ACCOUNTINGS, AUDITS, AND THE STATUTE OF LIMITATIONS
More problems arise for artists from flawed accounting provisions in recording artist contracts than from just about any other provisions. When artists are dependent on a record company to determine the sales of a recording and the amount of royalties due them, many factors come into play and there are innumerable concerns that arise, all of which need attention.
For example, many companies provide accounting documentation (that is, royalty statements) only when there are royalties “shown to be due.” If the record company shows the incorrect amount of royalties due, then according to this language, they did not err by paying you only what the accounting “shows” to be due. If they show no royalties to be due, they may not even bother sending a statement indicating the number of records sold during the accounting period. Furthermore, as we have seen, it may be a very long time (or never) before any royalties are actually due (shown or otherwise), so this practice may result in the artists never receiving any statement containing pertinent sales history data: information on total sales; where and to whom records were sold, and at what price and with what tax consequences; whether and to what extent reserves against the eventuality of returns were maintained (see below); whether there actually were any returns; and the number of records sold by foreign licensees or affiliates of the principal contracting record company. Yet without this information, the sales history of a record is hazy at best and impossible to determine at worst.
There are as many variations of accounting statements are there are companies. Only highly experienced accountants can sift through the plethora of information that a record company will thrust on them during an audit in order to determine the veracity of the statements. The royalty programs used by different record company computers also differ dramatically (and intentionally). This fact will impede any reasonable attempt at verifying not only artist royalties, but also mechanical royalties due publishers and mechanical rights societies. (See chapter 12 for a more detailed discussion of royalty audits.)
Truth in Royalty Statements
As stated earlier, all recording agreements provide that the company has the right to withhold royalties on a specified percentage of records sold, in anticipation of returns. (All records are distributed on a 100% guaranteed return basis, resulting in the bizarre possibility that every record ever shipped to a dealer might eventually be returned for credit one day.) These provisions have potentially far-reaching implications.
Let’s say that, contractually, the record company is allowed to withhold royalty payments “in reserve” on 15% of all records shipped. At the same time, 15% of the shipped records constitute “free goods.” Now, if 100 records are returned, shouldn’t only 85 of them be charged against the artist’s account, since the artist would never have received royalties on the remaining 15—the free goods—anyway? Shouldn’t returns be applied against the artist’s account in the same proportion as they are shipped—that is, with 15% of them free? Now that we have answered these questions, we ask, “How many of the 100 records should be subject to the 15% reserve right?” All of them? Eighty-five of them? If the answer is 85, then royalties reflecting 12.25 records will be held in reserve. If the answer is 100, then royalties reflecting 15 records will be held in reserve, which is 22% more. If the amount of money we are talking about is $100,000, the 22% difference is $22,000, not a small sum.
Note one exception to the rationale for maintaining reserves: DPDs (digital phonorecord downloads) cannot be returned; thus, there is no logic to retain reserves against these sales as if in anticipation of eventual returns. If your contract does not state this explicitly, the record company would have every right to add DPDs to their reserve cache according to the language they create covering the right to withhold royalties on reserved records.
Now, suppose that during a particular accounting period, 1 million records recorded by a particular artist have been manufactured and 750,000 have been shipped to dealers. Presumably, 250,000 records would remain in the record company’s inventory at its manufacturing facility or at its branches. What might the artist’s accounting statement look like? First of all, the actual manufacturing data will probably not appear because, contractually, the record companies do not have to provide that information. Will the number 750,000 appear? No. Because this number, as we have seen, does not really reflect the number of royalty-bearing records which have been distributed (shipped)—which is 541,875. That number is calculated as follows: first the 15% free-goods deduction is taken (85% of 750,000 is 637,500); then the reserve clause is applied, resulting in 541,875 units (15% of 637,500 is 95,625). So, even though 750,000 units have been shipped, the record company’s statement to the artist will not exceed 541,875 units as it is still too early for actual returns to occur.
But what if the accounting statement shows royalties calculated on only 250,000 units? Is there any way to know whether this reflects a true accounting of the number of records sold during the accounting period? The answer is no. Why? Because the record companies will invariably deny the artist and his or her auditor access to manufacturing data, inventory numbers will never be provided, free goods will not be separately accounted for, and an accountant would need a crystal ball to identify how many units have been held in reserve. Sorry. Some—but not all—record companies have begun to open up some of their manufacturing records, but I have yet to learn of any true transparency in this area.
Finally, suppose that you or your accountant suspect that, due to shady or haphazard or undisclosed accounting procedures, you have not received the royalties that are due to you. What recourse do you have? Your only legal recourse is to demand that the company open its books to an audit. But artists do not get the same benefit as all other citizens when it comes to such pursuits. Remember in the film The Sting when the Newman/Redford operation ran out of money and could not cover Robert Shaw’s bet? They shut him out. They waited until the horse race had begun and then closed the betting window. Record companies do the same thing. Just as artists begin to get a feel for the flow of royalties in relation to the success they are having, their right to audit is closed down. Audit limitations of one or two years are common—hardly enough time to get the “feel” of a series of accounting statements (especially if foreign sales are significant). Without that “feel,” it is difficult to determine even if the cost of an audit is justified. Too often, the time passes, and the opportunity is lost long before a real sense of the accounting history can be experienced. (See chapter 12, the section on statutes of limitation, this page.)
The increasingly effective alliance of artists—the Recording Artists’ Coalition (RAC) (www.grammy.org/recording.academy/advocacy/rac)—has begun to look into the fundamentally unfair nature of royalty statements issued by most every record company. They have also been active in seeking the repeal of laws which tie artists to long-term record contracts and laws which surreptitiously affect artists’ rights to recapture their masters under provisions of the existing Copyright Act. The RAC has enlisted the aid of the Democratic Party to introduce legislation dubbed the “Artists’ Bill of Rights” that addresses injustices suffered by artists. Issues of importance to RAC include what they claim are unfair accounting practices on the part of record companies. In 2009 RAC became an arm of NARAS (National Academy of Recording Arts and Sciences), the organization responsible for the GRAMMYs, reinforcing their commitment to the rights of artists.
HOW RESPONSIBLE SHOULD RECORD COMPANIES BE?
Courts have held that a contract clause requiring payment of royalties does not create a fiduciary relationship. If it did, the burden of paying would go much more to the heart of the agreement and a breach of financial undertakings would more easily permit termination. In a fiduciary relationship, the fiduciary owes to its beneficiary obligations far more stringent than that required of ordinary contracting parties. Consequently, the customary low level of responsibility and accountability on the part of re
cord companies means, in practice, that the burden of proof (such as proving that accountings are inaccurate) remains the artist’s; the record company does not have the burden of proving the accuracy of its accounting statements. One might think that the fact that the payer has exclusive control over the financial receipts would help the artist to transfer this burden—but one would be wrong. Even if a fiduciary relationship were to apply, a breach of fiduciary duty is a tort (a “wrong”), and not a contract breach. The statute of limitations for redress for torts is customarily three years rather than six years, which is the standard term for contractual claims. Thus, even if a fiduciary responsibility can be established, the chances are that by the time the right to assert a claim has been discovered, the three years will have passed. But this doesn’t really matter much anyway because the record contract invariably provides for a shortening of the traditional six-year contract statute of limitations to two or three years. Another common device that record companies use to increase their cash flow is to delay payments to artists. Book publishers rarely delay payment. Why? Because all of their costs are up front. Record companies, however, rely on the float—the use of money that they have, on paper, already dispensed. They will use you, the artist, as a bank. For example, Sony’s bank is in North Carolina! When you receive a royalty check, or even a tour support advance from the New York “home” office, your bank has to wait for the North Carolina bank to clear the funds. What is a few extra days to you? Not so much, other than what can be a considerable inconvenience. But consider how the sheer volume of a record company’s banking exchanges can affect their profitability. How clever of them. And the device appears nowhere in the record contract.
THE EFFECTS OF DIGITAL DOWNLOADING ON PRICING AND ROYALTIES
As technology continues to outpace the law, new methods of exploiting records are being discovered on a regular basis. The most important of these is the DPD, distributed via the Internet—in essence, the electronic transfer of sound (with or without video images), digitally, without an intervening sound carrier such as a CD or cassette. Methods of exploiting DPDs are also undergoing evolutionary processes such as the advent of subscription services offering digital downloads of limited, and even unlimited, quantity and duration, tethered downloads (those whose “life” expires after a certain number of days), and the like. Streaming services are becoming more and more popular as the youthful record “buyers” grow up “renting” music and not buying it.
The original grant of rights provisions (rights granted to the record company by the artist) in a record contract entered into before the era of DPDs no doubt included electronic rights such as are utilized in downloading digital copies of music. The industry has acknowledged this. But it is going to take a wizard to figure out the extent to which the royalty provisions apply to such new technological advancements as digital downloads; limited, or tethered, downloads; streaming; podcasting (permanent); and webcasting (not permanent). Areas of particular concern include identifying the territory of the sale, determining release commitments, determining the royalty rate, long-term availability, price, and licensing these rights to third parties.
Territory of Sale
In chapter 17 I discuss some of the issues involved in determining exactly where digital downloads may be said to take place. What country is identified as the country of sale will have on impact on royalty calculations. For example, suppose the download occurs in a country where the record company is entitled to pay a reduced royalty. Does the reduced royalty rate apply, or is the applicable royalty rate the one in effect in the territory in which the server is located—or where the original content provider is located?
Determining territoriality also impacts the recording agreement’s provisions relating to release commitments. What if the Internet server is located within the United States and the actual physical record is never released outside of the United States? If artists have the right to recapture their records in territories in which the record company fails to honor its release commitment, should they, then, have the right to claim reversion of their rights for those portions of the world in which the record was not released in tangible form? And if they do, can the artists then offer the record for sale via the Internet, which will have the effect of global availability, thereby interfering with the exclusive rights of the record company?
Determining the Royalty Rate Base for Digital Downloads
What should the royalty rate for DPDs be based on? List price? Receipts? List price with a discount? Now that the volume of digital downloads has reached a kind of critical mass, record companies are hard-pressed to explain why those costs traditionally accompanying the manufacture and distribution of a record should have any place at all in the way entitlements of the record company and the artist are calculated. (For purposes of this portion of this chapter, I am treating the interests of producers and artists as being in synch with each other, since producers’ entitlements are usually tied to those of the artist.) For example, when all the record company has to do is provide A&R and marketing services and present a digitized version of the music and lyric track to a server, the following costs should be out the window: the cost of artwork development and production, jewel boxes, CD manufacturing facilities, per-unit manufacturing costs, packaging the product, packing the product for shipment, and other shipping costs.
On the other hand, some costs will be specific to the sale of DPDs. The costs associated with credit card enablers, perhaps some “agent” or “dealer” fees to third-party website providers, conversion costs incurred in the course of digitizing music files, the cost of maintaining servers, and the cost of lost sales due to piracy or, conversely, the cost of preventing digital files from being pirated are all new. And, of course, record companies will remind us that the high costs of production, marketing, promotion, advertising, tour support, videos, and the like do not disappear once an artist’s music is offered for transmission over the Internet. (They do have a point, of course, but what does this have to do with packaging deductions?)
However one looks at it, coming up with new royalty formulas on the basis of download-related sales is not a simple matter. Note that digital downloads are not the only media affected by this dilemma; mastertones, ringtones, even digital streams have similarly created confusion among the labels themselves as to how to interpret their own contracts in calculating royalties due their artists.
Here are four ways to calculate an artist royalty:
1. The company pays a percentage of net receipts at the same rate as the artist’s royalty rate. Under this system, net receipts on a $0.99 DPD sold in the iTunes store would work out as follows: Apple takes a cut of $0.23, leaving $0.76. After deducting $0.01 for the union payment and $0.091 for copyright mechanicals (required by law), $0.659 is left. Assuming a royalty rate of 15%, the artist receives $0.10 on each sale—essentially the same amount as the owner of the musical composition.
2. The record company applies the royalty rate to the retail selling price of the DPD. For example, 15% of $0.99 equals $0.1485. This will probably be further reduced by a 25% packaging and a 25% new technologies deduction—depending on how they choose to interpret the contract. Thus it can be as low as 15% of $0.5569, which is $0.0835 (8 cents) if they play it that way. (The record companies have graduated from actual charges to virtual charges. Who says they aren’t growing “with the times”?)
3. The DPD is viewed as the product of a license (which it is), and the artist receives 50% of the record company’s net receipts of $0.659 (that is, $0.3295), the net after Apple’s cut, the union share, and the musical composition mechanical fee. Of course, this is the method preferred by artists and their representatives, and were the record industry a bit healthier, it is probably the way things would have gone but for the disaster caused by peer-to-peer sharing. The major labels are so desperate now that they are looking to find an edge every way they can. (If the music publishers/songwriters are successful in increasing their share from $0.091,
then, of course, the net to the record labels will change.)
In 2011 and 2012, litigation on this subject by a class of recording artists asserted the argument cited in Number 3 above. These cases are now being settled rather than have the parties go to trial. So we will never know for sure whether DPDs were actually authorized as sales of licenses. One of these settlements involved the groundbreaking FBT Productions LLC v. Universal Group case brought by a production company which originally signed Eminem as a recording artist. In this case, following a jury verdict in favor of the record label, Universal, the Third Federal Circuit Court of Appeals sided with FBT in finding that a DPD sale by iTunes was indeed a result of a license, as provided in Eminem’s agreement with Universal (FBT received an override, a percentage of sales, on certain records released by Universal after FBT was no longer officially Eminem’s production company.) In March 2012, Sony Music Entertainment settled a class action brought by disgruntled former Sony and Arista recording artists and their producers which essentially resolved their dispute for past royalties by characterizing past DPD sales as derived from a license, but treating future DPD sales as if they were retail sales, for which a royalty would be paid. These, and other record company settlements becoming public in the last few years have resembled the 15% of $0.99 ($0.1485 or $0.15) model (without deductions). This is not much different a formula than the customary application of the royalty rate to the suggested retail selling price of records. The difference with digital downloads, of course, is that there is no cost applicable to the sale: no inventory, no shipping, no packaging.
What They'll Never Tell You About the Music Business Page 10