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Is Self Auditing Hazardous to Your Health?

June 1, 2014

One of the surprising takeaways from the posted comments in the Copyright Office’s Music Licensing Study is the philosophical role reversal that seems to be in place.

The supposedly liberal music industry is almost uniformly demanding a return to the free market for songwriters.  The cyber libertarian Silicon Valley crowd is banging the table hard for more government regulation of artists and especially songwriters.  Remember that songwriters are subject to government regulation and price setting for two of the three major revenue streams–and have been for 70 years on performance royalties and on mechanical royalties for 105 years.

So far, anyway, the government doesn’t regulate what songwriters can charge for synchronization licenses.  Sync licenses are the fees that songwriter charge to use their song in motion pictures, television programs and, at least in theory, for online videos.

But the other two streams are largely regulated by the government–performance royalties through ASCAP and BMI are subject to the antitrust consent decrees that regulate how their respective songwriter members can license their songs and the rates at which they license them.  These private contracts cover webcasters like Pandora and radio like Sirius, AM/FM and television.   Mechanical royalties for certain types of Internet services like Spotify, Google Play and Amazon as well as traditional record companies are subject to a compulsory license and the rates set by an absurdly complex rate setting process that only the biggest players can afford to engage in.

You can agree or not that companies like Google that have received virtually no antitrust regulation should be left unregulated (despite Google’s bully tactics against indie labels and music publishers), but that the American people simply must be protected from those rampaging songwriters by government control of practically every move they make.

Even if you think that a proper role for the government is to set price controls for songwriters, what’s hard to understand is why songwriters are prohibited from auditing the royalty statements they received for the rates the government decide is correct under the license that the government forces them to participate in.

In late 1999, I was negotiating a deal with AOL.  This was a deal where AOL would be paying my client some money based on sales.  I noticed there was no audit clause in AOL’s form and I added standard royalty audit language.  When the next draft came back, the audit language wasn’t there.  I had a call with the customary 12 Acolytes of Steve from AOL on the phone (no one at AOL can negotiate anything by themselves) and I asked about my audit language.  I was told that AOL did not permit audits because they thought it was not a good use of AOL’s resources to permit themselves to be audited.

I asked the 12 blind mice on the call to think about those words for a minute.  “Do you think that makes you sound like good guys?, ” I asked.  “Or does it make you sound like douchebags?”  Judging by the silence, I don’t think they’d been asked that question before.  Or at least not quite that way.

Then I said, “Well, whatever you do, don’t buy a record company.  It’s not going to be a good look for you.”

And the rest, as they say, is history.

Financial Audits vs. Royalty Examinations

The term “audit” has a special meaning in the music business.  It is not the same as a financial audit, such as the audited books and records that public companies must maintain under GAAP, etc.  A royalty audit, royalty examination or compliance examination are used interchangeably and mean that someone, usually an expert royalty auditor (not necessarily a CPA), drills down on whether the entity paying royalties under a statute or contract has complied with their royalty payment obligations.

This royalty auditor does not work for the entity paying the royalties (the “licensee”).  That would seem odd, wouldn’t it?  If someone is supposed to pay you money based on a complex calculation, does it seem logical to you that the person doing the checking is the person who owes you money?  Not you?  If the IRS audited you but told you that their accountant would defend you and not your own?  Would that seem right?  Of course not.  The royalty auditor typically works for the person receiving the payment (the “licensor”).

The way this works in contracts with an audit right (like artist deals with record companies) is that the royalty auditor conducts their compliance examination and presents the results to the licensee.  There’s then a negotiation between the licensor and licensee and 9-1/2 times out of 10 the parties settle.  If they can’t settle, then the licensor gets to sue the licensee.  Does every artist audit?  No.  They have to pay for an audit and when you have to pay for an audit you are unlikely to do so unless there’s enough to cover the cost of the audit with some additional recovery.  This is exceptionally true of auditors who take the audit on a contingent fee basis–they’re not going to take the claim and lose money.

This process is what happens with artist royalties all the live long day.  It is absolutely unthinkable that an artist would be denied the right to audit in a record deal.  Yes, that’s right–the evil record companies routinely allow audits for artist royalties.

Audit rights also exist in the three other compulsory licenses in the Copyright Act, most analogously for the compulsory license for sound recordings.  Details are handled in the regulations.

And yet, the government’s compulsory license for mechanical royalties denies songwriters the same right.  Why is this important?

Because without an audit right, the songwriter never gets to check to see if the millions of lines of royalty payments in streaming services were paid correctly.  The government causes the songwriter to blindly accept payments from strangers to whom the government forces the songwriter to license.

The “Self Audit”

What takes the place of an audit right for the compulsory license is what the online companies call a “self audit.”  This is the provision in the regulations for the compulsory license that require monthly statements of account to be “certified” by an officer of the licensee like a CFO or vice president (“certified” meaning cross my heart).  The annual statement of account is also required to be certified by the licensee‘s certified public accountant.

Hence the Digital Media Association has coined the term “self audit”–a curious term to describe the process by which the licensee promises songwriters that their monthly statements are correct and then a CPA working for the licensee certifies to the songwriters that their annual statements are also correct.  Here’s the certification that the CPA must sign:

Each Annual Statement of Account shall also be certified by a licensed Certified Public Accountant. Such certification shall consist of the following statement:

We have examined the attached “Annual Statement of Account Under Compulsory License For Making and Distributing Phonorecords” for the fiscal year ended (date) of (name of the compulsory licensee) applicable to phonorecords embodying (title or titles of nondramatic musical works embodied in phonorecords made under the compulsory license) made under the provisions of section 115 of title 17 of the United States Code, as amended by Pub. L. 94-553, and applicable regulations of the United States Copyright Office. Our examination was made in accordance with generally accepted auditing standards and accordingly, included tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.

In our opinion the Annual Statement of Account referred to above presents fairly the number of phonorecords embodying each of the above-identified nondramatic musical works made under compulsory license and voluntarily distributed by (name of the compulsory licensee) during the fiscal year ending (date), and the amount of royalties applicable thereto under such compulsory license, on a consistent basis and in accordance with the above cited law and applicable regulations published thereunder.

(City and State of Execution)

(Signature of Certified Public Accountant or CPA Firm)

Certificate Number

Jurisdiction of Certificate

(Date of Opinion)

Note that this certification is in the form of an opinion from the CPA to the licensor.

What the opinion says is that the CPA has conducted an examination of the individual songwriter’s accounting statements, that the CPA conducted “tests of the accounting records” relating to that statement and that all other procedures were conducted to determine that the individual songwriter’s statement was presented “fairly.”

I would be speculating, but I would imagine that one reason that the Copyright Office adopted these regulations is that they thought that if they put a CPA on the hook for an opinion letter with this certification, a CPA would have to be an idiot to sign off if the record showed that no such examination was ever made or that it was made without much rigor.  And who might have a right to discover exactly what the CPA did?

Well probably the songwriter who is being asked to rely on the CPA’s opinion, right?  It seems that every songwriter receiving this opinion would have a right to ask the CPA–the songwriter’s ostensible fiduciary–exactly what the CPA did to comply with the regulations.

Because otherwise the “self audit” is conducted in the dark under the covers and no one really knows exactly what the CPA was looking at except the people with a financial incentive to benefit themselves by making sure that the CPA’s level of knowledge was very small.

The Influence of Self-Audits

The lack of an audit right has now found its way into YouTube’s standard indie publisher license and Amazon’s license for its services.  These people are working hard to make getting away with it part of their standard deal.

For companies like Google that have a significant advertising business, this will be no surprise.  Google does not allow their ad publishers to audit them, so the ad publishers really have no idea what “gross” is that they get a piece of.  And as we start moving into situations where statutory royalties are based on advertising revenue, it is well to keep that in mind.  This prohibition on auditing probably applies to Pandora as well (and Pandora has an exclusive ad publisher agreement with Google’s Doubleclick subsidiary according to Pandora’s public filings).  So this comes in handy for a digital service that pays a share of advertising revenue to songwriters–the service can argue that the service does not have the right to audit upstream to, say, Doubleclick, so songwriters (or artists for that matter) cannot question the gross advertising revenues.  And of course most definitions of advertising revenue won’t pick up payments outside of the ad publisher contract (or even non-recoupable sums paid under the ad publisher contract).

Even if a company certifies that they are accounting correctly–and let’s say that they are in fact doing so–they cannot certify that the upstream ad network is accounting to them correctly because they have no way to find out.  (Except YouTube, of course.  They could find out, they will likely just refuse to do so.  Kind of like AOL.)

The Danger of Self Audits

I would suggest to you that self auditing is not a healthy enterprise.  Nobody I’ve talked to about this issue believes for one minute that the CPAs involved have actually reviewed the millions of lines of royalty payments in a streaming service statement.  This includes people who work for streaming services–who spoke off the record.

In Aimee Mann’s litigation against Medianet, a declaration was produced that showed that 23% of songs available through Medianet were unlicensed. Before you blow that number off, realize that Medianet has approximately 20 million songs.  So 23% is 4.6 million songs.

Presumably, what may happen in such cases is that the service allocates a pool of royalties against all songs that they can match and never pays those they cannot match.  This would result in overpayments to some songwriters and zero payment to others.  In the same declaration, Medianet hired an expert to help them match, but still was only able to match 55% of their offering.  (Declaration of Stephen E. Grauberger, Esq. currently available at http://www.scribd.com/doc/155513456/grauberger-declaration)

Is this what is actually happening?  No one is likely to know if a licensee uses compulsory licenses because compulsory licenses do not permit a songwriter audit.

The Digital Media Association’s Copyright Office filing is representative of the self-interested enthusiasm that the retailers have for self-audits:

The Section 115 statutory license provides necessary procedures for self-auditing and certification. The self-auditing requirements provide rights owners with appropriate financial assurances regarding accountings.   At the same time, these requirements provide digital music services with appropriate protections against the possibility of direct audits by potentially tens of thousands of individual rights owners, which would be virtually impossible to administer and settle, and would significantly interfere with the day-to-day operations of digital music services.

Pretty much what AOL told me in 1999.

So here’s the problem.  Even if songwriters have the ability to audit an entity that issues blanket mechanical licenses (assuming such a blanket license becomes available), songwriters will still be up against a barrier if they are not granted a statutory right to audit under a statutory license.  The straw man raised by DiMA that there will be audits as far as the eye can see is not supported by evidence in situations where audits are permitted.  That’s not a reason to refuse songwriters the ability to audit, particularly if songwriters can either assign their audit rights to their publisher/administrator or form collectives for the purpose of auditing.

This is going to become particularly important if the many parties supporting repeal of the compulsory license altogether are successful.  If the 115 license goes away (prospectively), songwriters should still be allowed to audit retroactively (for the typical 3 year period).

The more that songwriters conduct audits, the better the system will get in the give and take of audit negotiations.  From my own experience, knowing that an audit will be coming makes for much more accurate royalty systems and internal controls.  It’s a fine day when a record company can say prove to their artist that they moved millions of units and did it with 95% accuracy.  (No one ever does this perfectly, by the way.)

But too much reliance on self-audits tends to create suspicion (like now) and distrust.  It creates arrogance like my experience with AOL. Plus it just sounds like a self-serving circle of the self-interested having a self-congratulatory money high.

It is just not healthy.

Yes, that’s right.  Too much self-auditing can make you go blind.

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