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CREATIVE ACCOUNTING

3/16/2015

 
By Mark Litwak Esq.

Filmmakers and profit participants often complain about distributors that engage in creative bookkeeping. This is one area where filmmakers concede the studios are sufficiently imaginative in their thinking. A frequent criticism is that distributors devise new and ingenious ways to interpret a contract so that all the revenue stays with them. Filmmakers believe that net profits are often illusory. Rarely does a share of net profits actually result in money received.

I have been involved in many creative accounting disputes and recovered millions of dollars for filmmakers cheated by distributors.  As a result of my experience,  whenever I negotiate a  distribution deal, I always try to tightly  define and limit expenses that are recoupable to those that are “direct, auditable, out-of-pocket, reasonable and necessary.” This means the distributor has to produce a receipt showing a legitimate payment to a third party in order to deduct that expense.  Less precise wording can leave enough ambiguity for a distributor to argue over which deductions are proper.

I recently won an award from a distributor that engaged in many of the typical tactics used to defraud filmmakers. Even though the distribution deal clearly prohibited the deduction of overhead, interest or legal fees, an audit revealed that the distributor had deducted those expenses.  The distributor even tried to claim its own attorney fees for negotiating the initial distribution deal with the filmmaker, as well as payment to his lawyer contesting the filmmaker’s right to terminate the agreement.  The filmmaker  was clearly within his rights to terminate the agreement, after the distributor repeatedly failed to provide producer statements and payments due.

The distributor tried to write off wages paid to staff members from ranging from executives to interns, and also deducted charges for cell phone calls, meals and entertainment and even staff parking.  Perhaps most outrageous, the distributor paid fees to one of its own top executives and attempted to hide this payment by making the payment to a company  owned by the executive that had ostensibly provided marketing services for the film. Since producer statements are summaries lacking in detail,  none of this misconduct was revealed until an audit was undertaken.

Distributors have attempted to hide their misconduct with missing or incomplete records. However, in cases where records essential to proving damages are in a distributor’s exclusive control, the courts have shifted the burden of proof to the distributor, to prove that their deductions are legitimate.

No doubt, there are numerous instances where producers or distributors have cooked the books to avoid paying back-end compensation to those entitled to it. Expenses incurred on one movie might be charged to another. Phony invoices can be used to document expenses that were never incurred. Some ruses are more subtle, and not readily apparent to the uninitiated.

Various court decisions have held that distributors have a duty to exercise good faith and fair dealing toward filmmakers. In Celador Int’l, Ltd. v. Disney Co., the court held that when a party has an interest in profits from a business, the person managing that business has to act in such a manner as to protect the interest of the profit participants. Celador created and executive produced a show entitled “Who Wants to Be a Millionaire,” which was highly successful in the United Kingdom. Celador later entered into an agreement with ABC and Buena Vista Television (both Disney subsidiaries) for a version of the Series to be produced for distribution in North America. Under the agreement negotiated by the parties, Celador was entitled to 50% profit participation.  Celador alleged that Disney breached its implied covenant of good faith and fair dealing because Disney assigned production of the Series to Valleycrest Productions, Ltd. (“Valleycrest”), a subsidiary of Disney, rather than seeking competitive deals from third-party producers.  According to Celador: “ABC agreed orally to license the Series for an ‘imputed per-episode license fee equal to Valleycrest’s per-episode production costs’.... As a result, the network exhibition of the Series could never reach profits after production costs, distribution fees, distribution costs, overhead, interest, etc. were deducted from any gross receipts.”  Consequently, the Series never generated any profits for Celador while  Disney benefited in the form of cost savings and increased profits to Disney affiliates.  As a result of decisions like Celador, filmmakers often try to restrict the distributor from making deals with affiliated companies or sub-distributors, unless the filmmaker consents to such arrangements.

It is important to understand that the major studios determine profits for participants using their own special accounting rules as set forth in their net profit definitions. The accounting profession has generally agreed-upon rules called Generally Accepted Accounting Principles (GAAP). There are special guidelines for the motion picture industry called Financial Accounting Standards Bulletin 53 (FASB 53). These rules provide, among other things, for the accrual method of accounting. Under this method, revenues are recognized when earned, and expenses are recognized when incurred. But distributors do not necessarily follow these rules. They may use GAAP and FASB 53 when accounting to their shareholders, or reporting to their bankers, but they often resort to their own Alice in Wonderland-type rules when they calculate net profits for participants. They may recognize revenue only when it is actually received, while taking expenses when incurred. So if the distributor licenses a film to a television network, the distributor may not count the license fee as revenue until they actually receive it. Even when they receive a non-refundable advance, they might not count it as income until the time of the broadcast. Meanwhile, they count expenses immediately, even if they have not paid those expenses yet.  This mismatching of revenues and expenses allows the distributor to delay payment to participants. It also allows distributors to charge producers interest for a longer time on the outstanding “loan” extended to a producer to make the film.

The Art Buchwald case illuminates some of the devices Paramount used to deny payment to net profit participants. Art Buchwald was a Pulitzer Prize winning author and syndicated columnist who  alleged that Paramount Pictures stole his script idea and turned it into the 1988 movie Coming to America. Although the movie generated more than $288 million in worldwide box office revenues, according to Paramount it had earned no net profits according to the profit definition in Buchwald's contract. The trial judge found many of Paramount’s accounting practices to be unconscionable and refused to enforce them. Paramount appealed, but the case was settled before the Court of Appeals could issue a definitive ruling on the issue.

If Buchwald had won the appeal, the precedent could have caused severe repercussions for all the major studios. That is because Paramount’s “net profit” definition was virtually identical to the definitions found throughout the industry. If Buchwald’s contract was invalid because it was unconscionable, then many other contracts could likewise be contested.

However, Buchwald could have lost the appeal.  The trial judge in Buchwald used the doctrine of unconscionability to invalidate a contract that Buchwald was trying to enforce. Courts have traditionally embraced this doctrine only when it was used as a defense, or shield, against enforcement of an unfair contract, rather than as a sword to enforce the terms of a contract against another. Courts have typically relied on the doctrine to protect uneducated people who have been taken advantage of. If an unscrupulous door-to-door salesman sells a refrigerator for an exorbitant price to a poor, illiterate consumer on an installment plan using a boilerplate contract not open to negotiation, the judge might refuse to enforce the contract because it “shocks the conscience of the court.”

Buchwald, however, was hardly a poor, defenseless victim. He was an intelligent, wealthy, and acclaimed writer represented by the William Morris Agency. If a judge was willing to rewrite his contract because it was unfair, then why not rewrite thousands of other writer contracts? Indeed, why not rewrite any unfair contract? Where does one draw the line? If any contract can be contested simply because it is unfair, then how can anyone safely rely upon the terms of a contract? And how can one conduct business if you cannot be sure your contracts will be enforceable?

Under long-established precedent, courts refuse to invalidate contracts simply because they are unfair. Law students are taught the principle that even a peppercorn—something worth less than a penny—can be valid consideration. This means that if you are foolish enough to sign a contract to sell your $200 bike for a dime, do not expect a court to bail you out of a bad deal. Absent fraud, duress, or some other acceptable ground to invalidate a contract, courts do not second-guess the wisdom of what the parties agreed to.

While the trial judge in the Buchwald case thought the doctrine of unconscionability could be invoked to invalidate a net profit definition, it bears noting that another Los Angeles Superior Court came to a different conclusion. In reviewing the accounting practices of Warner Bros. in the Batman case, the judge found that the plaintiffs had failed to prove that the studio’s net profits definition was unconscionable. The court noted that one of the plaintiffs who had negotiated the Warner Agreement was a former general counsel and senior executive

of a major motion picture studio who “knew all the tricks of the  trade,” and was knowledgeable about how these agreements worked.

Regardless of whether the Buchwald decision would have been upheld on appeal, the dispute has had an impact on the industry. The major studios have rewritten their contracts, replacing the phrase “net profits” with such terms as “net proceeds.” They want to avoid any implication that the back-end compensation promised participants has anything to do with the concept of profitability.

As a result of many highly publicized creative-accounting disputes, anyone who has clout insists on receiving either large up-front payments or a share of gross revenue. Distributors have consequently lost the ability to share risk with talent. Budgets have escalated to accommodate large up-front fees, with major stars now demanding $20 million per picture. Moreover, stars and directors have little incentive to minimize production expenses, since it doesn’t affect their earnings.

Not all complaints about creative accounting concern accounting errors. Many grievances reflect the inequality of the deal itself. The studio uses its leverage and superior bargaining position to pressure talent to agree to a bad deal. The distributor then accounts in accordance with the terms of the contract and can avoid paying out any revenue to participants because of how net profits are defined. The contract may be unfair, but the studio has lived up to its terms. It is only after the picture becomes a hit that the actor bothers to read the fine print of his employment agreement. This is not creative accounting. This is an example of a studio negotiating favorable terms for itself.

Keep in mind that there is no law requiring distributors to share their profits with anyone. Indeed, in most industries, workers do not share in their employer’s profits. Moreover, when a major studio releases a flop, losses are not shared; they are borne by the studio alone.


BORROWING AGAINST PRE-SALES

 By Mark Litwak


01/24/2015
 
In a pre-sale agreement, a buyer licenses or pre-buys movie distribution rights for a territory before the film has been produced. The deal works something like this: Filmmaker Henry, or his sales agent, approaches Distributor Juan to sign a contract to buy the right to distribute Henry's next film. Henry gives Juan a copy of the script and tells him the names of the principal cast members.
 
Juan has distributed several of Henry's films in the past. He paid $50,000 for the right to distribute Henry's last film in Spain. The film did reasonably well and Juan feels confident, based on Henry's track record, the script, and the proposed cast, that his next film should also do well in Spain. Juan is willing to license Henry's next film sight-unseen before it has been produced. By buying distribution rights to the film now, Juan is obtaining an advantage over competitors who might bid for it. Moreover, Juan may be able to negotiate a lower license fee than what he would pay if the film were sold on the open market. So Juan signs a contract agreeing to buy Spanish distribution rights to the film. Juan does not have to pay (except if a deposit is required) until completion and delivery of the film to him.

Henry now takes this contract, and a dozen similar contracts with buyers, to the bank. Henry asks the bank to lend him money to make the movie with the distribution contracts as collateral. Henry is "banking the paper." The bank will not lend Henry the full face value of the contracts, but instead will discount the paper and lend a smaller sum. So if the contracts provide for a cumulative total of $1,000,000 in license fees, the bank might lend Henry $800,000.

 Henry uses the loan from the bank to produce his film. When the movie is completed, he delivers it to the companies that have already licensed it. They in turn pay their license fees to Henry's bank to retire Henry's loan. The bank receives repayment of its loan plus interest. The buyers receive the right to distribute the film in their territory. Henry can now license the film in territories that remain unsold. From these revenues Henry makes his profit.

Juan's commitment to purchase the film must be unequivocal, and his company financially secure, so that a bank is willing to lend Henry money on the strength of Juan's promise and ability to pay. If the contract merely states that the buyer will review and consider purchasing the film, this commitment is not strong enough to borrow against. Banks want to be assured that the buyer will accept delivery of the film as long as it meets certain technical standards, even if artistically the film is a disappointment. The bank will also want to know that Juan's company is fiscally solid and likely to be in business when it comes time for it to pay the license fee. If Juan's company has been in business for many years, and if the company has substantial assets on its balance sheet, the bank will usually lend against the contract.

 In some circumstances, banks are willing to lend more than the face value of the contracts. This is called gap financing, and since the bank is assuming a greater risk of not being repaid its loan, higher fees are charged. Gap financing is helpful if the filmmaker is unable to secure enough pre-sales to cover the loan. The bank lends more than the amount of pre-sales based on its belief that the gap will be covered when unsold territories are licensed.

The bank often insists on a com­pletion bond to ensure that the filmmaker has sufficient funds to finish the film. Banks are not willing to take much risk. They know that Juan's commitment to buy Henry's film is contingent on delivery of a completed film. But what if Henry goes over budget and cannot finish the film? If Henry doesn't deliver the film, Juan is not obligated to pay for it, and the bank is not repaid its loan.

To avoid this risk, the bank wants a completion guarantor, a type of insurance company, to agree to put up any money needed to complete the film should it go over budget. Before issuing a bond, a completion guarantor will carefully review the proposed budget and the track record of key production personnel. Unless the completion guarantor is confident that the film can be brought in on budget, no completion bond will be issued.

First-time filmmakers may find it difficult to finance their films based on  pre-sales. With no track record of successful films to their credit, they may not be able to persuade a distributor to pre-buy their work. How does the distributor know that the filmmaker can produce something their audiences will want to see? Of course, if the other elements are strong, the distributor may be persuaded to take that risk. For example, even though the filmmaker may be a first-timer, if the script is from an acclaimed writer, and several big-name actors will participate, the overall package may be attractive. 

In a pre-sale agreement, a buyer licenses or pre-buys movie distribution rights for a territory before the film has been produced. The deal works something like this: Filmmaker Henry, or his sales agent, approaches Distributor Juan to sign a contract to buy the right to distribute Henry's next film. Henry gives Juan a copy of the script and tells him the names of the principal cast members.

 Juan has distributed several of Henry's films in the past. He paid $50,000 for the right to distribute Henry's last film in Spain. The film did reasonably well and Juan feels confident, based on Henry's track record, the script, and the proposed cast, that his next film should also do well in Spain. Juan is willing to license Henry's next film sight-unseen before it has been produced. By buying distribution rights to the film now, Juan is obtaining an advantage over competitors who might bid for it. Moreover, Juan may be able to negotiate a lower license fee than what he would pay if the film were sold on the open market. So Juan signs a contract agreeing to buy Spanish distribution rights to the film. Juan does not have to pay (except if a deposit is required) until completion and delivery of the film to him.  

Henry now takes this contract, and a dozen similar contracts with buyers, to the bank. Henry asks the bank to lend him money to make the movie with the distribution contracts as collateral. Henry is "banking the paper." The bank will not lend Henry the full face value of the contracts, but instead will discount the paper and lend a smaller sum. So if the contracts provide for a cumulative total of $1,000,000 in license fees, the bank might lend Henry $800,000.

 Henry uses the loan from the bank to produce his film. When the movie is completed, he delivers it to the companies that have already licensed it. They in turn pay their license fees to Henry's bank to retire Henry's loan. The bank receives repayment of its loan plus interest. The buyers receive the right to distribute the film in their territory. Henry can now license the film in territories that remain unsold. From these revenues Henry makes his profit.

Juan's commitment to purchase the film must be unequivocal, and his company financially secure, so that a bank is willing to lend Henry money on the strength of Juan's promise and ability to pay. If the contract merely states that the buyer will review and consider purchasing the film, this commitment is not strong enough to borrow against. Banks want to be assured that the buyer will accept delivery of the film as long as it meets certain technical standards, even if artistically the film is a disappointment. The bank will also want to know that Juan's company is fiscally solid and likely to be in business when it comes time for it to pay the license fee. If Juan's company has been in business for many years, and if the company has substantial assets on its balance sheet, the bank will usually lend against the contract.

In some circumstances, banks are willing to lend more than the face value of the contracts. This is called gap financing, and since the bank is assuming a greater risk of not being repaid its loan, higher fees are charged. Gap financing is helpful if the filmmaker is unable to secure enough pre-sales to cover the loan. The bank lends more than the amount of pre-sales based on its belief that the gap will be covered when unsold territories are licensed.

The bank often insists on a com­pletion bond to ensure that the filmmaker has sufficient funds to finish the film. Banks are not willing to take much risk. They know that Juan's commitment to buy Henry's film is contingent on delivery of a completed film. But what if Henry goes over budget and cannot finish the film? If Henry doesn't deliver the film, Juan is not obligated to pay for it, and the bank is not repaid its loan.

To avoid this risk, the bank wants a completion guarantor, a type of insurance company, to agree to put up any money needed to complete the film should it go over budget. Before issuing a bond, a completion guarantor will carefully review the proposed budget and the track record of key production personnel. Unless the completion guarantor is confident that the film can be brought in on budget, no completion bond will be issued.

First-time filmmakers may find it difficult to finance their films based on  pre-sales. With no track record of successful films to their credit, they may not be able to persuade a distributor to pre-buy their work. How does the distributor know that the filmmaker can produce something their audiences will want to see? Of course, if the other elements are strong, the distributor may be persuaded to take that risk. For example, even though the filmmaker may be a first-timer, if the script is from an acclaimed writer, and several big-name actors will participate, the overall package may be attractive. 

 

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    Disclaimer: The information in this blog post (“post”) is provided for general informational purposes only and may not reflect the current law in your jurisdiction. No information contained in this post should be construed as legal advice from the individual author, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this Post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.
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