrapped” old Beatles records, even as it was manufacturing new ones. In several instances huge quantities of records designated as scrap in fact were sold to a cut-out dealer who found their resale to be so lucrative he started manufacturing cut-outs himself, eventually selling some 1.7 million of them. Despite lacking any kind of contractual permission to do so Capitol also gave away thousands of Beatles records to “charity,” all of which ended up in the resale marketplace, Eliot op. cit. (p. 215); Knoedelseder, W. (1993) Stiffed – A True Story of MCA, the Music Business and the Mafia (p. 45). Exacerbating the problem, when an artist tries to audit the record company’s books, it is met with intransigence, Haring op. cit. (p. 214).

I do not mean the remarks set forth in this note as criticism of any of the artists I’ve mentioned in this note, or their respective management. My favorite record is a hit record. I think they all are fantastic and I congratulate them on their negotiating acumen. Furthermore the record business is not unique in its propensity for earnings manipulation as the recent history of companies such as Enron, Madoff & Associates and Lehman Bros. shows. Rather what I want to point out is that the fading diva syndrome is not favorable for the record company. I am not sure whether the type of earnings management exemplified by the fading diva syndrome rises to the level of actionable balance sheet manipulation. It does however illustrate what in my opinion usually are culpable errors of business judgment. Many of Capitol’s failings over the years are attributable to this problem.

Next: Capitol’s acquisition of United Artists Records.