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If there is a poster child for the battered Web music startup, Project Playlist is it. The company had to fight lawsuits from the record labels, is still trying to iron out licensing deals with those labels, lost its last CEO Owen van Natta to MySpace, lost its CFO Mike Sheridan, and by the looks of it is losing its audience. What else could go wrong?

Well, it looks like the self-styled music search engine is actually hosting MP3s of major label artists via content delivery networks such as Limelight. If you search for Britney Spears songs, for example, the second result is “(You Drive Me) Crazy.” The originating site where the MP3 was hosted, http://www.sarzamin.org/, is no longer available. But not to worry because Project Playlist cached the song on its CDN, Limelight Networks. Khalid Shaikh, a TechCrunch reader and developer who wanted to harness Project Playlist to create his own music site, discovered this arrangement and sent me the screencast above to prove it.

In the video, Shaikh speculates on the legality of this method of caching, which is impossible to say one way or the other without knowing the terms of Project Playlists’ licensing agreements with the labels. Project Playlist does have a licensing agreement with Sony, which owns the Zomba Label that Spears is on. But it certainly is a strange way to build a catalog of songs. And there are plenty of other examples, such as Alanis Morissette, who is on Warner Music, which is the one major lbel that still has not dropped its lawsuit against Project Playlist.

Project Playlist bills itself as a music search engine that lets people share playlists, not the songs underlying those playlists per se. On its About page, here’s how the service describes itself:

Playlist.com is an information location tool similar to Google® and Yahoo!® but devoted entirely to the world of music. Our purpose is to help you find and enjoy music legally throughout the web in the same way that other search engines help you find webpages, images, and other media

and . . .

Playlist.com allows you to discover all of this free music legally because we respect the rights of copyright holders and we insist that you do as well. . . . If an artist tells us that our search engine is linking to an illegally posted song, we will immediately take down the link to that music file.

The site doesn’t say anything about caching songs which have been taken down, for whatever reason, from other sites. But it does raise some interesting questions. Has Project Playlist crossed the line from a music search engine merely indexing the music that is already freely available on the Web to a music hosting service (albeit through its CDN proxies)? Or is Project Playlist acting just like Google or any other search engine here, merely caching the most popular content in its index?

When I contacted Josh Brooks, vice president of programming and content, he seemed genuinely surprised and said that this is the first time he’s ever seen anything like that. After viewing the screencsat, he says:

“Watching that troubles me and it should trouble anyone trying to do anything n digital music. It is a problem that has to be fixed. All I can say is it is going to be remedied because it needs to be.”

He also says that Project Playlist is in the middle of negotiations with labels to stream licensed songs directly:

“Playlist.com technology neatly aggregates song searches on the web and directs a user to a stream of music from the site where the song is hosted. In the very near future, our hosted music service will find a linked stream and replace it with a stream from the broad library of music we have licensed. Users can then listen and share the music on Playlist.com or through an off-site embeddable player. There are dozens of linked services out there. Playlist is actively working with the content owners to insure proper reporting and accounting for music we have licenses for.”

in other words, Project Playlist doesn’t want to be a music search engine anymore. It is already moving away from through the way that it is caching songs, but it needs to host those songs in a more straightforward manner if it wants the labels to take it seriously.

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One of the many unsavory aspects of the hiring of Owen Van Natta as the new CEO of MySpace: the rewriting of recent history around Van Natta’s involvement in Project Playlist. The communications group at News Corp. (MySpace’s parent company) is busy spinning Van Natta’s departure as a simple transition from one job to another, but that’s far from the truth. Nor does their story take into account the sad state of the company that he ran for just a few months before leaving for greener pastures.

Here’s how News Corp spins this: This is a natural changing of the guard as a CEO of a small startup takes a bigger job. There was an orderly transition, and Project Playlist has a new CEO with great experience. Nothing to see here, please move along.

Here’s the real story: Van Natta joined Project Playlist in November 2008, just about five months ago. He told investors and employees he was in for the long haul. And he hired an executive team under him that came with his promise that he’d lead the company to a win. Bob Pittman invested in the company, he told recruits, which is true. But he also let rumors that the company raised $20 million in new funding fly. In fact the company raised much less than that. And Van Natta also underplayed the problems with labels, suggesting that deals were imminent and the litigation was going to be settled. And now that Van Natta has abandoned the company, they’ve had to scramble to find someone to run the company. That’s why John Sykes, who was already a board member, was forced to step in.

In fact, we’ve heard, Van Natta’s playing down of the music label litigation led directly to the downfall of the company. The labels complained to MySpace and Facebook and threatened to sue them as well if they didn’t ban Playlist from their social networks. Both companies backed down quickly, and Playlist lost their main channels of distribution. MySpace banned them on December 19, Facebook followed on December 23. If Van Natta had made fewer bold statements, sources close to the labels say, those threats against MySpace and Facebook may have never been made.

Project Playlist traffic has plummeted since Van Natta took over the company. In October 2008, the month before he joined, 704,000 people visited the site from the U.S, according to Comscore. In March 2009 it had fallen to just 234,000. Page views also fell dramatically, from 9.6 million in October to just 6 million in March. Here are the traffic charts (unique visitors on top, page views below):

If Van Natta hadn’t ruffled so many feathers at the labels with his promises that litigation was nearing settlement, it’s likely the pressure on MySpace and Facebook would never have materialized, say sources, and traffic would have continued to climb.

At this point Van Natta likely wants everyone to simply forget about his infamous tenure at Project Playlist and focus on his more recent jobs at Facebook and Amazon. He doesn’t list the company on his LinkedIn profile at all (although he’s had five months to update it).

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Hot on the heels of the announcement that Owen Van Natta is unceremoniously leaving Project Playlist to run MySpace, Project Playlist has announced that John Sykes will be stepping in as CEO. Sykes is a co-founder of MTV, former president of VH1, and former president of Infinity Broadcasting, one of the largest radio broadcasting companies in the US. Sykes has been a boardmember at Playlist up until this point.

Project Playlist is a decidedly troubled company. After showing very impressive traffic numbers late last year, Playlist saw its traffic plummet after its embeddable playlists were removed from both MySpace and Facebook, which were threatened with lawsuits by the major music labels. Under the guidance of Van Natta, who only joined the company in November, the company had been making some headway with music industry. With his extensive background in the music industry Sykes may be able to keep Playlist on the right track, but Van Natta’s abrupt departure isn’t exactly a vote of confidence in the company.

Full press release below:

Palo Alto, Calif., April 24, 2009 – Playlist, the leading social media network where over 43 million music fans discover, create and share playlists, announced today that Board Member and industry veteran John Sykes has joined the company as Chief Executive Officer. As a Co-founder of MTV, President of VH1, and CEO of Infinity Broadcasting, Sykes brings extensive operating experience and industry relationships to the company as it partners with the music industry to provide advertising, subscription and e-commerce services to music consumers.

Owen Van Natta will serve as an Advisor to Playlist.

“John was a pioneer of the MTV revolution that forever changed the music industry landscape by giving fans a whole new way to discover and enjoy music,” said Bob Zangrillo, Chairman of Playlist. “Playlist looks forward to leveraging John’s tremendous track record operating media businesses and deep relationships in the music industry as it builds out the world’s premier social media service.”

“Creating and sharing playlists has become a phenomenon in our culture. With over 43 million registered users, Playlist is the number one site where fans go to discover, share and enjoy their favorite music,” said John Sykes, CEO of Playlist. “Leveraging our newly forged partnerships with the music community, we can now offer consumers deep access to their music and provide the industry with powerful new revenue streams.”

Playlist, one of the fastest growing sites on the Internet, continues to establish partnerships with the entertainment industry in an effort to offer a comprehensive collection of content that can be discovered, shared and monetized at www.playlist.com.

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