Advice on Creative Accounting by Mark Litwak on March 25, 2015 in Legal

Mark Litwak will be conducting an all-day seminar in New York City on April 24th, 2015 called Self Defense for Writers and Filmmakers with Volunteer Lawyers for the Arts. For more information, click here.

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 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.

About Mark Litwak: Mark Litwak is a veteran entertainment attorney and producer’s rep based in Beverly Hills, California. He is an adjunct professor at USC Gould School of Law, and the creator of the Entertainment Law Resources website with lots of free information for filmmakers (www.marklitwak.com). He is the author of six books including: Dealmaking in the Film and Television Industry, Contracts for the Film and Television Industry, and Risky Business: Financing and Distributing Independent Film. He can be reached at law2@marklitwak.com