Significant new royalty contract opportunities have emerged in Asia, South America, and Eastern Europe with the expanding global economy, and in sync, underreported royalty revenues from nondomestic licensees are rising at a dramatic rate.

As a result, Stonefield Josephson has noticed a resulting trend toward a potential substantial loss of income to licensors, based on royalty compliance inspections performed by its member firms.

The causes for the rapid rise in underreported royalties are broad in scope, ranging from legitimate business-process constraints emanating from sometimes overly complex global contracts, to weaker controls and intellectual property laws in expanding international economies.

Regardless of the causes of the underreporting, economic losses abound from the flourishing black- and gray-market distribution channels.

What's more, licensee-monitoring has grown increasingly difficult as businesses become more dispersed and as products can be sold in unmonitored global markets.

E-mails and phone calls to overseas licensees can often go unanswered and sales figures from retailers may not be reliable or even obtainable from many regions.

With significant licensee operations in hard-to-reach manufacturing locales throughout many regions that are notorious for black and gray-market activities, contract compliance professionals may be challenged more than ever to perform under the "right-to-audit" provisions included in many license agreements.

Digital Content: A Burgeoning Global Royalty Market
As royalties from digital content have helped to enrich many media companies for several years, contract compliance professionals are being deployed globally and more frequently to assess royalty payments from digitally distributed intellectual property, such as video games, ring-tones, wallpapers, video clips, full-length music tracks and similar media. Monitoring royalties related to digital content presents its own unique challenges.

Some licensees may be so concerned with being "first-to-market" or with the quantity of goods distributed that they can neglect creating effective accounting systems to properly capture complete downloads and allocate royalties appropriately.

Recovering lost royalties from licensees—sometimes in excess of 20 percent of reported royalties, in the author's experience—requires specially trained contract compliance professionals.

Licensees underreport digital media distributions and royalties for a number of reasons. These issues are often overlooked by accountants without proper intellectual property royalty auditing training.

Licensees can frequently use third parties to distribute digital content. These third parties may not be subject to the right-to-audit provisions listed in contracts between licensees and licensors.

It may also be unclear as to whether the licensee or the third party distributor has the responsibility to pay royalties to the licensor.

Licensors do not or cannot process the metadata provided by licensees to describe key aspects of their digital content.

Metadata accuracy affects the licensors' own ability to pay royalties to their content-creator partners (i.e., recording artists, song writers, game developers, etc.).

A licensee's self-reported royalty documentation may include only summaries of digital content sold, creating difficulty in retaining sufficient detailed delivery and revenue information to support royalty payments to licensors.

Royalty payments to licensors may be calculated on the basis of assumptions.

Licensors and/or third-parties may inappropriately exclude unidentified revenue from royalty payments to licensors.

Digital media licensing agreements may not appropriately address items such as undelivered content, free samples and product bundles.

Licensing agreements may restrict distribution of digital content to certain regions or localities. Tracking compliance with these restrictions can be complex.

Emerging Regional Trends
Digital-content royalties is just one area of concern for consumer product licensors. Global companies are facing a number of emerging regional challenges in monitoring their licensees.

Asia
Typically, for reasons ranging from the extent to which agreements work bi-laterally to tradition, Asian licensees have been reluctant to allow licensors to examine their financial records through trained professionals.

Such reluctance exists despite requirements or incentives for an examination and a specific obligation in their contract. Even identification by licensors of significant incidences of non-compliance or large financial consequences does not encourage field examinations in many instances.

In some cases, licensees have imposed conditions on license or royalty compliance examinations, such as restricting the records that may be accessed; limiting the time allocated to conduct fieldwork; and even requiring examination of records in cities other than where the documents are normally prepared and maintained, thus denying access to the staff that prepared the source documents.

In Asia, royalty compliance examinations have been seen as something that U.S. and European companies are likely to perform for Asian companies.

But, the author has seen instances where Asian companies are examining other Asian companies.

Indeed, some Asian licensors have sought to examine European- and U.S.-based licensees.

In Japan, for instance, where many companies have both licensors and licensees, some have been willing to respect their agreement to be subject to a royalty compliance examination despite concerns that such an exam would border on mistrust.

More and more, Japanese companies are requiring that compliance be tested, with litigation and arbitration to follow, if necessary. South Korean companies are also moving in this direction.

Some companies have advised their licensees that royalty compliance exams will be performed and that noncooperation will bring consequences.

This approach may work where a licensee needs the licensor more than the other way around. However, Stonefield Josephson considers the tactic extreme and ill-advised in Asia.

A number of licensors are working to change these attitudes.

Many have sought to educate the licensee that good corporate governance simply doesn't allow them to assume an "honesty system" will work, much in the same way that many companies typically require contracts before entering into transactions or demand letters of credit before shipping goods to customers.

They have explained the need to take some measure to verify compliance. In other words—trust, but verify.

Unfortunately, in a large number of instances, licensors' concerns about compliance in Asia have some basis, with the identification of large sums undeclared.

Examinations can be conducted successfully within Asia without unduly straining the relationship, especially if the program is managed carefully by the licensor and the experienced contract compliance professional who performs the royalty compliance examination.

North America
The breadth and scale of self-reporting programs placed in operation by licensors has had a favorable impact on the quality and accuracy of self-reporting to those licensors.

In the absence of such proactive monitoring programs in North America, the author's first-time royalty audits commonly identify underreported royalties in excess of 20% and occasionally, underreported royalties in excess of 100%.

The reasons for underreporting may be centered on aggressive contract interpretation, poorly written contracts that lack penalties to encourage proper and timely payments, royalty statements prepared by untrained employees, and a lack of licensee focus on their need to accurately self-report revenues and resultant royalties.

Licensors tend to see an immediate impact when they place a broad monitoring program into operation, with a positive "coattail" impact even on those licensees that are not included in the initial wave of examinations as word spreads quickly among licensees that the licensor has enacted a royalty-compliance program.

When starting a proactive royalty-compliance program, it is important the licensor communicates to all licensees the intent and scope of the program so as to maintain relationships and so the program be perceived as thorough, impartial and fair.

Generally speaking, North America licensors can fall into three primary groups:

Companies that proactively conduct ongoing royalty-compliance examinations as part of normal business operations and that budget for recoveries over costs each year;

Companies that are reactive, conducting fewer than a handful of royalty-compliance examinations, and only after a determining that the licensee is underreporting; and,

Companies that don't monitor licensees through royalty-compliance examinations.

Extreme care should be taken to help ensure the royalty-compliance professionals selected are specifically trained in third-party royalty auditing as licensors rarely have more than one chance to examine the records of the licensee and the resulting recoveries resulting from the skills of different auditors can be remarkably different.

When companies select royalty auditors, this cost can be offset by an agreement's cost recover provision. Such provisions are trending towards cost recovery at underreportings at the lesser of 5 percent or $10,000 in any one reporting period.

Additionally, companies with material revenues from self-reporting third-party licensees may now be required to enact royalty compliance programs to meet Sarbanes-Oxley Act requirements.

Europe - Middle East - Africa
While many licensees are based in Western Europe and North America, their factory operations increasingly have shifted to Eastern Europe in search of lower labor costs and other financial incentives.

As this manufacturing shift occurs, the author has found that professionals unfamiliar with traditional Western accounting internal controls and reporting are preparing royalty reports that almost always fail to properly account for manufactured licensed product, sales and resultant royalties.

Most often, experience shows that these misstatements appear to be honest misreading of complex foreign-language contracts.

In many instances, the errors are by individuals who have never seen a copy of the agreement and, therefore, are generally unaware of the unique restrictions that can affect the royalty due to the licensor, i.e., on-returns, minimum-selling prices, related-party sales, shrinkage, calculation of gross revenues, price protection, etc.

Securing records from licensees in a reviewable format can be difficult in Eastern Europe, as the local practices and accounting rules can affect how information is captured, retained, and presented.

Therefore, using a local royalty contract compliance professional skilled in local language, accounting practices, customs, tax laws, record retention requirements and industry practices is recommended for a successful royalty compliance examination in Eastern Europe.

In the EU, licensors may have to exercise their "rights of audit" to protect their intellectual property (IP) in countries that may not have a long tradition of proper IP protection.

But royalty-compliance examinations are not the only tool, especially in Eastern Europe. Licensors may wish to consider a broader strategy to protect IP by lobbying government officials to protect the rights of consumer product licensors. This is particularly important in regions where counterfeiting is a significant source of local employment.

Conclusion
Globalization has opened up many new markets for licensors. However, weak contracts not properly addressing collection penalties and right-to-audit needs, cultural differences and language barriers, and misunderstandings of regulations have made the efficient collection of royalties from licensees a challenge in many ways.

Sid Blum is a Stonefield Josephson Principal and business advisor. For information on dealing with IP licensees around the world, contact Sid Blum at 310-432-7458 or sblum@sjaccountin.com.

This article was initially published in IP Law 360. Published with permission from Portfolio Media, Inc.

 
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