I. INTRODUCTION

II. THE HOW
    A. Speed
    B. Quality
    C. Piracy

III. BUSINESS MODEL
     A. Distribution
     B. Window
     C. Pricing

IV. ISSUES
     A. Who Owns It?
     B. Territoriality
     C. Holdbacks
     D. Calculating Contingent Payments to Talent and Licensors
     E. Guild Residuals

V. CONCLUSION

I. Introduction

It's here! That is, distribution of films on the Internet, and it will have the same revolutionary impact on the film industry as the introduction of video in the '70s. It will require a complete rethinking of the film business, and the streets will be lined with dead bodies and lottery winners.

II. The How                                                                 Return to Top                                                                                             

Already, films that are shot on celluloid can be subsequently transferred to a digital file that is stored onto a computer server located anywhere in the world. In time, films will be shot digitally in the first instance, which will make this process easier. It will also expedite digital transmission of films to theaters. (Ah, but that is another story…) The server can hold many films, and anyone with a personal computer will be able to access the server and download the film (for a reasonable fee, of course). There are several barriers to making this a reality, but these barriers are rapidly falling:

A. Speed. Using a normal modem, it takes a full day to download a two-hour movie. There is currently available high-speed download technology, but it is relatively expensive. It is only a matter of time, however, before the cost drops and the technology becomes widely affordable. The next widely anticipated development is the implementation of broadband technology (the equivalent of unwinding a string into its separate strands), which will permit the rapid transmission of massive amounts of data, permitting the rapid download of films.

B. Quality. Currently, downloaded films are viewed right on the computer screen, and there is a serious degradation of quality compared to theaters or even video. Two recent developments are changing this, however. The first is that Microsoft recently introduced software that permits playback of downloaded films at thirty frames per second, comparable to VCR tapes played on TV sets. The second development is technology permitting downloaded films to be replayed directly on television sets, as opposed to on computer screens.

C. Piracy. The fear abounds that once a film is out there in the digital world, where perfect copies can be made over and over, rampant piracy will occur. There are two answers to this problem: The first is: So what? The studios have long ago accepted piracy as an unfortunate but acceptable cost of doing business. They crossed this bridge with video, they crossed this bridge with DVD, and they will cross it with Internet distribution. The second answer is that technology has been and will be developed that prevents downloaded films from being able to be re-transmitted to third parties.

A dream? Hardly. In April, a company called Sightsound distributed Artisan's film "Pi" over the Internet for $2.95. With the use of high-speed download technology, the film could be downloaded in about twenty minutes. Using Microsoft's software, the film could be played back at almost VCR quality. Sightsound claims to have patented technology that prevents the piracy of films once downloaded. Other companies have entered the fray, including Reel.com, Broadcast.com, Global Media, Inc., Reel Networks, and Shortbuzz.com.

III. Business Model                                                   Return to Top                                                                                       

A. Distribution. The most likely scenario is that studios will distribute their own films through their own servers, rather than licensing their films to third-party servers. This model seems likely for several reasons: First, it will permit the studios to maintain control over their film libraries, rather than risk losing control, particularly in the easily pirated digital format. Second, distribution costs will be relatively low (other than advertising, which the studios already know how to do); it will not require an extensive staff of employees, such as is required to service theatrical or video distribution. Finally, it gives the studios direct contact with the consumers, giving them the opportunity to cross-sell other films or media. The main benefit of the Internet is to give companies direct access to consumers, and the studios will not relinquish this benefit lightly.

It also seems likely that several of the studios may combine resources in a joint venture, analogous to UIP (for theatrical distribution) or CIC (for video). In this manner, consumers could hook-up with one server and obtain the vast majority of potential films.

B. Window. Initially, the Internet window will probably come after the video and pay-TV window, and before the free TV window. Those two windows are too well entrenched to permit being preempted lightly. In time, however, the Internet window should cannibalize both pay-TV and video, effectively moving up the Internet window to occur shortly after the theatrical release, analogous to the current video window.

It is highly unlikely, however, that Internet distribution will ever replace the primacy of the theatrical release. Just as video, pay-TV, television, DVD, etc., have not spelled the demise of theatrical, neither will Internet distribution. People -- particularly teenagers -- like to get out of the house, and it is difficult for any home system to compete with the large screen and multi-channel sound system of a theater.

C. Pricing. The per-film pricing for Internet distribution must drop compared to the video and DVD rental business. This is because there are no manufacturing costs associated with Internet distribution, and the distribution costs are far less. This substantial drop in costs can only correlate to lower pricing. It is also likely that in addition to, or in lieu of, a per/film fee, consumers could pay a monthly fee to have up to a specified number of films per month. The server should also be able to earn ad revenues through advertising, banners, and links to other Internet sites.

IV. Issues                                                                Return to Top                                                                                            

A. Who Owns It? The immediate issue will be: Who owns Internet rights? The disputes will include whether the producers granted the studios Internet rights in the first place, and whether the studios have licensed those rights to third parties. The answer will depend on the terms of each contract, and this issue will be endlessly litigated. Since Internet rights will cannibalize both video and pay-TV, one can expect the argument to be made that Internet rights come within the definition one or both of those rights. In the author's opinion, it is inappropriate to do so; it just cannot be said to be within anyone's reasonable expectations that "video" or "pay television" would include a media as novel and different as Internet rights. A more problematic issue is whether Internet rights fall within the definition of "video on demand" or "near video on demand" - definitions that have been used for some time in contemplation of unlimited at-will access to films. The difficulty is that it was generally contemplated that such access would be via cable or satellite, so it really will depend on the precise definitional language used. The simplest case is a future media clause, covering distribution by "all media, whether now known or hereafter devised." Whoever owns these rights should certainly own Internet rights.

B. Territoriality. Territoriality will be the single most problematic aspect of licensing Internet rights. Under current distribution models, most distribution rights are ultimately handled by different distributors on a territory-by-territory basis. For example, a German distributor may be licensed certain rights within Germany, and a French distributor may be licensed certain rights within France. Each distributor then distributes the film within its own country, and there are elaborate restrictions on inadvertent distribution outside of the prescribed territory, including terrestrial and satellite broadcast restrictions. All of this suffers the fate of the stone axe under Internet distribution because consumers in any part of the world can hook-up to a server located anywhere else. Unless caution is used, a licensee of Zimbabwe rights could set up a server permitting worldwide access to the film. Because of this risk, one solution is for both the licensor and licensee to "freeze" Internet rights until technology is developed and used that limits Internet access to within a proscribed country or territory. For example, technology may be developed limiting access to phone numbers starting with a certain prefix (although call forwarding may defeat this). The most likely solution is that Internet rights will be left with the licensor (typically a studio), and perhaps the licensor will be required to pay the licensee for revenues attributable to Internet access within the licensed territory. For example, it may become possible to source revenues within that territory based on phone number prefixes, or perhaps some specified percentage of worldwide revenues can be used.

Another approach is to license Internet rights, but to require the Internet version used by the licensee to be dubbed into the home language. This is similar to what is currently done for satellite broadcasts (unless they are encrypted for reception within the home territory). It is unlikely that requiring only subtitling will be sufficient if the film is still in English, as subtitling in a foreign language would not be an effective block against consumers who speak or understand English and are willing to ignore the subtitles.

C. Holdbacks. The resolution of determining the appropriate holdback for Internet rights will depend on where the Internet window falls, discussed above. As discussed there, one might expect Internet rights to initially be subject to a holdback until after the video and pay-TV window, with this holdback subsequently moving up to replace the video and pay-TV windows entirely.

D. Calculating Contingent Payments to Talent and Licensors. One of the wonderful battles will be over the calculation of participations owed to talent and overages owed to licensors. The resolution of this issue will depend on the business model used for Internet distribution. As discussed above, it is likely that the studios will undertake Internet distribution directly or through a multi-studio joint venture. In this case, the immediate question is what revenues constitute "gross receipts" as the starting point for calculating contingent payments. Talent and other payees will obviously take the position that revenues received by the server from consumers should constitute gross receipts. It can be predicted with absolute certainty that the studios will take the position that these revenues must be excluded, and that gross receipts must start with a deemed royalty paid by the server to the studio. For example, the studios still generally get away with including in gross receipts a deemed royalty as low as 20% on video revenues, and video revenues never include payments by the consumers, even if the studio owns the retailer (e.g., Blockbuster). Similarly, when Disney licenses films to ABC, its wholly owned network, only the revenues received by Disney, not ABC, are included in gross receipts.

If the studios prevail in adopting a similar inter-company deemed royalty model for Internet distribution, the remaining question is what the inter-company price will be. Presumably, it will be stated as a percentage of server revenues, and one can expect the studios' opening bid to be 20% (after all, they generally get away with this on video). In lieu of a percentage of gross receipts to the server, another model may be an arbitrary price, to some extent based on theatrical receipts, which is basically how inter-company sales to television networks are done.

Another issue will be what distribution fee, if any, applies to Internet gross receipts. If gross receipts are calculated at the server level, then it seems fair to have a distribution fee, albeit a low one, because distribution activities should be relatively modest. If, however, gross receipts are calculated based on a deemed royalty to the studio, then there should be no distribution fee, just as there should be no distribution fee on a deemed video royalty (unless the contract is really piggish).

The next issue will be what, if any, distribution costs are deductible. Again, if gross receipts are based on gross receipts to the server, then it is appropriate to deduct all actual costs incurred in connection with Internet distribution. If, however, gross receipts are calculated based on a deemed royalty to the studio, then no distribution costs should be deductible on the grounds that the royalty percentage is in lieu of all costs. For example, this is how video is typically handled. On this point, someone should argue that a large portion of theatrical advertising costs are intended to benefit Internet distribution, and so should not be deductible. (However, this same issue applies to the current calculation of video net receipts, and the author is not aware of anyone winning this argument . . .yet.)

A further complication will be how to allocate revenues among pictures, particularly if consumers pay a monthly subscription price in lieu of a per/film price. This same issue currently applies to any package sale of film rights, and the best that can typically be achieved is vague "fair and reasonable" allocation language in the contract.

Finally, you can be sure that, one way or another, ad revenue received by the server will not be included in gross receipts. If server income is included in gross receipts, there will most likely be a blanket exclusion for ad revenue. Alternatively, the very existence of ad revenue will be an argument as to why gross receipts must be calculated based on a deemed royalty to the studio, as in the case of an affiliated television network.

All of these issues will be particularly fun in the context of contracts that do not contemplate Internet distribution. The studios will most likely resort to self-help in the form of forming the server as a separate company and entering into a formal inter-company license. The interesting issue will be if the contract in question picks up revenues received by affiliates or refers to "at-source" accounting.

E. Guild Residuals. Another problematic issue will be determining how to calculate guild residuals on Internet revenue. Similar to the question of calculating contingent payments owed to talent and licensors, the question under the guild agreements is what will be the starting point for calculating gross receipts. Until the guild agreements are amended to expressly deal with this question, the same battles discussed above in connection with calculating participations and other contingent payments owed to third parties will apply in calculating guild residuals. But just where do Internet revenues fall under the current guild agreements, which currently divide film revenues into theatrical, video, pay-TV, and free-TV? Perhaps the answer is, "Nowhere."

V. Conclusion                                                            Return to Top                                                                                

The ability of consumers to pay to see a film of their choice at any time will have profound implications on the film industry. At a minimum, the value of film libraries should skyrocket, just as they did with the introduction of video. It will take years to sort out the business and legal implications of the new distribution pattern, and lawyers will have their hands full negotiating and drafting contracts that properly deal with the issues - or litigating those that don't.

YADDA, YADDA, YADDA

1. For more information go to http://www.legalelite.com/index.htm

2. If you need help or have a comment, please E-mail us at
questions@legalelite.com.