Polk Wagner and Eric Priest discuss the increasing problem of counterfeit CDs

Music piracy has existed for centuries, but it wasn’t until digital media came along that it really took off. Napster. Fake CDs. Pirate Bay. And even though the momentum in the industry appears to be headed away from buying physical media that hold your music in favor of digital downloads and streaming, the fact remains that an enormous number of fans still want to buy, own and listen to their favorite artists on CDs. Indeed, CD sales still account for about 40% of a $15 billion global music industry.

 But millions of the CDs those audiophiles have been buying online aren’t any more legitimate than a $20 Rolex, and music fans are filling the pockets of pirates instead supporting the music industry, artists and record labels. It’s gotten bad enough that recently, the American Association of Independent Music warned its indie label members of a rash of Chinese pirates selling CDs on Amazon.

University of Pennsylvania Law School professor Polk Wagner and Eric Priest from the University of Oregon joined the Knowledge at Wharton Show on Sirius XM channel 111 to discuss the latest iterations of the music piracy problem, and what the industry can do. (Listen to the podcast at the top of this page.)

An edited transcript of the conversation follows.

Knowledge at Wharton: Even though a majority of this problem seemingly is coming from overseas, it’s an issue that the U.S. has to address, is it not?

Eric Priest: Absolutely. A lot of people think that we’ve now moved to a completely online download or an online streaming music business. But in fact, in 2015, CD sales accounted for almost 40% of the recording industry revenue in the United States. So this is still a huge business. It’s still a $2 billion business. What we’re talking about is a prevalence of online counterfeit CD sales. That not only hurts the music industry, but it also hurts consumers, of course, because these people are buying CDs online because often they think it’s better quality than what you can get through a download. I know I certainly buy CDs online still because I’m a bit of an audiophile, and I prefer the quality of CDs.

But also, it affects the online retailers like Amazon or eBay and others, where these pirated CDs appear, because consumers really believe that they’re going to these sources because they are, first, getting legitimate products that are higher quality, but second, that they’re also supporting artists. This is actually something that really matters in the U.S.

Knowledge at Wharton: Is a majority of this problem coming from outside of the U.S. or — outside of Amazon and other e-commerce sites being part of the selling process — is there an element to this still happening here in the United States?

Polk Wagner: Well, there probably is. I think what you’ve certainly read about and what was specifically discussed inside the industry these days is the so-called “Chinese piracy.” And I think that that probably has a significant amount of truth to it, in part because the Chinese economy has become extremely efficient at doing this type of thing: taking products and making high-quality, but not quite the same, imitations of those and selling them. Their distribution networks are always getting better; the transportation networks are getting better; places like Amazon are getting better at making it seamless for consumers to get these sorts of products. And because those efficiencies have been worked through over the last several years, the ease of selling counterfeit goods on places like Amazon and eBay is going to only increase.

I’m sure there are still counterfeit operations going on in the United States. It is still quite easy to create a counterfeit CD. These are digital copies — basically, the same thing as the original. Now doing it really well — having the booklet and the CD jewel case and those sorts of things be identical to what is sold in the stores — can be complex and takes skill.

But in terms of the basic piracy, this is not anything that’s difficult.

“These are digital copies – basically, the same thing as the original. Now doing it really well — having the booklet and the CD jewel case and those sorts of things be identical to what is sold in the stores — can be complex and takes skill.” –Polk Wagner

Knowledge at Wharton: In terms of the problems with the licensing of music and the profits that come from it, we have to be talking about millions of dollars of lost revenue for the musicians and all of the people behind the scenes because of these pirated CDs.

Wagner: Sure. There’s a lot of debate about exactly how much this costs. Certainly, lost sales are lost sales. Now, whether some of those CD sales that are lost ultimately wouldn’t have been sold anyway is unclear. So there’s a lot to it. There’s also a school of thought that says something along the lines of, these sales of CDs often generate business in other ways. People listen to CDs, and then they want to go to the concert, or they buy merchandise, or whatever, so there are other ways that artists get paid as well.

So it’s not quite so simple as saying a lost sale is a direct loss. But certainly, this is not good. And I think you are going to see a further acceleration of the industry — out of necessity, as well as out of choice and convenience — moving towards different kinds of distribution technologies than the really old school.

Amazon has perfected the old-school distribution network. It’s so easy now to buy physical goods from Amazon. Their delivery system works really well, and people really like that. But at the end of the day, it is still old school, and I think you are going to see an increasing move towards the digitization of distribution.

Knowledge at Wharton: Is that what you expect to see from Amazon, Eric? Because part of this may be linked to the fact that it is an old-school distribution network.

Priest: Absolutely. You’ve already seen Amazon like other online platforms — Apple, etc. — for years moving toward more digital distribution. Both have moved not only to digital downloads, but now also to digital streaming, as Polk mentioned.

So there’s no doubt that that’s the trend, and consumption habits are changing rapidly to the point where the number of physical CD sales is dropping markedly every year. Having said that, again, for quite a long time, there will continue to be a market for CDs. It will eventually end up as a niche market. But there are people who just prefer to have the physical product for various reasons, whether it’s quality, whether it’s having the tangible product in-hand. So when people say that this isn’t as big of a deal because we’re moving toward an all-digital consumption economy — I think that’s right. We are moving in that direction. But as you mentioned at the beginning of the broadcast, this is still 40% of global sales. The U.S. and some countries have moved more rapidly toward the digital consumption models than the physical model. I think that it continues to be a significant source of revenue.

I think the other piece of it is that the revenue that’s actually derived currently from streaming, which is now taking over as the predominant music consumption platform — certainly in the U.S. and some countries — is not paying out the kinds of royalties and the kinds of revenues that the old CD sale model was. And there are lots of reasons for that. One is that the streaming model tends to be ad revenue-based.

So while it’s difficult to pirate — and you therefore don’t really have the piracy issues — it’s just not generating all that much revenue. That’s why you’ve seen many high profile artists come out and demand higher streaming revenues from sites like Pandora and Spotify. Actually, CD sales still account for a fairly hefty percentage of global music industry revenues, despite the fact that we’re in a transitional period.

Wagner: I agree with all of that, and I think one of the most interesting things to me about this phenomenon goes even beyond thinking about this in terms of losses to the music industry. It’s what it is revealing as some real challenges for these online retailers, in terms of trying to figure out from their end what’s going on with their sites. The RIAA — the Recording Industry Association of America — did a study over the summer where they ordered a bunch of CDs from Amazon. First of all, they found a very substantial percentage of them, almost one in four, were counterfeit. And second of all, it didn’t seem to matter whether they were ordering them from Amazon itself or from Amazon’s partner/distributors.

You might expect that Amazon is going to be less good at policing what’s happening in its partner distributors. But in fact, it turns out that Amazon has trouble figuring out whether the products that it’s actually selling itself are counterfeit. I think what these online retailers have largely done over the last several years in terms of trying to ferret out product quality and counterfeits is, in some sense, to crowdsource it. They rely very heavily on ratings and reviews from customers to reveal when there are problems. So returns, ratings and reviews are the way that Amazon and others deal with problems like counterfeits or just really bad quality. But you are seeing a serious breakdown of that approach. By all accounts, it seems like Amazon’s ratings and reviews, as well as those on eBay and elsewhere, are getting gamed. You can pay people, essentially, to write five-star reviews.

“The idea has been, ‘Let’s provide consumers with more choice at a lower price, and more access at a lower price.’ In effect, let’s price the pirates out of the market.” –Eric Priest

Knowledge at Wharton: Yes, that’s a big problem with Yelp.

Wagner: Yes. And this means that the model that a lot of these retailers had, which was to rely heavily on customers and reviewers to essentially police the things that were being distributed through their sites, appears to not be working anymore.

That then creates a choice for these companies. Is Amazon going to staff up and start actually reviewing in a much more systematic way to try to figure out how these counterfeit products get on the site? Or are they going to use an entirely different method of trying to police their site?

To me, what’s interesting is this: Even beyond the music industry, if you Google “counterfeiting on Amazon,” you see just an enormous problem. You see it in almost every area of technology and product, that there is this raft of potential counterfeits that are in the system, and it’s very difficult to figure out as a consumer whether you’re buying the thing you really think you’re buying.

Knowledge at Wharton: Obviously, counterfeiting has been a problem not just in the music industry, but in many other parts of the retail sector for decades now. And it hasn’t been fixed totally in any way, shape or form. A company like Amazon may be thinking about how they’re approaching this problem with music, but they also have to think in general about their entire operation in terms of dealing with counterfeiting overall.

Wagner: Sure. I think that one of the innovations that Amazon has brought to the industry is its incredible scale. They have distribution centers all over the place. They have these partner opportunities, where people can be a distributor through Amazon. There are so many different ways that they are trying to streamline, to bring efficiencies to the distribution approach. What they seem to have left out — I’m sure they have thought about it, but it’s less clear how they are going to fix it — is that when you have that level of scale, with thousands of different distribution channels coming into your thousands of different warehouses, how do you figure out whether things are authentic?

And all of this has to happen in a seamless, non-face-to-face, electronic, “everybody only wants to spend 10 seconds buying a product” model. What do you do — from the Amazon perspective?

Knowledge at Wharton: Eric, there is this thing known as “stream ripping,” which I hadn’t heard of before, that’s basically taking piracy to the next level in the digital world. Obviously, that’s something that the music industry is going to have to worry about.

Priest: Yes. Stream ripping is essentially where you use software to capture a digital audio stream or a digital video stream, often from YouTube. YouTube has been, up until recently, the biggest streamer of music. A lot of people think of Spotify as the No. 1 streaming site, and I think now it is. But up until recently, it was actually YouTube. That’s where people were getting most of their online music.

But YouTube, Pandora, Spotify — these are all sites where you can essentially set up some software on your computer so that once you play a song or video, you basically are able to record the song digitally on your computer and keep it. And the music industry fears a substitute for a sale. Because you don’t have to then download. The quality is probably not as good with a ripped stream as it is with a digital download, or certainly with a CD. But at the same time, many consumers don’t care. And many of these services — Tidal is one, Deezer is another — are some of the smaller online streaming services. They actually provide a high-quality stream.

They have less-compressed, better-quality streams. If you’re ripping them, they can act as a substitute to a sale. But I wanted to mention something, going back to what Polk said about the online retailers, Amazon and eBay. Polk is right that this is a pretty important aspect of their business — the customer’s trust, getting the screening of products right. And in fact, these sites actually do do a fairly heavy amount of screening. While we are talking about these U.S.-based sites, it’s important to recognize that there are other sites, especially some of the sites owned by Alibaba — Taobao [China’s equivalent to eBay], AliExpress — that have gotten into much more hot water from brand owners and copyright owners for the sale and distribution of infringing works.

And the volume of sales that those sites do and the volume of sales that Amazon does are just staggering. Amazon has something like 500 million products currently available. Sites like Taobao have an annual Black Friday-type sale in China; it’s called Singles Day. This year, they did $18 billion worth of sales on that one day.

“The RIAA did a study over the summer, where they ordered a bunch of CDs from Amazon. … almost one in four were counterfeit.” –Polk Wagner

Part of the problem is certainly on the front end for these sites. How do you screen for infringing or potentially counterfeit goods? Certainly, Amazon, eBay have been actually quite good at that. But from when I speak to copyright owners and intellectual property owners, what I am hearing is that there’s still a lack of transparency about the process. It’s not all that clear what they do in the way of screening. And they don’t communicate that well about to the brand owners — which means that brand owners have difficulty helping them, and copyright owners have difficulty helping them figure out best practices. And that is also a problem in this industry.

Wagner: Yeah, I would agree with Eric there. I think that there are clearly a number of problems across a variety of these industries and different retailers. Even to the extent that Amazon and eBay get their hands around the problem, there are potentially even larger retailers and larger issues looming when you talk about the worldwide market. Technology creates a “plate tectonics” type of movement in the way that people buy consumer goods. This is just another example.

Certainly right now, it appears that it would not be a good option for a music creator to cease distributing CDs, given that those still account for a very substantial percentage of worldwide music sales. On the other hand, the time will come at some point when the piracy issues, the other challenges associated with physical goods, become even larger. And then, of course, the pirates will turn to stream ripping. We can expect the same game of Whack-a-Mole that we see in all other areas of intellectual property to reemerge in that area. Right now, it seems pretty small. It certainly happens, people are doing it. I know that I talk to my students when I teach them intellectual property rights. It’s amazing how much they use sites like YouTube to listen to music. It seems to be incredibly inconvenient and not very good quality, but they think it’s OK. And that may be a way that people are consuming music differently than they used to.

They’re no longer carefully amassing a collection; they are much more casual about it. And this is a changing industry dynamic; as technology changes, the habits and likes of consumers are changing, as well.

Knowledge at Wharton: You go back 30-some-odd years, and MTV changed the music industry and how people thought about music. I guess what’s occurring with YouTube is similar in some ways to what we saw with MTV and VH1 and some of these other TV networks back then.

Wagner: Sure. MTV changed the music industry; the iPod changed the music industry [with] the advent of digital distribution; the iTunes Store changed the music industry. A lot of these things are going to change the music industry quite dramatically. I think that we are seeing that the industry is going to have to figure out that if you are a creator of music or of, frankly, any copyrighted content, you are going to have to be very attuned to the changes in technology as well as the habits of your consumers in order to stay half a step ahead of the pirates.

Knowledge at Wharton: Eric, how much do you think that the companies that are making the smartphones — the Samsungs, the Apples — have to be concerned about this? Will smartphone makers actually be on the forefront of this fight against the pirates? Or are they there already?

Priest: To talk about Apple first: Apple obviously has a lot invested in this because they just bought Beats — which is the headphone company and the Beats music service — in order to create their Apple Music service. They made that part of the foundation of their Apple Music streaming service and they invested billions in that acquisition. And they’ve invested billions more in the development of that service. They are pushing it out and trying to drive subscriber revenue. So, of course, they are certainly at the forefront of this issue. Companies like Spotify, these streaming companies, tech companies, are certainly at the forefront of this issue. And they see themselves really as the answer to piracy.

They see litigation as not being the answer to piracy because, in effect, the attempts to sue individual infringers were not very successful for the recording industry in the U.S. The idea has been, “Let’s provide consumers with more choice at a lower price, and more access at a lower price.” In effect, let’s price the pirates out of the market.

And that has been, I think, really, the approach. There’s conflicting data on whether it’s working or not. Some studies say that, in fact, piracy is being driven down, although other cash cows for the music industry are being driven down as well. So digital downloads, which were quite lucrative for the music industry, are dropping precipitously. Certainly, CD sales are dropping as streaming becomes the dominant form of music consumption.

“The quality is probably not as good with a ripped stream as it is with a digital download, or certainly with a CD. But at the same time, many consumers don’t care.” –Eric Priest

But at the same time, some people are saying that piracy is decreasing. Others are saying that it’s not, especially with stream ripping and that sort of thing. It’s still unclear. But I think that the music industry has certainly hitched their wagon to this idea that we can use innovative business models as a way to battle piracy, and that’s going to be better than making law and litigation the forefront of their strategy.

Knowledge at Wharton: Eric, are streaming services being hurt by all of this activity? Obviously, people make a decision as to whether or not they want to subscribe to a streaming service or not. I’d guess this is one of those areas that may need further investigation just to see how significant of a problem this is.

Priest: I think that’s right. Part of the problem that you’re seeing is that while companies like Spotify and Apple Music have been able to trumpet pretty significant subscribership — tens of millions of paying subscriber — the reality is that the numbers are still low. Spotify is still not a profitable company. At current subscriber levels — and the concern is that they are starting to plateau — it’s unclear how sustainable the current streaming model is.

That’s certainly a worry for the music industry. I think people still are bullish on streaming, but it’s not clear that there’s an economically viable future there. I think eventually, there is. But you need to have paying subscribers, you need to have people paying into the system in order to make it work. And this is one of the reasons why artists and labels are still very skeptical of the streaming model, even though many of them want to see it take off. Right now, the revenues that it’s producing for artists and even for the streaming companies are not sustainable in the long-term.

Wagner: I agree with that. I think the lesson here is that, looking forward, we’re going to have a lot of creative destruction. There’s going to be a lot of new models that pop up and we’re going to see whether they work. Some of them will work, some of them won’t, some of them may be viable, some of them won’t be viable. I think the lesson for the music industry is that whatever you do, you can’t stand still, because everything is changing under your feet. And if you wait, your entire market could be gone.