Wednesday, October 06, 2010


Filmmakers and profit participants often lament about distributors engaging in creative bookkeeping. This is one area where filmmakers concede that studios are sufficiently imaginative in their thinking. A frequent complaint is that the studios continually devise new and ingenious ways to interpret a contract so that all the money stays in their pockets. The general consensus among filmmakers is that net profits are illusory. Rarely does a share of net profits generate hard cash.

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 subtler, and not readily apparent to the uninitiated.

The major studios determine profits for participants using their own special accounting rules as set forth in their net profit defi¬nitions. 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 account¬ing. 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 NBC, 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 as soon as they are incurred, even if they have not paid them. 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 the producer to make the film.

The Art Buchwald case illuminates some of the devices Paramount used to deny payment to net profit participants. The trial judge found many of these practices to be unconscionable and therefore refused to enforce them. Paramount appealed, and the case was settled before the Court of Appeals could rule on the issue.

If Buchwald had won the appeal, the precedent would 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 be contested.

In my opinion, Buchwald may well have lost the appeal had the case been decided. The trial court 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? How can you 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.

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.

Excerpt taken from Mark Litwak’s Risky Business, 3nd edition, 2010.