CONTINGENT PAYMENTS TO TALENT AND LICENSORS
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Schuyler Moore, Esq.
Stroock & Stroock & Lavan LLP

1. Introduction
2. Gross Receipts
    a. Date of Reporting Gross Receipts
    b. Exclusions From Gross Receipts
    c. Allocations
    d. Licensing to Affiliates
3. Distribution Fee
    a. Calculation Based on Gross Receipts
    b. Rate
    c. Subdistributors
4. Distribution Expenses
    a. In General
    b. Accruals
    c. Payments to Affiliates
    d. Trade Dues and Trade Shows
    e. Taxes
    f. Deducting Gross Participations
    g. Costs of Developing Ancillary Media
5. Production Costs
6. Accounting
7. Audits
8. Possible Alternative
9. Conclusion

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1. INTRODUCTION

2.GROSS RECEIPTS

a. Date of Reporting Gross Receipts.
Unlike the calculation of expenses, in which the goal is to accelerate the calculation, a film company's goal with respect to gross receipts is to report any payment received as income as late as possible. This is achieved by a number of means. For example, advance payments, even if non-refundable, are routinely reported as income over the period to which the advance relates: If a television network pays an advance to show a film on television, the advance is commonly reported as income only upon expiration of any holdback on television exploitation, and even then, often over the term of the license.

Another approach is to offset the income with a large reserve for possible refunds. This is a common approach, for example, with video sales: A huge portion of video sales is commonly offset with a reserve for potential refunds, the amount and timing of which are unilaterally set by the film company. Yet another approach is to not report gross receipts until revenues are received in the United States in U.S. dollars, which delays the reporting of gross receipts attributable to freely remittable foreign currency already received by the film company.

b. Exclusions From Gross Receipts.
The standard contractual definition of gross receipts contains a lengthy list of outright exclusions, with no excuses offered. For example, it is common to exclude any income from theme park exploitation of film rights and to exclude all litigation proceeds. Even where the contract is silent, film companies often find a way to avoid reporting gross receipts. For example, it is common for licensees to pay film companies fees referred to as "exclusivity fees" or "access fees," which are purportedly for the right to enter into a contract with the film company covering a number of films, so the payments are not allocated to any films at all. Another example is television barter income, which is earned when film companies license film rights to a television station or network in exchange for free television advertising time in lieu of a cash payment. Although the advertising time has the same value as cash to the film company, sometimes this value is overlooked when reporting income. These type of issues will only be picked up on a thorough audit.

c. Allocations.
Another favorite technique to minimize gross receipts is to allocate gross receipts away from the film in question and to something else. For example, it is common to allocate a portion of gross receipts to any shorts preceding the film. In addition, films are commonly sold in a package with other films, particularly for television and foreign sales, and film companies submit to the irresistible impulse to allocate the package fee as much as possible away from the successful films, which generate participations, to the turkeys, which don't. Film companies argue strenuously to retain their right to make "appropriate" allocations, instead of making allocations by some objective formula, such as the ratio of gross theatrical receipts of the films in question.

d. Licensing to Affiliates.
By far the most extensive problem is licensing rights to affiliates and only reporting as gross receipts the payments to the film company from the affiliates. The most common form of this practice occurs with video income, where the standard practice is to license video rights to an affiliate in exchange for a royalty equal to 20% of video sales by the affiliate. By this simple expedient, gross receipts from video sales -- the single largest element of gross receipts -- is reduced by 80%. The same practice is also prevalent for the exploitation of all ancillary rights, such as soundtrack and merchandising rights. Even if a film company makes millions of dollars from the sale of soundtracks or merchandise, only a small royalty will be reported as gross receipts.

3.DISTRIBUTION FEE

a. Calculation Based on Gross Receipts. Distribution fees are based on gross receipts, not net receipts. In an industry where distribution expenses (excluding distribution fees) average approximately 35% of gross receipts, the practice of calculating distribution fees on gross receipts inflates the fees. When talent with clout are able to negotiate a deal that includes video and merchandising gross income (i.e., gross receipts minus manufacturing costs), they must be careful to avoid having distribution fees based on gross receipts instead of gross income (gross receipts minus manufacturing costs). For example, if video sales had been reported on the normal artificial royalty basis, which is analogous to a gross income calculation, the distribution fee would only apply to the royalty (as a substitute for gross income), not to the gross receipts.

b. Rate. The other extraordinary aspect of the distribution fee is the rate itself. It averages 30% and increases to 40% for television syndication and foreign exploitation. At this rate of fees, it becomes almost impossible to reach net profits.

c. Subdistributors. Some film companies calculate gross receipts and distribution fees at the level of any independent subdistributors that are used. Many participants assume that this approach works in their favor because the gross receipts received by subdistributors will generally be higher than the gross receipts received by the film company from the subdistributors, but the actual result may be worse depending on the particular facts (for example, when the sub-distributors net receipts are less than the amount of any advance paid to the film company.)

Another problem is that film companies may charge their full distribution fee even though distribution is actually handled by a subdistributor that is charging its own fee. This results in a doubling up of distribution fees, and provides a distribution fee to film companies for undertaking no work. If properly negotiated, the contract should provide that the film company's distribution fee is reduced by the fees (or retained share of income) of subdistributors, or the film company should merely get a low override (like a 10% distribution fee) when there is a subdistributor.

a. In General. Every film company's list of distribution expenses begins with the mantra "all costs relating to distribution of the film including, without limitation . . ." This clause makes the subsequent list of specified costs superfluous. Before film companies even get to the list of specifically allowed costs, they deduct every imaginable cost related to the film under the quoted clause. To add insult to injury, distribution expenses are often increased in a number of ways. For example, all film companies receive discounts and rebates from service providers they use on a regular basis (such as advertising sources and print duplication labs), yet these rebates and discounts are not usually netted against distribution expenses. In addition, film companies commonly allocate expenses to more than one film, and it is not uncommon for the total allocation to exceed 100% of the expense.

b. Accruals. One method film companies use to accelerate distribution expenses is to accrue and deduct expenses to be incurred in the future. In accruing future expenses, film companies typically do not follow standard generally accepted accounting principles; they often effectively accrue and deduct an estimate of the expenses they expect to incur in the future. In some cases, the accrued expenses may not actually be paid for several years, as in the case of residuals paid to guilds or participations payable to third parties.

c. Payments to Affiliates. As with the calculation of gross receipts, film companies often deduct payments to affiliates for various actual or purported services, usually at a mark-up over actual cost. For example, payments are made to affiliates for services relating to artwork, marketing, manufacturing, publicity, etc., and in each case the price is artificially set by the film company, usually on the high side.

d. Trade Dues and Trade Shows. Film companies always deduct as a distribution expense a portion of their trade dues, such as dues paid to the Motion Picture Association of America, even though these trade dues do not relate directly to the distribution of any particular film. Similarly, film companies deduct all trade-show costs.

e. Taxes. Film companies always deduct withholding taxes as a distribution expense (or exclude withholding taxes from gross receipts, which reaches the same result). However, the withholding taxes are a dollar-for-dollar credit against the film company's U.S. tax liability, so the film company is effectively retaining the full benefit of the withholding taxes, without passing on any portion of the benefit to participants. Since withholding taxes are based on gross receipts, this methodology results in a windfall to film companies.

f. Deducting Gross Participations. The standard practice is to calculate net profits after deducting gross participations payable to third parties. Many participants attempt to avoid this result by providing that they will be entitled to "X% of 100% of net profits," but unless the definition of net profits specifically precludes the deduction of gross participations to third parties, the result will be the same. The net result is that gross participations make achieving net profits next to impossible.

g. Costs of Developing Ancillary Media. A substantial investment is often required to develop ancillary media, such as a separate interactive program based on a film. The full amount of such an investment is commonly deducted as a distribution expense, effectively putting the participants at risk with respect to exploitation of ancillary media. It is preferable if the income and expenses relating to ancillary media are not crossed against expenses and costs relating to the film itself.

In many ways, the deduction and recoupment of production costs brings with it the same issues and problems associated with distribution costs. Thus, as with distribution expenses, production costs typically include hefty payments to affiliates for various production services. Similarly, production costs rarely reflect discounts or rebates from third parties or savings to the film company from the sale of props or equipment used in the film. On top of all this, there is added the film company's "overhead fee" of approximately 15%. In addition, the cost of a film is usually artificially increased by twice the amount of any actual production costs over a certain level, usually 105% of the budget. While this approach may be fair as applied to the director and the producer, who may have control over the cost of the film, it is clearly unfair as applied to other participants who do not have control over costs.

Another difference between production costs and distribution expenses is that an additional interest charge is added to production costs, and this interest charge is always higher than the film company's actual cost of funds. Film companies treat participations as production costs instead of as distribution expenses because that treatment permits interest and the overhead fee to be charged on the participations.

The periodic accounting statements sent out to participants are notable only for their brevity and opaqueness. There is usually no detailed break-out of gross receipts and expenses, and it is next to impossible to reconcile the statements with the contractual provisions. On average, the statements may be reporting income actually received by the film company six months previously, but any payments to the participants do not include interest.

Participation and license contracts almost always state that the accounting statements may not be disputed after some relatively short period of time (such as twelve months), effectively creating an extremely short statute of limitations. Worse yet, a participant may not have the resources or desire to audit the film company during the early years of a film's release, because the film company clearly may not have recouped the aggregate of its distribution and production costs by that time. By the time the film does generate net profits, the film company will state that the prior years are closed to audit, so that all that can be audited is the current year's results.

In many cases, the only realistic remedy for curing suspected reporting errors is a thorough audit, but the standard contracts make this all but impossible. First, film companies typically have the right to approve the auditor - unheard of in any other industry. Second, auditors are spoon-fed limited books and records of the film company (and not of its affiliates). For example, auditors are almost never given access to the general ledger or underlying contracts that would show unreported income or rebates. In addition, auditors are generally not given the right to make copies of any documents, which hamstrings a thorough review.

And what happens when an underpayment is discovered, admitted, and paid? The contracts do not provide for any interest on the payment, and the contracts rarely provide for the payment of auditors' fees, even in the case of a gross underpayment.

A possible alternative to the current approach is to have participations tied directly to the worldwide box-office grosses as reported weekly in the trades (Variety or The Hollywood Reporter). Historically, the ratio of the worldwide box-office gross for any film compared to the worldwide revenue from all media for that film received by the studio is about 1:1.5. In other words, for every $1 million of worldwide box-office gross, a film can be expected to generate approximately a total of $1.5 million gross revenues worldwide from all media to the studio.

The other variables that are necessary to approximate net profits are (1) the final cost of the film, (2) distribution expenses, and (3) distribution fees. The final cost of the film is relatively easy to ascertain, and the parties could, in any event, simply agree up-front to an estimate of the final cost for purposes of net profits. The calculation of distribution expenses is where many disputes arise, but these disputes could be avoided by treating distribution expenses as a stated percentage of gross revenues (typically, distribution expenses run at approximately 40% of gross revenues received by the studio), with a floor of a stated dollar amount of distribution expenses equating to what the studio believes it will spend at a minimum. The final variable, distribution fees, can be simplified by roughly averaging the current multitude of different fees for different media into one uniform percentage applied to all gross revenues received by the studio. Historically, such an average would be approximately 35%.

By thus converting the variables into easily quantifiable values, the calculation of net profits becomes simple. Let's run through an example using the following assumptions:

Share of net profits:                                   5%
Deemed cost of film:                                 $30 million
Distribution fee:                                        35% of gross revenues
Deemed distribution expense floor:             $15 million
Deemed distribution expense percentage:   40% of gross revenues
Worldwide box-office gross:                        $200 million

Based on these assumptions, the studio would be deemed to receive gross revenues worldwide from all media of $300 million (equal to 150% the worldwide box office). The calculation of net profits would thus be as follows:

$300 million deemed gross revenues
    30 million cost of film
   105 million distribution fee (35% of $300 million)
   120 million distribution expenses (40% of $300 million)
____
  $ 45 million net profits.

The payee would thus be entitled to a net profits payment of $2,250,000 (5% of $45 million).

For this approach to be embraced, the studios will have to appreciate the following advantages that will accrue to them:

· First and foremost, significantly lower costs for making films. If payees know that the calculation and payment of net profits will be meaningful, they will be willing to accept significantly lower up-front payments as compensation.

· Shifting of risk. If a film performs poorly, the studio will have less invested in it, and if the film performs well, the studio will be able to afford the payments of net profits.

· Reduction of legal fees attributable to drafting and negotiating long, arcane net profits definitions.

· No audits!

· Far less, if any, litigation relating to net profits.

· Perhaps a lower percentage of net profits to the payees as a trade-off for the certainty of calculation and payment.

Similarly, payees will have to appreciate the following advantages that will accrue to them:

· Short and understandable net profits definitions.

· The amount owed is easy to monitor by simply reading the trades.

· Faster payments, because they depend only on domestic box-office gross.

· Reduction of legal fees attributable to drafting and negotiating long, arcane net-profits definitions

· No audits!

Yes, there is a trade-off. The proposal is designed to render an approximation, not an exactitude. Particular films may vary from the statistical average, either on the ratio of worldwide gross revenue to the U.S. box office or on the ratio of distribution expenses to gross revenues. Thus, the formula may be imbalanced toward either party on such films. What can be said with some assurance, however, is that the proposal will always be better than the current lunacy.

The amusing aspect of the participations process is that film companies, by gradually making the concept of contingent compensation almost meaningless, have shot themselves in the foot. What used to be a valid and necessary means for spreading risk in a risky industry is now discounted as a joke. The result is that talent demands money up-front or a gross participation, resulting in top star salaries reaching the astronomical figure of $20 million per film.

Film companies would be far better served if they return to a realistic and fair approach to contingent compensation, which would result in a drastic reduction in fixed film costs and the spreading of risk. Participations would be paid on successful films, where it can be afforded, and unsuccessful films would not be the devastating blow that they are today.

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