Film Industry Faces Complex Issues in Move to Gain Digital Revenues

Like other sectors of the entertainment industry, the film industry is looking to the digital age for new revenue streams. Even with digital-piracy concerns, film studios are positioning themselves to capitalize on Internet sales of their products. This summer, for example, motion pictures from several major studios and key independent providers became available on CinemaNow for downloading and copying by consumers for DVD-machine play. In the following interview ' conducted by Entertainment Law & Finance Editor-in-Chief, Stan Soocher ' George A. Cooke, a law partner in the New York office of Manatt, Phelps & Phillips, discusses distribution of motion pictures in the digital age. Cooke's practice consists largely of content and distribution concerns in film, new media and television. He came to Manatt, Phelps in July from the New York office of O'Melveny & Myers. Before that, he worked at Home Box Office for 20 years, including as senior vice president and chief counsel.

EL&F: How is the move to distributing motion pictures through digital downloading affecting licensing negotiations?

Cooke: We're certainly in the midst of a paradigm shift in terms of the ways in which motion pictures are distributed. The effects of this shift on film-licensing negotiations begin with issues in the major studios themselves, namely determining where in their organizational structure rights like electronic sell-through (ie, the sale of a permanent copy through such means as Internet downloading, as opposed to the limited time use of video on-demand) fit in. At this point, electronic sell-through is being claimed alternatively by both those responsible for traditional hard-copy home-video distribution and those handling pay-per-view and video on-demand distribution. As a result, it's often difficult for a licensee to conclude an agreement with either camp without bringing the other to the table as well.

Turning to the effect of digital downloading on negotiations themselves, it is helpful to note preliminarily that there have been three traditional models for monetizing the distribution of motion pictures: 1) the pay-per-transaction model prevalent for theatrical, home-video, pay-per-view and on-demand distribution; 2) the advertising model used for broadcast television; and 3) the subscription model used in basic and pay cable. Sorting out where electronic sell-through fits among these models involves reference to the sequential distribution windows that have historically been used for exploiting motion pictures. (See the sidebar below for a timeline of the distribution windows for motion pictures.)

Since electronic sell-through is still in its early stages of development, the studios are naturally anxious to preserve maximum flexibility in their negotiations with 'downstream' licensees in the sequence of distribution as to the manner in which the studios price electronic sell-through under one, or some blend of, these three pricing models of fee-per-transaction, ad-supported and subscription. The downstream licensees, on the other hand, are naturally concerned that the pricing model for an early electronic sell-through product not destroy the value of their downstream rights for the same motion picture. Pay-television services, for example, pay a significant premium for the right to be the first subscription-based provider of motion pictures as distributed by electronic means. In light of this, allowing an earlier subscription offering of electronic sell-through could seriously undercut their business. That said, to date the economic structures for electronic sell-through that I have seen are primarily based on pay-per-transaction models in which the studios set the wholesale price to subdistributors at a per-unit fee. This is being done with the studios tying the wholesale price for electronic sell-through distribution to a price point at, or about, the wholesale price of a hard copy.

Another set of issues affecting these negotiations derives from the question of whether ' and how ' the so-called 'first-sale doctrine' of copyright law applies to the digital copies. This doctrine provides that the re-transfer of a purchased copy of copyrighted material is legal without going back to obtain permission from the copyright owner. Because of this doctrine, rights holders like the studios seek to establish a high level of protection on the earlier windows of product distribution through contractual restrictions and requirements for licensee digital-rights-management (DRM) technology. A rights holder will naturally seek to coordinate the price point for its product against the stage of its distribution sequence. To that end, it's natural to seek a DRM regime where re-distributable copies are priced high (as in traditional DVDs) and lower-priced copies as delivered by video on-demand or pay-per-view are neither [commercially] re-distributable nor [intended to be] accessible for viewing beyond limited time periods of either a day, a weekend or a week. To do this requires complex and interrelated technologies that are costly to licensees and may limit the appeal of their own distribution window. You can spend a lot of time balancing these concerns in a negotiation.

EL&F: How are territories being negotiated in Internet distribution deals for motion pictures, in light of the international scope of the Internet?

Cooke: Most of the licenses I've seen recently have been broken down a traditional country-by-country basis as opposed to a single world-wide basis, which may be in the future, but not now. The current deals are still bound territorially to reflect the traditional sequencing of the distribution windows for foreign countries ' though there's certainly been a lot of pressure on that model as we see more and more event films being released simultaneously across international boundaries.

EL&F: How have talent-revenue participants and the entertainment unions and guilds reacted to digital-distribution issues?

Cooke: There are strong and conflicting interests between talent and guilds, on the one hand, and motion-picture producers and distributors on the other as to how revenues arising from digital downloads of motion pictures are to be characterized. In line with what I mentioned earlier in regard to which studio departments one has to negotiate with for licenses for electronic sell-through, there are differing perspectives as to whether these digitally driven revenues are an extension of traditional hard copy home-video distribution, on the one hand, or pay-per-view or subscription television, on the other hand; each of which has a different formula for determining talent participations and residuals. There has long been, for example, a separate definition for so-called 'gross revenues' arising from DVD sales, as opposed to from the TV licensing of films with respect to both talent participations and residuals.

On a basic level ' setting aside A-list talent that have been able to demand the type of participation they want ' for most of those who participate in motion-picture revenues, the calculation of their share begins with the definition of what type of, and when, revenues enter the participation equation. This is a model where for home video you traditionally deducted as much as 80% of home-video revenues 'off the top' to recoup manufacturing and marketing costs before such revenues ever got included as a part of 'gross revenue.' For electronic sell-through distribution, such costs are minimal. It's almost a pure electronic transaction, so arguably the basis for the older economic model no longer exists. On the other hand, to abandon the old model because there is a shift in technology would arguably disadvantage rights owners by rebalancing their traditional splits with talent and the guilds, without any corresponding reduction in direct-salary costs. With the cost structure of manufacturing a hard copy no longer pertaining, both sides are seeking to benefit from this windfall of lower distribution costs. This type of back and forth is going on not just with respect to electronic sell-through, but also with all the other new revenue sources like wireless. It's all subject to negotiation. The point is that we have new technological models for distribution that are driving reconsideration of the traditional revenue categories and splits and they make for challenging negotiations.

EL&F: How do local laws impact licensing negotiations in terms of the ability to utilize DRM to minimize the unauthorized use of digital content?

Cooke: There are regulations in certain European territories, for example, that guarantee consumers the right to make limited copies of audio-visual products for personal use. Other regulations set out certain privacy protections that prevent the collection of information regarding users of Internet and online services that may be engaged in file sharing. These regulatory protections can conflict with licensor-imposed DRM regimes that are designed to prohibit such copying or file sharing. Lately, I've been involved with trying to sort out the extent to which motion-picture licensees can both fulfill their DRM obligations to licensors as to infringing activities by consumers and still comply with the local regulatory regime. What kind of information, for example, can licensees collect and pass on to licensors? If you're trying to monitor improper distribution like peer-to-peer file sharing, you need a record of what users are communicating. How far can licensees legally go in fulfilling licensors' requirements like sending consumers revocation notices and taking other actions? These can be hard issues to resolve.

Complicating these negotiations further is the fact that there isn't yet a uniform DRM technology. There are competing technologies. Licensees are worried, for instance, about how to proceed where one licensor wants one DRM system and another licensor wants a different system. A licensee may find itself in the position of having to comply with both licensors in order to get product, and the various DRMs are expensive and of uncertain effectiveness. Years ago, such issues were addressed in one sentence in a licensing agreement. These security provisions now can be as long, or longer, than the rights agreement itself. There is regularly a separate stage in a rights negotiation tied to the wide range of licensee obligations on how to protect digitized information.

In the end, this is all really about risk allocation. How do you allocate the risk of peer-to-peer file sharing between a licensor and a licensee? The risk for a licensor is that a licensee will somehow permit or enable peer-to-peer file sharing in a way that destroys the value of the content. Licensees, on the other hand, are properly concerned about being downstream in the sequence of the distribution windows.

A licensee may agree today to pay a premium price for a motion picture based on the first right to distribute it in a particular medium, and then face the risk that a year later it become so widely pirated that the license is worthless.

Thus, a huge issue for licensees is that they are putting themselves into agreements whereby the value of the product is set in advance and then, because of prior usage of the product, when the window finally arrives, the licensees may not be able to exploit it at a profit. The film industry has, of course, faced this situation with each incarnation of a new distribution model, but now it is more complex.

EL&F: Is there a way to ease the negotiating of this DRM issue?

Cooke: Given that one characteristic of a lot of these film-licensing deals is their length ' they can go out 5 or 10 years ' the structure for addressing these issues between licensor and licensee has to be flexible and prospective. It's easy to do deals for 1 year in that sense, because for a DRM technology that works well now, the costs and risks are largely known. It becomes much more complicated when looking ahead 3, or 5 or 10 years, where you just don't know where the technology is going.

So an interesting challenge is what criterion you establish to determine acceptable DRM protection, and who gets to call the shots as to what's acceptable. Among the range of solutions are criterion based on so-called 'industry-accepted technologies,' the use of an outside expert or arbitrator, or simply allowing the deal to terminate without damages if a licensee either cannot, or will not, bear the risk and expense of adopting a new or revised licensor-mandated DRM technology.

Distribution Windows for Motion Pictures

(in Generally Accepted Order)

• Theatrical Release
• Airline/Hotel Pay-Per-View (PPV): 2-3 months after Theatrical Release
• Home Video: 3-4 months after Theatrical Release
• Video On-Demand (VOD)/PPV: 30-45 days after Home-Video Release
• Premium Subscription: Earliest of 11-13 months after Theatrical Release; 5-6 months after Home-Video/PPV/VOD
• Broadcast/Basic Cable: 12-16 months after the start of Premium Subscription

Like other sectors of the entertainment industry, the film industry is looking to the digital age for new revenue streams. Even with digital-piracy concerns, film studios are positioning themselves to capitalize on Internet sales of their products. This summer, for example, motion pictures from several major studios and key independent providers became available on CinemaNow for downloading and copying by consumers for DVD-machine play. In the following interview ' conducted by Entertainment Law & Finance Editor-in-Chief, Stan Soocher ' George A. Cooke, a law partner in the New York office of Manatt, Phelps & Phillips, discusses distribution of motion pictures in the digital age. Cooke's practice consists largely of content and distribution concerns in film, new media and television. He came to Manatt, Phelps in July from the New York office of O'Melveny & Myers. Before that, he worked at Home Box Office for 20 years, including as senior vice president and chief counsel.

EL&F: How is the move to distributing motion pictures through digital downloading affecting licensing negotiations?

Cooke: We're certainly in the midst of a paradigm shift in terms of the ways in which motion pictures are distributed. The effects of this shift on film-licensing negotiations begin with issues in the major studios themselves, namely determining where in their organizational structure rights like electronic sell-through (ie, the sale of a permanent copy through such means as Internet downloading, as opposed to the limited time use of video on-demand) fit in. At this point, electronic sell-through is being claimed alternatively by both those responsible for traditional hard-copy home-video distribution and those handling pay-per-view and video on-demand distribution. As a result, it's often difficult for a licensee to conclude an agreement with either camp without bringing the other to the table as well.

Turning to the effect of digital downloading on negotiations themselves, it is helpful to note preliminarily that there have been three traditional models for monetizing the distribution of motion pictures: 1) the pay-per-transaction model prevalent for theatrical, home-video, pay-per-view and on-demand distribution; 2) the advertising model used for broadcast television; and 3) the subscription model used in basic and pay cable. Sorting out where electronic sell-through fits among these models involves reference to the sequential distribution windows that have historically been used for exploiting motion pictures. (See the sidebar below for a timeline of the distribution windows for motion pictures.)

Since electronic sell-through is still in its early stages of development, the studios are naturally anxious to preserve maximum flexibility in their negotiations with 'downstream' licensees in the sequence of distribution as to the manner in which the studios price electronic sell-through under one, or some blend of, these three pricing models of fee-per-transaction, ad-supported and subscription. The downstream licensees, on the other hand, are naturally concerned that the pricing model for an early electronic sell-through product not destroy the value of their downstream rights for the same motion picture. Pay-television services, for example, pay a significant premium for the right to be the first subscription-based provider of motion pictures as distributed by electronic means. In light of this, allowing an earlier subscription offering of electronic sell-through could seriously undercut their business. That said, to date the economic structures for electronic sell-through that I have seen are primarily based on pay-per-transaction models in which the studios set the wholesale price to subdistributors at a per-unit fee. This is being done with the studios tying the wholesale price for electronic sell-through distribution to a price point at, or about, the wholesale price of a hard copy.

Another set of issues affecting these negotiations derives from the question of whether ' and how ' the so-called 'first-sale doctrine' of copyright law applies to the digital copies. This doctrine provides that the re-transfer of a purchased copy of copyrighted material is legal without going back to obtain permission from the copyright owner. Because of this doctrine, rights holders like the studios seek to establish a high level of protection on the earlier windows of product distribution through contractual restrictions and requirements for licensee digital-rights-management (DRM) technology. A rights holder will naturally seek to coordinate the price point for its product against the stage of its distribution sequence. To that end, it's natural to seek a DRM regime where re-distributable copies are priced high (as in traditional DVDs) and lower-priced copies as delivered by video on-demand or pay-per-view are neither [commercially] re-distributable nor [intended to be] accessible for viewing beyond limited time periods of either a day, a weekend or a week. To do this requires complex and interrelated technologies that are costly to licensees and may limit the appeal of their own distribution window. You can spend a lot of time balancing these concerns in a negotiation.

EL&F: How are territories being negotiated in Internet distribution deals for motion pictures, in light of the international scope of the Internet?

Cooke: Most of the licenses I've seen recently have been broken down a traditional country-by-country basis as opposed to a single world-wide basis, which may be in the future, but not now. The current deals are still bound territorially to reflect the traditional sequencing of the distribution windows for foreign countries ' though there's certainly been a lot of pressure on that model as we see more and more event films being released simultaneously across international boundaries.

EL&F: How have talent-revenue participants and the entertainment unions and guilds reacted to digital-distribution issues?

Cooke: There are strong and conflicting interests between talent and guilds, on the one hand, and motion-picture producers and distributors on the other as to how revenues arising from digital downloads of motion pictures are to be characterized. In line with what I mentioned earlier in regard to which studio departments one has to negotiate with for licenses for electronic sell-through, there are differing perspectives as to whether these digitally driven revenues are an extension of traditional hard copy home-video distribution, on the one hand, or pay-per-view or subscription television, on the other hand; each of which has a different formula for determining talent participations and residuals. There has long been, for example, a separate definition for so-called 'gross revenues' arising from DVD sales, as opposed to from the TV licensing of films with respect to both talent participations and residuals.

On a basic level ' setting aside A-list talent that have been able to demand the type of participation they want ' for most of those who participate in motion-picture revenues, the calculation of their share begins with the definition of what type of, and when, revenues enter the participation equation. This is a model where for home video you traditionally deducted as much as 80% of home-video revenues 'off the top' to recoup manufacturing and marketing costs before such revenues ever got included as a part of 'gross revenue.' For electronic sell-through distribution, such costs are minimal. It's almost a pure electronic transaction, so arguably the basis for the older economic model no longer exists. On the other hand, to abandon the old model because there is a shift in technology would arguably disadvantage rights owners by rebalancing their traditional splits with talent and the guilds, without any corresponding reduction in direct-salary costs. With the cost structure of manufacturing a hard copy no longer pertaining, both sides are seeking to benefit from this windfall of lower distribution costs. This type of back and forth is going on not just with respect to electronic sell-through, but also with all the other new revenue sources like wireless. It's all subject to negotiation. The point is that we have new technological models for distribution that are driving reconsideration of the traditional revenue categories and splits and they make for challenging negotiations.

EL&F: How do local laws impact licensing negotiations in terms of the ability to utilize DRM to minimize the unauthorized use of digital content?

Cooke: There are regulations in certain European territories, for example, that guarantee consumers the right to make limited copies of audio-visual products for personal use. Other regulations set out certain privacy protections that prevent the collection of information regarding users of Internet and online services that may be engaged in file sharing. These regulatory protections can conflict with licensor-imposed DRM regimes that are designed to prohibit such copying or file sharing. Lately, I've been involved with trying to sort out the extent to which motion-picture licensees can both fulfill their DRM obligations to licensors as to infringing activities by consumers and still comply with the local regulatory regime. What kind of information, for example, can licensees collect and pass on to licensors? If you're trying to monitor improper distribution like peer-to-peer file sharing, you need a record of what users are communicating. How far can licensees legally go in fulfilling licensors' requirements like sending consumers revocation notices and taking other actions? These can be hard issues to resolve.

Complicating these negotiations further is the fact that there isn't yet a uniform DRM technology. There are competing technologies. Licensees are worried, for instance, about how to proceed where one licensor wants one DRM system and another licensor wants a different system. A licensee may find itself in the position of having to comply with both licensors in order to get product, and the various DRMs are expensive and of uncertain effectiveness. Years ago, such issues were addressed in one sentence in a licensing agreement. These security provisions now can be as long, or longer, than the rights agreement itself. There is regularly a separate stage in a rights negotiation tied to the wide range of licensee obligations on how to protect digitized information.

In the end, this is all really about risk allocation. How do you allocate the risk of peer-to-peer file sharing between a licensor and a licensee? The risk for a licensor is that a licensee will somehow permit or enable peer-to-peer file sharing in a way that destroys the value of the content. Licensees, on the other hand, are properly concerned about being downstream in the sequence of the distribution windows.

A licensee may agree today to pay a premium price for a motion picture based on the first right to distribute it in a particular medium, and then face the risk that a year later it become so widely pirated that the license is worthless.

Thus, a huge issue for licensees is that they are putting themselves into agreements whereby the value of the product is set in advance and then, because of prior usage of the product, when the window finally arrives, the licensees may not be able to exploit it at a profit. The film industry has, of course, faced this situation with each incarnation of a new distribution model, but now it is more complex.

EL&F: Is there a way to ease the negotiating of this DRM issue?

Cooke: Given that one characteristic of a lot of these film-licensing deals is their length ' they can go out 5 or 10 years ' the structure for addressing these issues between licensor and licensee has to be flexible and prospective. It's easy to do deals for 1 year in that sense, because for a DRM technology that works well now, the costs and risks are largely known. It becomes much more complicated when looking ahead 3, or 5 or 10 years, where you just don't know where the technology is going.

So an interesting challenge is what criterion you establish to determine acceptable DRM protection, and who gets to call the shots as to what's acceptable. Among the range of solutions are criterion based on so-called 'industry-accepted technologies,' the use of an outside expert or arbitrator, or simply allowing the deal to terminate without damages if a licensee either cannot, or will not, bear the risk and expense of adopting a new or revised licensor-mandated DRM technology.

Distribution Windows for Motion Pictures

(in Generally Accepted Order)

• Theatrical Release
• Airline/Hotel Pay-Per-View (PPV): 2-3 months after Theatrical Release
• Home Video: 3-4 months after Theatrical Release
• Video On-Demand (VOD)/PPV: 30-45 days after Home-Video Release
• Premium Subscription: Earliest of 11-13 months after Theatrical Release; 5-6 months after Home-Video/PPV/VOD
• Broadcast/Basic Cable: 12-16 months after the start of Premium Subscription