The Clearinghouse Concept
Chapter 5 of my ongoing book review of "The Big Picture: The New Logic of Money and Power in Hollywood", by Edward Jay Epstein
SUMMARY: A behind-the-scenes odyssey into the world of the Hollywood motion picture industry examines the complex ways in which the major entertainment empires—Viacom, Time Warner, NBC/Universal, Fox, Sony, and Disney—make their money, profiling the individuals who created these vast conglomerates and the various ways in which Hollywood has evolved to survive financially (Taken from Amazon.co.uk)
Last week, in my review of chapter four, I outlined how Epstein give us a sketch about how movie studios cooperate with each other in less visible ways. In the old system, he tells us, "studios were conceived of as vast factories manufacturing movies as if they were an industrial product" (p. 106). The financial burden of the studios under that system was significantly high. In the new system, they have instead adopted a sort of outsourcing paradigm where, by involving more participants, they minimise financial risk at the cost of sharing the profits. But who controls the flow of money? Or more importantly, who decides what share of the money each participant receives?
The key idea is the collection and distribution of income (clearinghouse). "Unlike the revenue flow in the older system, in which movies usually returned almost all their money in a year, the income now flows in over the lifetime of licensable rights" (p. 110). Remember that, in the new system, box-office rentals 1 are no longer the main source of income for movie studios. By controlling the information on which the payments are based, "the studio[s] [...] decide (initially at least) who is entitled to what part of it, and when, and under what conditions" (p. 111). The idea is simple: To keep as much profit as possible. And the mechanism to achieve it is through a combination of legal maneuvers and dubious accounting practices.
The author dedicates two sections to summarise the main sources of inflows and outflows of money, but I want to concentrate in what he calls "the most important job of the clearinghouse" (p. 118): The allocation of money.2 During the time when the book was published (2003), the home video market was most profitable than the box-office for many titles. Maybe it still is, considering all the revenue coming in from digital stores, but the takeaway surrounding this market is that studios, in order to distribute profits, developed a "royalty system" similar to the one then used in the music business. Here are Epstein’s own words (p. 119):
It originated in 1976, when videos consisted mainly of exercise and pornography tapes and were sold by independent distributors to small stores. Since the distributors allowed the stores to return unsold copies long after they were issued, it was difficult to calculate retail sales. So, instead […] the distributors agreed to pay the producers a flat 20 percent of the wholesale price, regardless of how many videos were returned; this payment, considered a "royalty," became the notional gross for calculating payments to the artists or other participants
The allocation of money, at least in the home-video segment and as I understand it from Epstein’s explanation, worked more or less like this: In a masterstroke, movie studios also became the video distributor (that’s why all of them created their own home-entertainment divisions), which allowed them to calculate two different "grosses" for accounting purposes: "[O]ne derived from the studios’ total sales of videos and the other derived from the 20 percent royalty fee" (p. 119). In simple terms, you had a commercial entity that had created two 'pockets' for depositing money. At first, all the money was deposited in one pocket (home-entertainment division), but instead of distributing profits from this big pocket, they would withdraw 20 percent (royalty) and "pay it" to the other, small pocket (movie studio), leaving the big pocket with 80 percent. Since movie stars would sign their contracts directly with the movie studio (small pocket), their share of the profits would be calculated based on a smaller amount of money.
Here’s a hypothetical example. For a 20 percent fee on a 100 million adjusted gross, an actor, instead of getting 20 million (20% of 100 million) would only get 4 million (20% of 20 million), effectively 'losing' 16 million due to accounting rules that separated the money into two different 'pockets'.3 Arnold Schwarzenegger, due to his strong negotiating power, bypassed this rule for his Terminator 3: Rise of the Machines contract (see image caption above). Epstein refers to this as an "extraordinary clause" (p. 123). Instead of the 20 percent standard, his fee was raised to 35 percent and was calculated based on 100 percent of adjusted gross receipts, not the 20 percent royalty fee as was common practice, meaning that the company couldn’t withhold any money from him the way they did with other participants (p. 123).
Arnold was, of course, an exception. The rest just had to play the game based on the studios' rules. "In almost all cases, these contracts are vetted by the participants' agents and the talent agency’s lawyers. So if there’s a deception involved in the clearinghouse allocations, it is, like so many aspects of Hollywood relations, a willing self-deception" (p. 123).
This is the money that a studio receives from movie theatres, via the studios' distribution arms, after all deductions have been taken. In other words, it is a net amount, rather than the gross number reported on media outlets on a weekly basis.
It is important to understand that the clearinghouse, in this context, is basically a concept, not a brick and mortar studio division with a physical address. There’s no phone extension for the 'clearinghouse' department either, but it’s helpful in the sense that allows a reader to understand that somehow, money needs to be collected and contracts need to be managed and settled by someone.
These accounting rules had nothing to do with the Generally Accepted Accounting Principles (GAAP) that govern the accounting profession (nor IFRS for that matter). Quite simply, they were made-up rules for the studio’s own benefit. Since the book was originally published in 2003, I admit to the reader that I don’t know if the studios still use these practices the way they’re described in the chapter. I can only suspect that there’s a likelihood that dodgy accounting practices are still being done, but that’s about it. I’m aware that there’s some material out there that covers the subject, but that’s beyond the scope of this review series.