Star Wars: The box-office awakens

It's too early to tell whether Star Wars: The Force Awakens will become the biggest grossing film of all time - Goldman Sachs says it won't even come close - but it's already shattered box office records, earning over US$500 million globally during its first weekend. The really interesting question, however, is whether the movie will ever go into profit. After all, Return of the Jedi (now known as Star Wars: Episode VI) never turned a profit, although its worldwide unadjusted gross is over US$475 million.

Now, don't worry. This isn't another column dumping on Hollywood accounting. (Easy though that would be.) What I actually want to do is offer a partial defense of the contract practices that so often send news reporters into a tizzy.

The cases get a lot of hype. An actor, director, writer or producer - let's call him a star - sues the studio, claiming that he's earned nothing from his net profit position in a blockbuster. The studio responds that there are no net profits to distribute.

There's bad publicity for the studio - "How can a movie that made that much money never break even?" - and, sometimes, a quiet settlement. Now and then there's a trial. And then things calm down for a while.

Because of the wide coverage accorded a handful of cases, the availability heuristic might make the casual observer imagine Hollywood is rife with accounting fraud.

This seems unlikely. Had the existing studios so completely squandered their reputational capital, others playing by different rules would have arisen by now, and the talent would have flocked to them.

Moreover, if the challenged accounting methods were regularly struck down by the courts, the studios would have come up with new ones.

They haven't. And there's a reason for that.

Most of us, when we hear references to net profit, think about revenue minus expenses, and that's what studio heads have in mind when they discuss the profitability of their movies. For purposes of the star's contract, however, net profit means something else entirely.

Typically, the agreement with the studio will reference something called the Standard Profit Definition. The SPD spells out the method by which net profits will be calculated, and the studio will insist upon a clause making its SPD a part of the contract.
A lot of the fun that is poked at Hollywood accounting is really an attack on the SPD.
For example, when a studio pays itself a large "distribution fee" - essentially, profit - or adds a 15 per cent overhead charge for its marketing expenses - essentially, more profit - the studio is doing exactly what the SPD allows it to do. In other words, the studio is enforcing the contract.

Most complaints about Hollywood accounting are really second thoughts about the contract to which the star has already agreed - a star who is usually represented by an agent and a lawyer.

That's why, as the financial analyst Harold Vogel points out, "net profit" in the star's contract is really what in any other industry would be termed a bonus. The contract makes the bonus subject to definitions in the SPD.

Most complaints about Hollywood accounting, he argued, are really second thoughts about the contract to which the star has already agreed - a star who is usually represented by an agent and a lawyer.

In court, the record of the SPDs is mixed. Certainly plaintiffs win the occasional big victory. But it's getting harder for industry insiders to claim that they were snookered.
Even in California, where the law is skeptical of adhesive contracts, the SPD can survive charges of unconscionability, at least when the plaintiffs are familiar with industry practices.

When the producers of the cult hit Napoleon Dynamite brought suit against Fox Searchlight, claiming that they were unaware of the studio's definition of net profits when they signed the preliminary agreement, the court ruled that incorporation of the definition by reference was sufficient to bind them.

That's not to say that no plaintiff ever has a good case. No doubt the motion picture industry, like any other, is sometimes in the wrong. But scholars who've studied the structure of compensation in Hollywood tend to find it surprisingly rational.

The Harvard economist Richard Caves, in his book Creative Industries: Contracts Between Art and Commerce, reminds us that a rational individual can reasonably decide to trade fixed income now for the chance of greater income later.

Of course that later income might never arise - studies suggest that something like one film out of seven will pay net profit participants - but the willingness of the talent to accept that risk lowers the risk for the studio, thus enabling a greater investment in production and marketing. And probably allowing the studio to make more films.

Columbia law professor Victor Goldberg contends that too much income at the front rather than the back end can distort the incentives of the participants whose joint efforts create the motion picture.

One of those participants is the studio, which knows that its distribution fee goes up as gross receipts go up. When actors accept net positions, moreover, they make it easier for the studio to hire a big star (actor or director) who will take a gross position.

The big star increases the likelihood of the film's success, a prospect that typically adds to the long-term compensation of the other participants.

Rational doesn't mean perfect, and the studio's joint role as profit participant and profit calculator raises serious questions about moral hazard.

Yet it's hard to argue that industry regulars are the victims of systematic advantage-taking. Studio profit margins aren't huge, and typically there are investors waiting to be paid back.

As Vogel puts it: "To survive over the long term, studios must have sizable financial buffers that can easily support the capital costs, cushion the risks incurred in the normal course of operations, and also provide for a degree of flexibility when selecting from competing potential projects."

The narrow definition of net profit - which, again, is really a bonus - helps provide that buffer.

So when the The Force Awakens earns its gazillion dollars, and the inevitable stream of articles arrives noting that the film has never gone into profit, let's take a deep breath and remember that the studio is most likely just enforcing the contracts as written.

Negotiating with sharp elbows isn't always pleasant, but it might also be what keeps the studios afloat.
Bloomberg