Napster and Bertelsmann: It Seemed Like A Good Idea...

A bad deal is still giving the German media conglomerate nightmares

In early July, the music industry received its first bit of good news in a long time. Sales for the first half of 2004 showed a 7% increase after several years of losses. Nobody was happier than the folks at BMG, the music unit of German media giant Bertelsmann whose U.S. market share rose four percentage points, to 20%, largely on the success of chart-toppers such as Usher, Outkast, and Avril Lavigne. The gains come after the industry's bleakest era, when digital piracy crippled BMG and other music stalwarts.

Now, though piracy has abated some, a legacy from the old days could deliver another devastating blow to Bertelsmann. A July 14 decision by U.S. District Court Judge Marilyn Hall Patel will force the media company to defend itself against two lawsuits seeking as much as $17 billion in damages. In 2000, Bertelsmann struck a partnership with illegal file sharing service Napster to keep it alive in hopes of converting it to a legal venue for online music sales. Patel denied a motion by Bertelsmann to throw out the suits, which claim that when Bertelsmann lent Napster more than $85 million over two years, it deliberately prolonged Napster's ability to traffic in millions of illegally copied tunes. The irony: At the same time, BMG was suing along with others to put Napster out of business. "[Bertelsmann] flouted copyright law," says Carey R. Ramos, a partner at Paul, Weiss, Rifkind, Wharton & Garrison, who is representing songwriters and publishers. Another suit by music rivals EMI Group PLC and Universal Music Group (V ) makes a similar claim.

Judge Patel's judgment doesn't mean the claim is true -- and privately held Bertelsmann, with sales in 2003 of $20 billion, strongly denies liability. "The facts simply do not support the allegations of control on Bertelsmann's part," Bertelsmann general counsel Ulrich Koch says. EMI and Universal officials declined to comment.

But having the cases proceed to fact-finding creates a huge headache for Bertelsmann CEO Gunter Thielen, who already has plenty of them. Tepid ad sales worldwide as well as slow growth in Europe have forced massive cost-cutting at the company's far-flung media holdings, which include Europe's RTL Group television and the Gruner + Jahr magazine unit. Such measures were just enough to restore a meager profit of $47 million in the first quarter on sales of $4.55 billion, vs. a $479 million loss the year before.


Bertelsmann managers are also dealing with a series of local crises, such as disarray in the U.S. magazine operations, troubled by management turnover and fiascoes such as the noisy demise last year of Rosie magazine. "If the company is liable for half or even a quarter of what these [copyright lawsuit] plaintiffs are seeking, it's a big burden," says veteran media analyst Harold Vogel.

Even if Bertelsmann doesn't wind up paying big money, the case is a huge distraction for top brass. Former CEO Thomas Middelhoff, forced out in 2002, was the most vocal advocate for the Napster loan. But current CEO Thielen and other top brass such as CFO Siegfried Luther took part in decision-making back then. They and other execs, including former Justice Dept. antitrust chief Joel I. Klein, briefly Bertelsmann's CEO for corporate services, could be called to testify if there is a trial.

How great is the company's risk? The plaintiffs contend that following the first loan to Napster in November, 2000, Bertelsmann kept the file-sharing service up and running even though it was violating copyright laws. For every illegally swapped song, lawyers say there's a maximum penalty of $150,000. Bertelsmann is likely to argue that, far from controlling Napster, co-founded by 17-year-old Shawn Fanning, it looked on helplessly as the startup's managers argued bitterly among each other. By the time Bertelsmann exec Konrad Hilbers became CEO in 2001, the service was nothing more than a Web site, the company is expected to contend. Judge Patel ordered Napster shut down in July of that year. A legal Napster now operates under software maker Roxio Inc. (ROXI ), which bought its assets out of bankruptcy in 2002.

Bertelsmann's hope is that, after a period of extensive pretrial fact-finding, the suits will be tossed for lack of evidence. But Bertelsmann also has to worry about disgruntled former execs who have little incentive to defend their former boss. Strauss Zelnick, BMG's CEO until December, 2000, who opposed the Napster loan, is among those cooperating with the plaintiffs, BusinessWeek has learned. Zelnick declined comment.

The lawsuit is unlikely to affect BMG's planned venture with Sony Music Entertainment (SNE ), which won European regulatory approval on July 19. But as BMG continues to thrive, and CEO Thielen labors to restore healthy profits companywide, the Napster lawsuit is anything but soothing background music.

By Jack Ewing in Frankfurt and Tom Lowry in New York

Before it's here, it's on the Bloomberg Terminal.