Well, it was a combination of factors of course: their weak position in the west after all the problems durring the 5th generation, Sony's huge market share and deep pockets (simply announcing the PS2 having a substancial impact), and the CD-R problem of course, which was more of a perceived risk for developers than a serious problem. (it would facilitate genuine bootlegers for sure, but the internet was nowhere near to facilitating casual pirating -at most there could be physical peer to peer disc swapping and ripping+burning)
Sega was slow to react though, they should have made a major anouncemnt (and effort) concerning added security on new models. (really though, they screwed up with that oversight, only dev systems should have had that functionality -that and they should have had some additional security mechanism as well, though they probably thought the propritary format would take care of that -and indeed may have otherwise)
In spite of Sony, I don't see why the DC couldn't have continued its success to a reasonable degree without that major problem. (especially considdering the limited success Nintendo and MS had later on)
Yeah, I like the built-in headphone splitter, but the A/V ports would obviously make more sense on the back, and the SMS slot would have gone either in front or directly behind the genesis one. (though goign that route, they'd probably have the Genesis slot an expanded version of the SMS slot, with outboard connectors for MD carts -like A7800 or the SNES)
Really though, it seems like providing SMS compatitibility may have limited the Genesis's design, and as cool as compatibility is, it only really made sense for the EU market. (the MD would have merited it a lot more, but of course, the Saturn went a different route)

