Protecting Record Producer's Interest In Music-Royalty Audit Scenarios

An unfortunate fact in the recording industry is that successful records result in audits by royalty participants. This is partly due to the entrenched distrust that artists have for record companies and partly to simple prudent business practices. If an artist sells hundreds of thousands or millions of units around the world, it would be the rare company that could move that many pieces of product without making a mistake. Sometimes the mistakes are just mistakes, and sometimes an audit holds up a mirror that reveals what happens under the record company hood – warts and all. And the “all” category can be very interesting.

An audit is usually conducted by an accountant to verify the books and records of the record company that back up accounting statements. From the record company's point of view, audits are a necessary evil. At major labels, the administrative cost associated with an audit is usually much more burdensome than dealing with any subsequent payments generated by the audit itself. In fact, fiscally sound record companies will reserve funds on the contingent-liability side of their financials to deal with audits that they know are in progress or are likely to occur. This reserve includes an unsegregated amount to cover artist, producer, mixer and remixer royalty payments.

To simplify their audit responsibilities, among other reasons, some years ago record companies largely stopped engaging producers directly, and began requiring artists to engage producers and bear the burden of accounting and paying producer royalties as a matter of contract. This put the producer in the awkward position of having to audit – perhaps even sue – the artist with whom the producer has a creative relationship.

The Letter of Direction

Producers typically do not want to have to go after artists to be paid royalties and certainly not to audit, much less sue. The producer's response was to require the artist to direct the artist's record company to pay the producer at the source. So, producers continue to be paid by record companies under a letter of direction from the artist that instructs the record company to pay the producer a share of the artist's royalties specified in the services agreement the producer has with the artist.

All of this would make it appear to the producer that he or she is paid directly by the record company and would logically have an audit right against the record company. However, this isn't usually the way it works. Producers must audit the artist unless the producer specifically negotiates an audit right against the record company. Record companies will strongly resist agreeing to permit producers to audit them directly for a number of reasons. The most legitimate reason is that the record company could be put in a position of having a producer audit the artist's income stream when the artist has not, or has not yet, chosen to audit the record company for the same units – a situation that could get very untidy.

So producers don't usually audit record companies and have good reason not to audit an artist. What a producer often does is to wait until the artist audits the label and then expects to participate in a share of the artist's audit recovery.

But many producer agreements do not require the artist to notify the producer that the artist is conducting an audit. Because many artist audits are actually precursors to renegotiation of the artist's recording agreement, the artist and record company may fold the audit settlement into the renegotiation, and never formally settle the audit. If the artist does not have a contractual obligation to notify the producer of the audit, the producer may miss out on a prorata share of what the audit settlement would have been paid had the audit been conducted and concluded separately from the renegotiation of the artist's contract.

Audits based on particular royalty statements must be conducted within a contractual-limitations period of time that is fixed in the artist's agreement with the record company (and as between the producer and the artist, in the producer's services agreement). This is usually anywhere from 12 to 36 months after the date that an audit statement was (or should have been) rendered by the record company to the artist. If the artist does not audit the record company during that time period, the artist waives his or her right to audit that royalty statement again.

Another provision of artist agreements limits the period in which an artist may sue the record company for non-payment, or inaccurate payment, of royalties. That period should extend at least a few months, if not a year, beyond the end of the audit period, but sometimes is the same period of time as the audit period.

The same is true of the producer's right to audit the artist, although the producer audit periods are often slightly shorter than the periods that apply to the artist against the record company. An artist who has not audited a record company at the time that the producer notifies the artist of an audit will want to have enough time to give notice of his or her own audit of the record company. This is because the money to pay the producer on the producer's audit will frequently come from the artist's recovery against the record company – otherwise the artist must pay the producer's recovery out of pocket, which is not a favored result. (See The Stages of Auditing a Record Company below.)

If the artist is conducting a renegotiation, the renegotiation process will probably get started after audit field work has commenced, or possibly following the submission of the audit report if the audit is to be part of the leverage the artist wishes to exert against the record company in the renegotiation. As a result, it is worth producers negotiating a provision in their services agreements to deal with the situation in which the artist commences, but does not conclude, an audit – or waives the right to audit as part of a renegotiation or otherwise. This is particularly true in that if the producer does not audit the artist but rides the coattails of an artist's audit of a record company, the costs of the audit are taken off the top, so the producer is in effect paying for the audit, too. If a producer is paying a share of the audit costs, there is no reason why a producer should not get the necessary information and notices needed to properly protect the producer's interests.

Given the problems that may arise, the following audit issues are worth covering when negotiating an agreement for a producer to work with an artist:

Notification of an Audit. At a minimum, the artist should notify the producer as soon as an audit is initiated. Artists are required to notify the record company of their intention to audit, and then schedule a time for the artist's auditor to do field work. The easiest way for producers to be notified of an audit is to require the artist to copy the producer on the audit notice that the artist sends to the label.

Conducting the Audit. Any auditor engaged by the artist should provide to the producer copies of all non-privileged information regarding the audit, possibly including copies of the auditor's field work and definitely including the audit report that is sent to the record company in support of the artist's claims at the conclusion of the audit. The audit report is the operative document that dictates the parameters of any settlement of an audit

Audit Recovery. If the audit does not evolve into a renegotiation, then the applicable portion of any recovery by the artist should be allocated to the recoupment of any unrecouped recording costs of the records concerned, and to the payment of any payable producer royalties. This allocation may cause a previously unrecouped record to become recouped, triggering a retroactive payment under the producer agreement. If the producer's account is already in a recouped position, the producer should be paid through a prorata share of the audit recovery when the artist receives that payment without having to wait for the regular semiannual statements. If the artist's account is still unrecouped after the audit payment, but the producer's account is recouped, the artist should cause the record company to pay through the producer's share of the recovery.

Renegotiation After the Delivery of the Audit Report. If an artist commences a renegotiation with the record company after the delivery of an audit report, there is a fixed reference point as to what the artist's determination was of the money that was at stake in the audit. If there is no formal settlement of the audit due to a renegotiation, a producer can use the audit report as a reference point to determine how much they should be paid. The producer should get a prorata share of the calculations made by the artist's auditor as part of the report.

Artists may resist this approach, as the auditor is the artist's advocate in this situation and will likely take an aggressive interpretation of potential audit claims and the value of those claims. Audit reports tend to be dragnets of every conceivable contract interpretation (including questioning the validity of the 25% packaging deduction on compact discs, for example, even though clearly stated in the artist agreement). In any event, the audit report is probably the best method of deciding how much the producer's recovery should be.

Renegotiation Before the Delivery of Report. Here, the artist and producer only have the artist's auditor's field work to rely on to reach a number that results in a fair settlement because the audit was not concluded. Even so, the field work should point to the potential value of claims made and the producer should not be required to engage an auditor to cover the same ground, although the producer may elect to do so and conduct a new audit of the artist. If the producer chooses to rely on the artist's auditor's field work, the artist and producer should negotiate in good faith in order to reach a fair conclusion based on those findings.

Artist's Waiver of Audit Rights. Because the artist is often in the position of being able – and required – to waive audit rights in settlement of an audit, the artist acts largely as a quasi (or perhaps actual) fiduciary of the producer. As a practical matter, if a producer audits an artist and the artist is not in turn able to audit the record company for the same period, the artist may cry poverty when the producer seeks to audit the artist, causing the producer to possibly back off. Therefore, the producer effectively relies on the artist to protect the producer's audit rights and recovery. Given this practical reality, artists should not be able to waive their audit rights without at least notifying their producers.

Producer's Waiver of Audit Rights. However these audit issues are addressed in the producer agreement, the producer should not be required to waive the producer's audit rights against the artist until the producer has affirmatively accepted an alternate approach to auditing the artist.

Producer-Writers. The foregoing can also apply to an audit for the payment of mechanical royalties if the artist obtains a mechanical license from the producer under controlled composition provisions in the producer's services agreement. If a producer is also a writer or a publisher of songs at issue in an audit, the producer-writer should seek protection against losing a recovery due to a renegotiation by the artist on applicable recordings if that renegotiation also deals with mechanical royalties. This factual setting is often less acute because a record company typically obtains mechanical licenses directly from the producer-writer or designee so that payment of mechanical royalties to the producer should be separate from any renegotiation of the artist agreement. But the issue is worth noting. Also, if a producer-writer has issued mechanical licenses directly to the record company for songs recorded in masters subject to the producer agreement, the producer may audit the same units that would be at issue for record royalties by auditing under the mechanical licenses. The results of the mechanical royalty audit can then be extrapolated to determine if the producer is entitled to additional record royalties under the producer agreement.

These points may not be “gimmes” when negotiating a producer agreement, but certainly go a long way toward protecting a producer's rights in a manner consistent with the goals of the majority of producer contracts.

The Stages of Auditing a Record Company

• Desktop Audit: The auditor reviews the accounting statements received by the artist or the producer to determine whether there are any obvious inconsistencies that justify an audit.
• Notification of Audit: The artist sends a notice to the record company specifying the reasons why the artist wishes to audit the record company. The producer would send the same notice to the artist in a producer audit.
• Field Work: Field work is the basis on which the auditor prepares the audit report. The auditor arranges a time to visit the record company, and reviews the company's books and records to verify the underlying invoices, etc., that the record company used to prepare its royalty statements.
• Audit Report: The auditor converts the field work into a report that states the audit claims made and the reasons for those claims.
• Negotiation and Settlement: The record company and the artist's representatives negotiate a settlement of the claims made in the audit report. If no settlement is possible, the artist may seek other remedies.

An unfortunate fact in the recording industry is that successful records result in audits by royalty participants. This is partly due to the entrenched distrust that artists have for record companies and partly to simple prudent business practices. If an artist sells hundreds of thousands or millions of units around the world, it would be the rare company that could move that many pieces of product without making a mistake. Sometimes the mistakes are just mistakes, and sometimes an audit holds up a mirror that reveals what happens under the record company hood – warts and all. And the “all” category can be very interesting.

An audit is usually conducted by an accountant to verify the books and records of the record company that back up accounting statements. From the record company's point of view, audits are a necessary evil. At major labels, the administrative cost associated with an audit is usually much more burdensome than dealing with any subsequent payments generated by the audit itself. In fact, fiscally sound record companies will reserve funds on the contingent-liability side of their financials to deal with audits that they know are in progress or are likely to occur. This reserve includes an unsegregated amount to cover artist, producer, mixer and remixer royalty payments.

To simplify their audit responsibilities, among other reasons, some years ago record companies largely stopped engaging producers directly, and began requiring artists to engage producers and bear the burden of accounting and paying producer royalties as a matter of contract. This put the producer in the awkward position of having to audit – perhaps even sue – the artist with whom the producer has a creative relationship.

The Letter of Direction

Producers typically do not want to have to go after artists to be paid royalties and certainly not to audit, much less sue. The producer's response was to require the artist to direct the artist's record company to pay the producer at the source. So, producers continue to be paid by record companies under a letter of direction from the artist that instructs the record company to pay the producer a share of the artist's royalties specified in the services agreement the producer has with the artist.

All of this would make it appear to the producer that he or she is paid directly by the record company and would logically have an audit right against the record company. However, this isn't usually the way it works. Producers must audit the artist unless the producer specifically negotiates an audit right against the record company. Record companies will strongly resist agreeing to permit producers to audit them directly for a number of reasons. The most legitimate reason is that the record company could be put in a position of having a producer audit the artist's income stream when the artist has not, or has not yet, chosen to audit the record company for the same units – a situation that could get very untidy.

So producers don't usually audit record companies and have good reason not to audit an artist. What a producer often does is to wait until the artist audits the label and then expects to participate in a share of the artist's audit recovery.

But many producer agreements do not require the artist to notify the producer that the artist is conducting an audit. Because many artist audits are actually precursors to renegotiation of the artist's recording agreement, the artist and record company may fold the audit settlement into the renegotiation, and never formally settle the audit. If the artist does not have a contractual obligation to notify the producer of the audit, the producer may miss out on a prorata share of what the audit settlement would have been paid had the audit been conducted and concluded separately from the renegotiation of the artist's contract.

Audits based on particular royalty statements must be conducted within a contractual-limitations period of time that is fixed in the artist's agreement with the record company (and as between the producer and the artist, in the producer's services agreement). This is usually anywhere from 12 to 36 months after the date that an audit statement was (or should have been) rendered by the record company to the artist. If the artist does not audit the record company during that time period, the artist waives his or her right to audit that royalty statement again.

Another provision of artist agreements limits the period in which an artist may sue the record company for non-payment, or inaccurate payment, of royalties. That period should extend at least a few months, if not a year, beyond the end of the audit period, but sometimes is the same period of time as the audit period.

The same is true of the producer's right to audit the artist, although the producer audit periods are often slightly shorter than the periods that apply to the artist against the record company. An artist who has not audited a record company at the time that the producer notifies the artist of an audit will want to have enough time to give notice of his or her own audit of the record company. This is because the money to pay the producer on the producer's audit will frequently come from the artist's recovery against the record company – otherwise the artist must pay the producer's recovery out of pocket, which is not a favored result. (See The Stages of Auditing a Record Company below.)

If the artist is conducting a renegotiation, the renegotiation process will probably get started after audit field work has commenced, or possibly following the submission of the audit report if the audit is to be part of the leverage the artist wishes to exert against the record company in the renegotiation. As a result, it is worth producers negotiating a provision in their services agreements to deal with the situation in which the artist commences, but does not conclude, an audit – or waives the right to audit as part of a renegotiation or otherwise. This is particularly true in that if the producer does not audit the artist but rides the coattails of an artist's audit of a record company, the costs of the audit are taken off the top, so the producer is in effect paying for the audit, too. If a producer is paying a share of the audit costs, there is no reason why a producer should not get the necessary information and notices needed to properly protect the producer's interests.

Given the problems that may arise, the following audit issues are worth covering when negotiating an agreement for a producer to work with an artist:

Notification of an Audit. At a minimum, the artist should notify the producer as soon as an audit is initiated. Artists are required to notify the record company of their intention to audit, and then schedule a time for the artist's auditor to do field work. The easiest way for producers to be notified of an audit is to require the artist to copy the producer on the audit notice that the artist sends to the label.

Conducting the Audit. Any auditor engaged by the artist should provide to the producer copies of all non-privileged information regarding the audit, possibly including copies of the auditor's field work and definitely including the audit report that is sent to the record company in support of the artist's claims at the conclusion of the audit. The audit report is the operative document that dictates the parameters of any settlement of an audit

Audit Recovery. If the audit does not evolve into a renegotiation, then the applicable portion of any recovery by the artist should be allocated to the recoupment of any unrecouped recording costs of the records concerned, and to the payment of any payable producer royalties. This allocation may cause a previously unrecouped record to become recouped, triggering a retroactive payment under the producer agreement. If the producer's account is already in a recouped position, the producer should be paid through a prorata share of the audit recovery when the artist receives that payment without having to wait for the regular semiannual statements. If the artist's account is still unrecouped after the audit payment, but the producer's account is recouped, the artist should cause the record company to pay through the producer's share of the recovery.

Renegotiation After the Delivery of the Audit Report. If an artist commences a renegotiation with the record company after the delivery of an audit report, there is a fixed reference point as to what the artist's determination was of the money that was at stake in the audit. If there is no formal settlement of the audit due to a renegotiation, a producer can use the audit report as a reference point to determine how much they should be paid. The producer should get a prorata share of the calculations made by the artist's auditor as part of the report.

Artists may resist this approach, as the auditor is the artist's advocate in this situation and will likely take an aggressive interpretation of potential audit claims and the value of those claims. Audit reports tend to be dragnets of every conceivable contract interpretation (including questioning the validity of the 25% packaging deduction on compact discs, for example, even though clearly stated in the artist agreement). In any event, the audit report is probably the best method of deciding how much the producer's recovery should be.

Renegotiation Before the Delivery of Report. Here, the artist and producer only have the artist's auditor's field work to rely on to reach a number that results in a fair settlement because the audit was not concluded. Even so, the field work should point to the potential value of claims made and the producer should not be required to engage an auditor to cover the same ground, although the producer may elect to do so and conduct a new audit of the artist. If the producer chooses to rely on the artist's auditor's field work, the artist and producer should negotiate in good faith in order to reach a fair conclusion based on those findings.

Artist's Waiver of Audit Rights. Because the artist is often in the position of being able – and required – to waive audit rights in settlement of an audit, the artist acts largely as a quasi (or perhaps actual) fiduciary of the producer. As a practical matter, if a producer audits an artist and the artist is not in turn able to audit the record company for the same period, the artist may cry poverty when the producer seeks to audit the artist, causing the producer to possibly back off. Therefore, the producer effectively relies on the artist to protect the producer's audit rights and recovery. Given this practical reality, artists should not be able to waive their audit rights without at least notifying their producers.

Producer's Waiver of Audit Rights. However these audit issues are addressed in the producer agreement, the producer should not be required to waive the producer's audit rights against the artist until the producer has affirmatively accepted an alternate approach to auditing the artist.

Producer-Writers. The foregoing can also apply to an audit for the payment of mechanical royalties if the artist obtains a mechanical license from the producer under controlled composition provisions in the producer's services agreement. If a producer is also a writer or a publisher of songs at issue in an audit, the producer-writer should seek protection against losing a recovery due to a renegotiation by the artist on applicable recordings if that renegotiation also deals with mechanical royalties. This factual setting is often less acute because a record company typically obtains mechanical licenses directly from the producer-writer or designee so that payment of mechanical royalties to the producer should be separate from any renegotiation of the artist agreement. But the issue is worth noting. Also, if a producer-writer has issued mechanical licenses directly to the record company for songs recorded in masters subject to the producer agreement, the producer may audit the same units that would be at issue for record royalties by auditing under the mechanical licenses. The results of the mechanical royalty audit can then be extrapolated to determine if the producer is entitled to additional record royalties under the producer agreement.

These points may not be “gimmes” when negotiating a producer agreement, but certainly go a long way toward protecting a producer's rights in a manner consistent with the goals of the majority of producer contracts.

The Stages of Auditing a Record Company

• Desktop Audit: The auditor reviews the accounting statements received by the artist or the producer to determine whether there are any obvious inconsistencies that justify an audit.
• Notification of Audit: The artist sends a notice to the record company specifying the reasons why the artist wishes to audit the record company. The producer would send the same notice to the artist in a producer audit.
• Field Work: Field work is the basis on which the auditor prepares the audit report. The auditor arranges a time to visit the record company, and reviews the company's books and records to verify the underlying invoices, etc., that the record company used to prepare its royalty statements.
• Audit Report: The auditor converts the field work into a report that states the audit claims made and the reasons for those claims.
• Negotiation and Settlement: The record company and the artist's representatives negotiate a settlement of the claims made in the audit report. If no settlement is possible, the artist may seek other remedies.