Select Committee on Trade and Industry Minutes of Evidence


Memorandum submitted by British Phonographic Industry Ltd

1.  INTRODUCTION

  The structure of the submission is as follows:

    —  Sections 2 and 3 give industry background relevant to the parallel imports issue.

    —  Sections 4 and 5 assess the effects of parallel trading on both producers and consumers.

    —  Section 6 considers the various intellectual property issues that are raised in the context of the parallel imports debate.

2.  BRITISH PHONOGRAPHIC INDUSTRY (BPI)

  The British Phonographic Industry is the record companies' trade association. The BPI represents more than 200 record companies in the UK and its members produce most of the country's recorded music.

  The BPI was founded in 1971 and has a democratically elected Council existing of the managing directors of large and small companies from a variety of musical backgrounds. The Council meets on a regular basis to confront issues affecting the music industry.

  The BPI hosts the annual BRIT awards ceremony. This honours the best of British and international music talent and is broadcast throughout the world.

  The BPI operates a Research and Information Department which collects, collates and publishes statistical information about the size and value of the market for recorded music in the UK. The BPI also has an Anti-Piracy Unit which targets pirated and counterfeit CDs and gives educational seminars to public enforcement bodies and the record industry. The legal department provides advice to members and negotiates on their behalf with other music bodies.

  The Events department supports BPI members by arranging attendance at international trade fairs which promote British exports.

  Through the British Record Industry Trust, whichis funded by charitable events and indivdual donations, the BPI sponsors a number of initiatives to promote education and employment in the record industry and elsewhere. This ranges from the BRIT School for Performing Arts and Technology to the Nordoff-Robbins Music Therapy Centre which works to help disabled children communicate through music.

3.  CHARACTERISTICS OF THE UK RECORDING INDUSTRY

  3.1  Contribution of the recording industry to the UK economy.

  The contribution of the recording industry to the UK economy has to be seen in a broader context than merely the production of recordings. The record industry generates high value added and employment for composers, musicians, studios, producers, manufacturers, music publishers, collection societies, retailing and distribution, and managers, agents and promoters.

  The best data currently available on the value of the music industry to the UK economy relates to 1995 and is provided by The Value of Music (a National Music Council Report into the value of the UK Music Industry prepared by the University of Westminster November 1996).

  The value-added[3] of the UK music industry was estimated by the report at £2.5 billion (including earnings generated overseas). This is broken down in table 1.


Table 1

Total Value Added (£m)
Live performance: rock and pop etc.300.0
Live performance: classical etc.146.0
Other artists' earnings525.0
Opera and musical theatre120.0
Recording (including manufacturing and distribution) 415.4
Music publishing85.5
Collection societies23.3
Retailing and distribution334.1
Musical instruments: production, retailing and distribution 319.0
Managers, agents, promoters132.0
Education and training100.9
Total2,501.2


  This value-added generates considerable employment. In 1995, the music sector in the UK generated the equivalent of 115,200 full time jobs. When part-time workers are added, at least 160,000 people were actively involved in the creation and distribution of music.

  A BREAKDOWN OF EMPLOYMENT IN THE MUSIC INDUSTRY IS SHOWN IN TABLE 2.

TABLE 2

Estimated Employment
Live performance: rock and pop etc.42,000
Live performance: classical etc.6,383
Other artists' earnings3,888
Opera and musical theatre1,250
Recording (including manufacturing and distribution) 14,944
Music publishing1,195
Collection societies971
Retailing and distribution18,898
Musical instruments: production, retailing and distribution 9,000
Managers, agents, promoters15,562
Education and training1,072
Total115,163


  3.2  The "Value of Music" report notes that with value added of £2.5 billion, the music industry is of similar size to industries such as water supply (£2.4 billion in 1994) and larger than organic and inorganic chemicals (£2.1 billion), electric motors (£1.9 billion), electronic components (£1.7 billion) and shipbuilding(£1.6 billion).

  3.3  The nature of the recording industry.

  The recording industry is a particularly high-risk industry. The level of investment required is extremely high and there is a good deal of uncertainty in the expected return. On average, only 1 in 10 recordings are successful.

  This is well summarised on page 73 of the Department for Culture, Media & Sport's Creative Industries Mapping Document (1998) ["DCMS Report"].

    "The recording industry is high risk, requiring substantial upfront investment in new artists and repertoire (A&R). Record companies invest approximately 12-13 per cent of revenues in A&R, one of the highest ratios of R&D expenditure of any industry. The industry relies on a handful of "blockbuster" hits to cover the losses from the majority of recordings that do not sell enough copies to cover the initial investment."

  Confirming the point on levels of investment, the Monopolies and Mergers Commission report on the supply of recorded music (June 1994) commented on the fact that the DTI had observed that 20 per cent of record industry turnover is devoted to A&R expenditure, together with expenditure on fixed capital formation. The DTI found that this compared well with 2.2 per cent R&D in manufacturing generally and even compares well against electronics with 10.2 per cent.

  Despite this level of investment, many recordings are produced at a loss or just a modest profit. That this is true is proven by the rates of return received by investors in the recording industry. A recent study by NERA[4] on behalf of DGXV of the European Commission showed the following rates of return for the period 1992-1997:

NERA report—Table 2.1: Page 16 of Appendix C.2
Operating Profit Margin (92-97)
Majors5.6 per cent
Independents-0.1 per cent


  These profits are modest by general standards and, in the case of the independent record industry, are negative. Of course, within these aggregated figures are examples of recordings that are extremely successful which earn a much higher return than that shown above. On the other hand, it also includes recordings for which the losses are very significant where the recording is a complete failure.

3.4  THE "MAJORS"

  The five major recording companies are BMG, EMI, Sony, Universal and Warner. These are global companies with operations in markets throughout the world. Notwithstanding the multinational nature of these companies, each of the individual country offices is typically a nationally based company. This means that they have indepedent decision-making ability from the parent. Most importantly for the debate on parallel imports, they have indendent budgets to invest in local repertoire.

3.5  THE "INDEPENDENTS"

  The DCMS 1998 report on the creative industries notes that 29 per cent of albums sold in the UK were supplied by 800 independent record companies (based on 1991 data). This proportion has barely changed in recent years and is higher than any of the individual market shares of the majors.

  A feature of independent companies is that they are too small to have operations on a global scale. The domestic (UK) market is the most important market due to the fact that it is here that the company will have a selling infrastructure and can compete head on with the majors. On export markets, however, it is impossible for most independent companies to have own selling operations. Thus there is a simple choice for export markets.

  Either recordings are licensed to unrelated companies in each export market or the finished product is exported through unrelated distributors.

  Before considering the effect of parallel imports on the independent record industry in section 4.3, it is important to look at the income flows in the domestic and export markets in a little more detail.

  In the domestic market, the independent company is responsible for the recording from the original recording, through manufacture of the CD, to the sale to a dealer. The exact process varies according to the genre. However, generally, high levels of investment are made in promotion and advertising for sales on the domestic market. Not every recording will be successful and therefore it is an extremely risky business. Although particular recordings may make substantial profits, often these merely cover the losses of other recordings that have flopped. This is a highly competitive market and, thus, the independent record companies have to be highly efficient and dynamic economic operators. Because of this some of them are able to make overall profits, but given the riskiness of investment, many make losses even on the domestic market and there are many company failures each year. Thus, for many recordings, the domestic market is not sufficient to cover the high investment costs.

  The export market, on the other hand, is not viewed in the same way. The independent record companies do not have the infrastructure in each market to run their business in the way that they do in the domestic market. Therefore, export markets are viewed very much as marginal sales. If a record has made a profit at all on the domestic market, export sales are profitable as long as they cover marginal costs. Thus, although all companies would like to receive as high a price as possible for export sales, they accept the price that each market bears. In the case of licensing, it is only royalty income that is received. It can be noted that this means that the UK independent record company does not have any control whatsoever on selling price (they merely receive a royalty income based on a fixed percentage).

  The key difference, therefore, is that for the domestic market, UK independent record companies price on a full average cost basis. For export markets, they price on a marginal cost basis if it is necessary in order to be able to sell in the overseas market in question.

  These characteristics were reflected in the DCMS creative industries report:

    "The indies play an important role in the industry, discovering new sources of talent, and establishing new fashions. However, as a result they bear a disproportionate risk of developing new repertoire."

  Given all of the above points, it is clear that both the UK and export markets are crucial to the business of UK independent record companies and loss of either market would raise serious questions about the viability of many of these companies.

3.6  The industry does not only produce pop music

  Pop and rock music clearly dominate the industry in value terms. However, fewer than one quarter of BPI members are regarded as pop music specialists and indeed there are just as many companies whose output includes classical music. The range includes the spoken word, jazz and brass band music. BPI's membership even includes specialists in Christian and other religious recordings. This reflects the diverse nature of the independent record companies.

4.  HOW PARALLEL IMPORTS WOULD AFFECT THE UK RECORDING INDUSTRY

4.1  The general effects of international exhaustion

  Currently, parallel imports are permitted when the first sale has taken place inside the EEA (ie Community exhaustion). When the original sale is made outside the EEA, the rights within the EEA have currently not been exhausted. International exhaustion would mean that rights were exhausted on the first, legitimate sale anywhere in the world.

  The general effect of this is that prices could not differ according to different circumstances in different markets. The implication of this will differ for the majors and independents. We will consider each of these in turn.

  The term "parallel import" implies that a product is being imported "in parallel" to an original export transaction. This is not always the case in the record industry. Recordings can be licensed to, and manufactured by, different companies in different countries. In such a situation, the parallel import may be an identical product to the domestically produced product but there is no original export transaction.

  In the past, a common source of imports has been North America. The dramatic fall in Asian currency values over the last 18 months suggests that countries such as Thailand, Malaysia and Indonesia are now more likely sources. Also, countries in Central and Eastern Europe with less developed economies and where piracy levels are rife, are another obvious source, as the industry develops its operations in these territories. With the current strength of sterling, such parallel importation is bound to occur on a very significant level.

4.2  The effect of international exhaustion on the majors

  The introduction of international exhaustion would not necessarily have a significant impact on the business of the major recording companies in global terms. However, it would change the structure of these companies' global business.

  As noted in section 3.3, all of the majors in the UK have independent artist and repertoire budgets. This is invested in developing UK talent. The result of this is that an investment might be made in a band that, initially at least, is only expected to do well in the UK market. Although such a recording may be sold in export markets, it is unlikely that the same level of investment would occur.

  If recordings can come back into the UK through parallel traders from non-EEA markets, the higher price in the UK (required to cover the investment costs) will be compromised. In effect, the parallel trader will be free-riding on the original promotion and advertising investment for the UK market.

  Introducing international exhaustion risks losing this independent function of the UK divisions of the majors. International exhaustion will mean that prices cannot differ between markets. Thus, in effect, companies' strategies will become more global as a global price will have to be charged for each recording (the only differences reflecting transport and other costs).

  The risk for the UK economy is that the unfettered role of the local office is lost as global strategy is decided by head office in the biggest market (the US) and profits revert back to the US, rather than remaining with the UK divisions as at present. Such a situation would result in job losses for the UK as well as a lower investment in UK talent.

4.3  The effect of international exhaustion on the UK independent record industry

  If parallel imports are permitted from all countries, the UK independent record company has four possible responses:

    —  Raise export prices.

    —  Lower domestic prices.

    —  Leave prices as they are.

    —  Refuse to supply export markets where prices are lower than domestic market.

  We can look at the consequences of following each of these choices in more detail.

Raise export prices

  Firstly, it can be noted that increasing price in the export market is not an option. Independent record companies are price takers in export markets. The choice is to sell at the market price or not sell at all.

  It can also be noted that it would not be possible to increase licence fees given that they are already set at the price the particular market can bear.

Lower domestic prices

  Reducing prices on the domestic market is also not a viable option. The price cannot be lowered because many UK independent record companies are already on the borderline of commercial viability.

Leave prices as they are

  The principal effect of this will be that, where export sales have been priced on a marginal cost basis and are then re-imported, they will displace domestic sales priced on an average cost basis. The effect will be an overall fall in profitability caused by parallel traders free-riding on the investment of the independent record companies.

  In additon there would be a fall in royalty income in two ways. Firstly, even where royalties are payable at the same percentage rate, the amount received will be reduced because it will have been calculated on the basis of lower prices. Secondly, royalties from low priced markets are likely to be at lower percentage rates.

  Lastly, the profit associated with the manufacturing element in the domestic market will be lost where products have been licensed on the export market.

  As explained above, considerable investment in A&R, advertising and promotion take place in the domestic market. The same investment has not taken place for marginal export sales. Thus, parallel traders importing CDs from low price countries will be free-riding on the expenditure of the UK independent record companies. This is a classic case of market failure. The response to the free-riding problem is that UK independent record companies will not make investments because they can be too easily undermined. Thus, fewer new recordings will be made. Given the importance of the independent sector as highlighted in the UK Goverment Creative Industries Report, this would have a negative impact on the UK music industry as a whole.

Refuse to supply export markets where prices are lower than domestic market

  This is a means by which parallel imports could be prevented. However, it means that a crucially important source of income (as highlighted above) is cut.

  In all four scenarios above, the independent producers would lose income and thus profitability would deteriorate.

  It can be noted that, if the majors were to reduce their discretionary UK A&R budgets as discussed in 4.2 above, this would also have a negative effect on the independent companies. The links between the independent companies and the majors are strong and any weakening of the majors' independence in the UK will have knock-on effects for the independent record companies. This provides a unique infrastructure and environment for the industry.

5.   HOW PARALLEL IMPORTS WOULD AFFECT CONSUMERS

5.1  Effect on prices

  Allowing parallel imports by introducing international exhaustion is likely to have only modest effects on consumer prices.

  The following points should be noted:

    —  Price differences are over-estimated when appropriate adjustments are made.

    —  Price differences that exist are explainable by reasons other than protection of intellectual property rights.

    —  Where there is an opportunity to parallel imports, traders will increase their profits rather than lower retail prices.

  These points can be considered in more detail:

    Price differences are over-estimated when appropriate adjustments are made—There is much pejorative media comment about the price of recorded music, particularly CDs. Press articles often run price comparisons to show how UK consumers are paying too high prices for their CDs. However, these stories are often extremely misleading for a number of reasons. For example, in the case of comparisons between UK and US prices:

—  First, price comparisons often fail to take into account differences in taxes.

—  Secondly, royalty rates are lower in the US than in the UK.

—  Thirdly, the UK market is a much smaller market than the US market (most often used in the price comparisions). It is not surprising that, given the average volume sale in the US is much greater than a typical sale in the UK, prices are lower in the US. Also, the cost of manufacturing does not differ significantly between the US and UK. Therefore, US firms more quickly recoup the fixed cost element of a recording.

—  Fourthly, a higher level of service is provided in the UK than in the US and therefore UK distribution costs are higher.

—  Fifthly, the cost of retailing is higher in the UK than in the US, caused by such factors as cost of planning permission and higher rates, rent etc and other associated costs.

—  Lastly, there is a much larger range of mid-price and budget CDs available in the UK. The average price difference across all types is much less than the full price pop CDs.

    Price differences that exist are explainable by reasons other than protection of intellectual property rights—This was confirmed in the MMC report. In announcing the reference to the MMC, the Director General drew attention to high prices relative to the USA. He expressed concern that use of copyright law to restrict parallel imports may frustrate competition. However, the MMC is clear in its conclusion:

  "We do not ascribe the price differentials to the right of a copyright owner to control parallel imports. It seems unlikely that removing that right would lead to a reduction in the price of recorded music generally."

  Exchange rates are the principal cause of price differences between both EU member states and with countries such as the US. This was confirmed by the MMC report, which stated that "perceptions are crucially influenced" by the exchange rate. Given the prevailing exchange rate, price differences between the UK and other countries may increase and decrease according to developments.

  The fact that price differences can be explained by factors other than parallel import restrictions was backed up by the MMC study into prices of other products. The MMC studied prices of goods relating to leisure activities and found that in almost all product groups, average prices were higher in the UK than USA and concluded that CD prices were not out of line with a range of goods. More recently, as set out in the NERA Report of 8 February 1999 (Annex C, table 2.5, page 19) an international comparison of international retail prices of sound recordings was made across a range of formats and price levels. The average UK price was

10.47 and the average US price was

10.52, indicating lower average prices across the wide range of recordings available in the UK. Indeed UK prices were lower than the other EC countries surveyed, including Germany, Holland, Sweden, Denmark and Belgium.

  Where there is an opportunity to parallel import, traders will increase their profits rather than lower retail prices—The points made above indicate that the opportunities for parallel importing are perhaps less than is sometimes claimed. However, it is clear that some opportunities for parallel importing would exit if international exhaustion was introduced (due to marginal cost pricing of exports).

  Where importers parallel import products from overseas markets, this is highly unlikely to have any effect on retail prices. More likely, the parallel importers will increase their profits on an unfair basis due to the fact that they are free riding on the promotion and advertising expenditure of the UK companies.

5.2  Loss of choice

  The choice of recordings for consumers is likely to be reduced as less investment will be made in UK bands.

  Parallel traders tend to "cherry-pick" the records that are already successful. Therefore, there is likely to be an increased emphasis on the best-selling hits.

  There would be less diversity of music as investments would have to be more certain of commercial success in order to be viable. Many of the independent record companies whose existence would be threatened by parallel imports are in niche markets. Parallel traders would not be interested in providing a diverse range of music—instead, "free-riding" activity is likely to be concentrated only on commercially successful titles.

 6. INTELLECTUAL PROPERTY ISSUES

6.1 Are trademarks sufficiently protected?

  Trademarks are, in general, adequately protected in the UK as the current legislation stands.

  However, should international exhaustion be introduced for trademarked goods, the level of protection would be inadequate for the record industry. Although record companies are often able to rely on copyright law to prevent parallel imports of their recordings, in certain circumstances it is very difficult and using trademark law is much more straightforward.

  The distribution of recordings on-line via the internet will become increasingly popular over the next few years. When dealing with this type of distribution, it is much easier to use trademark law than copyright law. To proceed successfully in relation to copyright infringement on parallel importation via the internet, it is necessary to show that the importer is not the consumer (who has a defence because he is not importing in the course of a business). In relation to trademarks, the same is not true.

  Similarly, when dealing with the parallel importation of physical goods, copyright law does not always provide an available remedy; if a recording is made in a non-Rome Convention country, such as the USA, and subsequently imported into an EEA Member-State which does not protect such recordings, such as Sweden, the trademark right will in principle be the only legal tool to stop parallel imports. This means that if international exhaustion for trademark rights was introduced, a significant number of important recordings could be freely imported as there would be no ability to rely on copyright law.

6.2 What are the main problems with existing measures to detect and prevent counterfeiting and piracy? How can such measures be made more effective?

  In general, the experience of using the anti-counterfeit regulation (Council Regulation 3295/94) has been very positive. One reason for this is that national customs services in the EU have gone beyond the strict requirements of the Regulation and kept a general watch for CDs arriving from certain specified countries, rather than taking action only when informed about the specific shipments. For example, UK Customs seized 47,000 infringing CDs bound for the Dutch market as a result of a request from the BPI to be on the lookout for CDs coming in from Singapore.

  The issue of piracy and counterfeiting is currently the subject of an in-depth review in the EU under the EU Green Paper on combating Counterfeiting and Piracy in the Single Market. The BPI has submitted a response to this Green Paper as well as endorsing the very detailed submission prepared by IFPI. In very general terms, measures under UK law are satisfactory, although the BPI believes that enforcement should be strengthened and that theft of intellectual property should treated on a par with theft of real property. In addition, there is often a failure of the part of law enforcement agencies to prosecute intellectual property crimes due to a lack of resources. Finally, the very low levels of fines and prison sentences handed down by the courts, despite heavier penalties being available under the law, do not provide an adequate deterrent.

  We believe the situation would be improved if counterfeiting and piracy was recognised as a serious crime and that CD piracy would be greatly reduced if there was mandatory regulation of CD plants and compulsory use of unique identification codes such as the Source Identification (SID) Code.

6.3  INTERNATIONAL AGREEMENTS AND ENFORCEMENT OF IPR

  The BPI supports international IP initiatives through WIPO and the WTO. However, it vigorously opposes the introduction of any form of international exhaustion for intellectual property rights, for the reasons set out in this paper. The BPI urges the UK Government to ensure that the WIPO Treaties on copyright protection in the on-line environment are quickly implemented into EU legislation through the Copyright Directive and the E-Commerce Directive in order that the creative industries can do business on-line and effectively fight internet piracy.

6.4  THE IMPACT OF PARALLEL IMPORTS ON IPR ENFORCEMENT

  Sound recordings are particularly prone to pirating and counterfeit activity and it is estimated that pirate sales of CDs and cassettes worldwide in 1997 were worth £4.5 billion. Introducing international exhaustion would have an extremely significant effect on the enforcement of intellectual property rights in the UK.

  Pirate recordings have become increasingly sophisticated and today are often indistinguishable from authorised copies. It should also be noted on a practical level that border controls will necessarily become less effective against the importation of pirate goods if they are also required to deal with the unfettered flow of large numbers of parallel imports.

  Given that there are good reasons to maintain the current system of Community exhaustion with regard to trademarks and copyright (as set out in sections 4 and 5) the benefit in terms of strong protection against piracy is a massive bonus in maintaining the existing regime that should be taken into account.

30 March 1999


3   The value added figure is that which remains after such costs as management fees and recording costs are deducted from gross revenues. Back

4   The Economic Consequences of the Choice of Regime of Exhaustion in the Area of Trademarks (February 1999). Back


 
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