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Navigating Rough Seas:
Recording Royalty Issues
(Originally appeared in “Entertainment Law & Finance,” October, 2003)
An unfortunate fact in the recording industry is that successful records
result in audits by royalty participants. This is partly due to the
entrenched distrust that artists have for record companies and partly
to simple prudent business practices.
If an artist sells hundreds of thousands or millions of units around
the world, it would be the rare company that could move that many pieces
of product without making a mistake. Sometimes the mistakes are just
mistakes, and sometimes an audit holds up a mirror that reveals what
happens under the record company hood, warts and all. And the “all”
category can be very interesting.
An audit is usually conducted by an accountant to verify the books and
records of the record company that backup accounting statements. From
the record company’s point of view, audits are a necessary evil. At
major labels, the administrative cost associated with an audit is usually
much more burdensome than dealing with any subsequent payments generated
by the audit itself.
In fact, fiscally sound record companies will reserve funds on the
contingent-liability side of their financials to deal with audits that
they know are in progress or are likely to occur. This reserve includes
an unsegregated amount to cover artist, producer, mixer and remixer
royalty payments.
To simplify their audit responsibilities, among other reasons, some
years ago record companies largely stopped engaging producers directly,
and began requiring artists to engage producers and bear the burden
of accounting and paying producer royalties as a matter of contract.
This put the producer in the awkward position of having to audit --
perhaps even sue -- the artist with whom the producer has a creative
relationship.
Stages of Auditing a Record Company |
The Letter of Direction
Producers typically do not want to have to go after artists to be paid
royalties and certainly not to audit, much less sue. The producer’s
response to this development was to require the artist to direct the
artist’s record company to pay the producer at the source.
So, producers continue to be paid by record companies under a letter
of direction from the artist that directs the record company to pay
the producer a share of the artist’s royalties specified in the producer’s
services agreement with the artist.
It appears to the producer that he or she is paid directly by the record
company and would logically have an audit right against the record company.
However, this isn’t usually the way it works. Producers must audit the
artist unless the producer specifically negotiates an audit right against
the record company.
Record companies will strongly resist agreeing to permit producers to
audit them directly for a number of reasons. The most legitimate reason
is that the record company could be put in a position of having a producer
audit the artist’s income stream when the artist has not, or has not
yet, chosen to audit the record company for the same units -- a situation
that could get very untidy.
So producers don’t usually audit record companies and have good reason
not to audit an artist. What a producer often does is to wait until
the artist audits the label and then expects to participate in a share
of the artist’s audit recovery.
But many producer agreements do not require the artist to notify the
producer that the artist is conducting an audit. Because many artist
audits are actually precursors to renegotiation of the artist’s recording
agreement, the artist and record company may fold the audit settlement
into the renegotiation, and never formally settle the audit.
If the artist does not have a contractual obligation to notify the producer
of the audit, the producer may miss out on a prorata share of what the
audit settlement would have been paid had the audit been conducted and
concluded separately from the renegotiation of the artist’s contract.
Audits based on particular royalty statements must be conducted within
a contractual-limitations period of time that is fixed in the artist’s
agreement with the record company (and as between the producer and the
artist, in the producer’s services agreement). This is usually anywhere
from 12 months to 36 months after the date that an audit statement was
(or should have been) rendered by the record company to the artist.
If the artist does not audit the record company during that time period,
the artist waives his or her right to audit that royalty statement again.
Another provision of artist agreements limits the period in which an
artist may sue the record company for non-payment, or inaccurate payment,
of royalties. That period should extend at least a few months, if not
a year, beyond the end of the audit period, but sometimes is the same
period of time as the audit period.
The same is true of the producer’s right to audit the artist, although
the producer audit periods are often slightly shorter than the periods
that apply to the artist against the record company. An artist who has
not audited a record company at the time that the producer notifies
the artist of an audit will want to have enough time to give notice
of his or her own audit of the record company. This is because the money
to pay the producer on the producer’s audit will frequently come from
the artist’s recovery against the record company -- otherwise the artist
must pay the producer’s recovery out of pocket -- not a favored result.
(See sidebar on page * for the stages of auditing a record company.)
If the artist is conducting a renegotiation, the renegotiation process
will probably get started after audit field work has commenced, or possibly
following the submission of the audit report if the audit is to be part
of the leverage the artist wishes to exert against the record company
in the renegotiation.
As a result, it is worth producers negotiating a provision in their
services agreements to deal with the situation in which the artist commences
-- but does not conclude an audit -- or waives the right to audit as
part of a renegotiation or otherwise. This is particularly true in that
if the producer does not audit the artist but rides the coattails of
an artist’s audit of a record company, the costs of the audit are taken
off the top, so the producer is in effect paying for the audit, too.
If a producer is paying a share of the audit costs, there is no reason
why a producer should not get the necessary information and notices
needed to properly protect the producer’s interests.
Given the problems that may arise, the following audit issues are worth
covering when negotiating an agreement for a producer to work with an
artist:
Notification of an Audit. At a minimum, the artist should notify
the producer as soon as an audit is initiated. Artists are required
to notify the record company of their intention to audit, and then schedule
a time for the artist’s auditor to do field work. The easiest way for
producers to be notified of an audit is to require the artist to copy
the producer on the audit notice that the artist sends to the label.
Conducting the Audit. Any auditor engaged by the artist should
provide to the producer copies of all non-privileged information regarding
the audit, possibly including copies of the auditor’s field work and
definitely including the audit report that is sent to the record company
in support of the artist’s claims at the conclusion of the audit. The
audit report is the operative document that dictates the parameters
of any settlement of an audit
Audit Recovery. If the audit does not evolve into a renegotiation,
then the applicable portion of any recovery by the artist should be
allocated to the recoupment of any unrecouped recording costs of the
records concerned, and to the payment of any payable producer royalties.
This allocation may cause a previously unrecouped record to become recouped,
triggering a retroactive payment under the producer agreement.
If the producer’s account is already in a recouped position, the producer
should be paid through a prorata share of the audit recovery when the
artist receives that payment without having to wait for the regular
semiannual statements. If the artist’s account is still unrecouped after
the audit payment, but the producer’s account is recouped, the artist
should cause the record company to pay through the producer’s share
of the recovery.
Renegotiation After the Delivery of the Audit Report. If an artist
commences a renegotiation with the record company after the delivery
of an audit report, there is a fixed reference point as to what the
artist’s determination was of the money that was at stake in the audit.
If there is no formal settlement of the audit due to a renegotiation,
a producer can use the audit report as a reference point to determine
how much they should be paid. The producer should get a prorata share
of the calculations made by the artist’s auditor as part of the report.
Artists may resist this approach, as the auditor is the artist’s advocate
in this situation and will likely take an aggressive interpretation
of potential audit claims and the value of those claims. Audit reports
tend to be dragnets of every conceivable contract interpretation (including
questioning the validity of the 25 percent packaging deduction on compact
discs, for example, even though clearly stated in the artist agreement).
In any event, the audit report is probably the best method of deciding
how much the producer’s recovery should be.
Renegotiation Before the Delivery of Report. Here, the artist
and producer only have the artist’s auditor’s field work to rely on
to reach a number that results in a fair settlement because the audit
was not concluded. Even so, the field work should point to the potential
value of claims made and the producer should not be required to engage
an auditor to cover the same ground, although the producer may elect
to do so and conduct a new audit of the artist. If the producer chooses
to rely on the artist’s auditor’s field work, the artist and producer
should negotiate in good faith in order to reach a fair conclusion based
on those findings.
Artist’s Waiver of Audit Rights. Because the artist is often
in the position of being able to -- and being required to -- waive audit
rights in settlement of an audit, the artist acts largely as a quasi
(or perhaps actual) fiduciary of the producer. As a practical matter,
if a producer audits an artist and the artist is not in turn able to
audit the record company for the same period, the artist may cry poverty
when the producer seeks to audit the artist, causing the producer may
back off auditing the artist.
Therefore, the producer effectively relies on the artist to protect
the producer’s audit rights and recovery. Given this practical reality,
artists should not be able to waive their audit rights without at least
notifying their producers.
Producer’s Waiver of Audit Rights. However these audit issues
are addressed in the producer agreement, the producer should not be
required to waive the producer’s audit rights against the artist until
the producer has affirmatively accepted an alternate approach to auditing
the artist.
Producer-Writers: The foregoing can also apply to an audit for the payment
of mechanical royalties if the artist obtains a mechanical license from
the producer under “controlled composition” provisions in the producer’s
services agreement. If a producer is also a writer or a publisher of
songs at issue in an audit, the producer-writer should seek protection
against losing a recovery due to a renegotiation by the artist on applicable
recordings if that renegotiation also deals with mechanical royalties.
This factual setting is often less acute because a record company typically
obtains mechanical licenses directly from the producer-writer or their
designee so that payment of mechanical royalties to the producer should
be separate from any renegotiation of the artist agreement. But the
issue is worth noting.
Also, if a producer-writer has issued mechanical licenses directly to
the record company for songs recorded in masters subject to the producer
agreement, the producer may audit the same units that would be at issue
for record royalties by auditing under the mechanical licenses. The
results of the mechanical royalty audit can then be extrapolated to
determine if the producer is entitled to additional record royalties
under the producer agreement.
These points may not be “gimmes” when negotiating a producer agreement,
but certainly go a long way toward protecting a producer’s rights in
a manner consistent with the goals of the majority of producer contracts.
Christian L. Castle is senior counsel, in the Music Group at Akin
Gump Strauss Hauer & Feld LLP in Los Angeles. Telephone: 310-229-1000;
e-mail: ccastle@akingump.com.
And check out a related article by Mr. Castle, “Getting
A Fair Share Of The Digital Pie”.
This article has been reprinted with permission from the “Issue Date”
October 2003 issue of “Entertainment Law & Finance” © 2003 ALM Properties,
Inc. All rights reserved. Further duplication without permission is
prohibited.
