Pandora Sees the Light On Audit Rights

Music industry licenses that require a music service to pay a royalty to a copyright owner have traditionally included what’s come to be called an “audit clause”.  Because so much information required to actually confirm that royalties are paid properly is under the control of the person doing the paying, the control of that information by the party in whose interest  lies the underpayment creates significant moral hazard.

Under Pandora’s new version of the direct publishing license for their on-demand streaming service currently being circulated by MRI, we get some good news.  Here’s why….

In the MRI license Pandora has dropped many of the restrictions on royalty compliance examinations (commonly called “audits”) that it tried to get the Copyright Royalty Judges to impose on artists and record companies through the sound recording statutory license.  SoundExchange conducts these audits under the compulsory license on behalf of featured artists, nonfeatured artists and sound recording owners.

This will, no doubt, come up on one of the appeals of the CRJs, so hopefully the ruling of the Copyright Royalty Judges (called “Web IV”) on this issue will now be moderated by reality in the form of this new Pandora commercial benchmark.  And we all know how important Pandora’s contracting practices are for benchmarking the law the rest of us must live under.

Digital services are new to royalty audits and have perpetuated the charade started with the very record companies these services are quick to criticize–this time that somehow only certified public accountants have the qualifications to conduct royalty audits of the services.

There is a great tradition in record deals of trying to load up as many restrictions as possible on the artist’s auditor to suppress the number of “inbound” audits coming at the record company.  Almost all record companies will drop the CPA requirement, because in reality everyone knows that royalty compliance has nothing to do with GAAP, financial statements or any of the other tools of the CPA’s trade.  More on this below from a Warner Music Group executive.

Royalty compliance examinations are a science of knowing where to look, knowing when you’re being lied to, and having the means to hold feet to the fire.  And due to the complexity of streaming and its billions of lines of royalties, an auditor also needs to have the technical expertise, staff and systems to manage enormous volumes of data.

This is not a knock on CPAs, but that expertise has nothing to do with GAAP or the skill set tested by the CPA licensing examinations.  The reason that a digital service traditionally wants a CPA requirement is that (1) it is usually more expensive (unnecessarily so), and most importantly (2) very few CPAs do royalty compliance examinations of digital services so the service is likely to be audited by someone who doesn’t know where–or how–to look.  (All due respect to CPAs, but royalty compliance–especially the specific skill set required for digital service audits–is simply not part of their training.)

The National Association of Broadcasters went even further in the recent Web IV proceeding with the full-throated support of Pandora’s CFO Michael Herring–under the CRJ’s new rules not only must a compulsory license audit be conducted by a certified public accountant, that CPA must also be licensed in the jurisdiction where the audit is conducted.  This is another one of the real howlers enunciated with a straight face by the Copyright Royalty Judges in their Web IV determination recently published.  (See the final determination paragraph G6.)

Not even the evil record companies ever tried to get away with this licensing requirement under the audit clauses of record deals, probably because they would have been laughed out of the room.  Unfortunately, that’s not possible with the government’s boot on your throat in the form of the Copyright Royalty Judges.

Warner Music Group executive Ron Wilcox gave an excellent summary of this issue in his Web IV testimony (at p. 15):

WMG’s agreements generally do not require that a certified public accountant (“CPA”) perform royalty audits with its digital partners. Auditors who conduct royalty audits of digital services generally do not draw on the set of skills required to pass the CPA exam.

Rather, royalty auditors must be able to understand the technical systems that WMG’s partners use, to interpret data those systems maintain and generate, and the like. For example, a royalty auditor may have to examine a streaming service’s server logs and content databases to determine the accuracy of the service’s statement of performances and royalty payments.

This could require understanding how the service’s systems record digital performances, how those records are retained, and how those records are used to generate royalty statements. In addition, royalty auditors must be familiar with some of the unique conventions and jargon in the music industry as well as the royalty terms applicable to each service provider.

For instance, auditors need to understand how to calculate a pro-rata share from a label pool, how performances are defined in the relevant contracts, and how to account for non-royalty-bearing plays.

Because royalty audits require extensive technical and industry-specific expertise, in WMG’s experience a CPA certification is not generally a requirement for conducting such audits. To my knowledge, some of the most experienced and knowledgeable royalty auditors in the music industry are not CPAs.

For some unknown reason, the Copyright Royalty Judges chose to disregard this testimony from one of the most experienced and knowledgeable executives in the music business.  Who happened to get the issue exactly right, by the way.

So the CRJ’s disconnected ruling on this issue was unfortunate.  Especially so because this ruling affects all SoundExchange audits–conducted on behalf of artists, musicians, vocalists and record companies.  The CRJ’s ruling makes an already difficult practice Jesuitical in the extreme and adds untold expense and inefficiency to an already cumbersome process.

But good news has come to light–actually great news.  Pandora has seen the error of their ways on this issue and has dropped both the CPA requirement and the licensing requirement in its most recent push for direct licensing conducted by MRI.  This is truly great news and indicates a welcome change of heart at Pandora.

Here’s the new language in Pandora’s announced streaming service:

Audit: In order to enable PUBLISHER to be satisfied that it is being accounted to on an accurate and timely basis in connection with the Pandora Services (including by verifying that the calculation of all financial information is correct), PUBLISHER may appoint an independent third-party auditor (“Auditor”) to examine and make copies and extracts of Pandora’s books, records and server logs related to the use of PUBLISHER Compositions and fulfillment of Pandora’s obligations under this Agreement (collectively, the “Accounting Materials”), such audit to occur at Pandora’s offices and at PUBLISHER’s expense.

This is a triumph of reason over the absurdly out of touch positions taken during Web IV by Pandora, NAB and others, and should immediately be brought to the attention of the appeals court to conform the audit regulations in line with the Pandora commercial benchmark.

 

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