That doesn't look like fair use to me. He took an album cover, made a minor transformation to it, and used the result as an album cover.
http://mrgan.tumblr.com/post/6840184364/hand-pixelated
"That cover is NOT the original photo, downsampled. It’s a hand-crafted, precisely drawn interpretation of the source. Anyone who’s ever seriously put pixels to screen will tell you that this is an actual artistic method, one with its own challenges, tricks, and yes, an aesthetic."
If painting a version of a photo in oils is allowed, then this is allowed.
Second, the test for fair use doesn't include some percentage of copying. Here (http://arstechnica.com/tech-policy/news/2011/03/copyright-tr...) is a case where copying an entire article got ruled "fair use".
Third, in my judgement, the transformation was quite extensive. Compare representations of neckties in both images. Lots of transformation. Is my judgement better or worse than yours?
This is incorrect. 17 USC 107 spells out four criteria on which fair use claims are to be evaluated, the third of which is "the amount and substantiality of the portion used in relation to the copyrighted work as a whole".
Now it is true that using the entire work doesn't automatically preclude the success of a fair use claim, but it's a much steeper hill to climb and will rest heavily on the other factors being in your favour, which wasn't the case with Kind of Bloop (the significance of the transformation seems to be up for debate, the work was very definitely commercial, some apparent degradation of the commercial value of the photo-as-album-art since it was being used here as album art without payment).
This is why posting free copies of other people's movies online is considered damaging. Even if you don't make money yourself, you create an option from a potential customer who would pay to avoid doing so. In this case, the pixelated version is on par with the tracks themselves - legitimate variations that are conspicuously different.
Indeed, the presence and proliferation of noticeably derivative works like this tend to increase the iconic and commercial value of the source by creating the kind of halo effect people associate with "the original." It's entirely reasonable to assume that "Kind of Bloop" actually enhances the commercial value of "Kind of Blue", and everything associated with it.
IANAL, but for real, it looks a great deal like fair use to me.
The problem is that attempting the fair use defense results in an "I win or you lose" case, where either the defendant wins the case and loses some money, or the defendant loses the case and loses some more money.