We’ve been able to pay to digitally download sound recordings through legitimate services for over a decade now, and these services have grown pretty rapidly in terms of both scale and profitability. So much so, that iTunes (so far the most successful of the digital distribution platforms) has sold more than 10 billion songs since its inception, and has passed on over $12 billion in revenues to record labels. That’s an enormous amount of money.

Because of the scale, profitability, and rapid growth of this method of distribution, you’d expect that many of the legal issues surrounding artist compensation and royalties for digitally distributed sound files would have been hammered out by now. As it happens, though, a recent class action suit filed by Rob Zombie, David Coverdale, Dave Mason, and the estate of Rick James against Universal Music Group indicates that there’s still the potential for major upheaval when it comes to apportioning royalties. These all-star plaintiffs allege in James v. UMG Recordings that UMG has run a “scheme” to improperly withhold royalties from artists by defining digitally distributed sound recordings as “sales” and not “licenses.”

In record contracts, UMG and other labels set aside different royalty percentages for the “sale” of music versus the “licensing” of music. For a “sale,” artists are typically paid between 10 and 20 percent of revenues, reflecting the costs associated with manufacturing, shipping, and selling physical copies of recorded media at retail locations. However, for “licensing” a track, the royalty rates are far more favorable to the artists, as there are fewer costs associated with the profitable exploitation of the work through licensing; typically the label only has to negotiate a few terms with the licensee, and then sits back and collects the royalties that roll in. As a result, an artist’s percentage of revenues typically runs closer to 50 percent for revenues earned through the “licensing” of recordings.

This means a lot of money rides on whether or not a particular use of a sound recording is defined as a “sale” or a “license.” This is especially a problem in the case of older artists whose record contracts were drafted without specific provisions covering digital distribution royalties. As the more cynical among us would expect, current industry practice has record labels defining the revenues from digital distribution platforms in these cases to be “sales,” allowing the labels to collect the lions’ share of royalties for this new (and very profitable) market. The plaintiffs allege that the digital distribution of their sound recordings via digital music services like iTunes, and through “mastertones” (cell phone ringtones, etc.) is actually done through “licenses”, and not “sales,” and that as a result the labels have been underpaying them.

This claim relies heavily on the Ninth Circuit’s decision in F.B.T. Productions, LLC v. Aftermath Records, and the Supreme Court’s refusal to grant certiorari on that case last March. We wrote on this case last year here, but here’s an abridged version of the important particulars: In September 2010, the Ninth Circuit decided in F.B.T. Productions that agreements that allowed “distributors, cellular phone carriers, and other third-parties to. . .  produce and sell permanent downloads and mastertones [of sound recordings] in exchange for periodic payments based on volume of downloads, without any transfer in title of. . . copyrights to recordings were ‘licenses.’” In this way, the Ninth Circuit indicated that distribution of physical products were “sales” of copies (with the associated costs for “packaging” and “shipping” and “breakage”), while any digital downloads, cell phone ringtones or waiting tones, or other similar services were to be construed as “licenses.”

This ruling also makes sense with how we “buy” content online in other areas. Certain online content distributors (such as Steam, which distributes video games, and Amazon’s Kindle eBook store) note in their terms of use that you are only paying for a “license” to download and use a file, not for actual ownership of a copy of the file. In fact, in some cases these “licensors” have rescinded the license, as happened when Amazon (somewhat ironically) removed George Orwell’s 1984 from its store and all of it’s customers associated Kindle devices.

UMG and other labels are obviously not thrilled with the result of F.B.T. Productions, as they had previously defined these uses as “sales” and collected their 80-90% royalties on everything from sound recording downloads through iTunes and Rhapsody to Verizon, Sprint, AT&T, and T-Mobile ringtones. . . uses that now, under F.B.T. Productions, might be considered to be licenses. If James v. UMG Recordings succeeds, not only will labels make less money off of future digital distributions, but they might well owe a lot of artists a substantial amount of back royalties.

In this way, compared to F.B.T. Productions, the James v. UMG Recordings suit is the real game-changer. The scope of its claims and the sheer number of artists involved in the proposed class mean there is potentially a HUGE amount of money involved. In F.B.T Productions, the amount in question was somewhere between $17-20 million. Conservative calculations put together by the Future of Music Coalition indicate that, if F.B.T. Productions were to apply to all eligible contracts, labels could owe artists as much as $2.15 billion in royalties from iTunes sales alone!

For their part, the labels are claiming that the decision in F.B.T. Productions is a unique situation, as in that case the language in question was part of a unique contract, rather than the standard form contracts employed by the bigger labels. The plaintiffs in James are essentially looking to determine whether or not F.B.T. Productions applies to the standard form contracts that are used by labels in the vast majority of cases.

The artists who stand to gain the most from this suit are those older “catalog artists” whose music sells consistently and whose contracts were drafted before these digital distribution mechanisms became popular. Most modern artists include provisions in their contracts that expressly deal with digital distribution methods. However, for those artists that are affected, this is huge news; many of them are living on a fixed income, and would benefit immensely from the new income rates yet might not be able to bring suit on their own.

The plaintiffs know this, and by filing the suit as a class action, they are acting as representatives for the interests of artists who may not be able to afford to bring suit to recover their royalties owed under F.B.T. Productions on their own. Plus, by suing as a class action, they are able to bring a lot more money into play, both in terms of their own ability to pay legal costs (helping them survive the long pretrial battle) and also maximizing the amount of potential money available for a judgment or settlement.

As a result, this case is big news in the music industry. If the plaintiffs are able to force a favorable outcome (either by settlement or, less likely, through litigation) it could provoke a rash of similar suits against other labels, resulting in a fairly substantial redistribution of wealth in the industry. The really interesting part is that, with the current battered state of record labels, this “redistribution” of royalties could be disastrous, especially with copyright termination issues right around the corner!

As a final point, it is interesting to note that in James, in F.B.T. Productions, and in the course of day-to-day business, the labels are absolutely adamant that digital distribution results in sales and not licenses. But, at the same time, EMI is claiming in a suit against ReDigi (a site that allows users to sell “used” MP3s) that digitally distributed sound recordings are NOT sales but licenses, so as to prevent the site from raising the first-sale doctrine as a defense to EMI’s suit. We wrote about the ReDigi suit here, if you’re interested.

We’ll see if they’re allowed to have it both ways.