As the Sarbanes-Oxley Act - whose date of compliance was pushed back into this March - goes into full mode in a little over a month we decided to replay an article we did last year on the subject -- editor 1/26/2005
By Richard Menta 4/22/04
Rock Historian Dave Marsh once described being an artist in the record industry as the equivalent of sharecropping. In sharecropping, the farmer doesn't really own the vegetables they raise, the landowner does. The landowner pays them a fee for the amount of produce they create, but charges back the cost of the feed, fertilizer, use of equipment, even water - all at inflated prices. In the end, the sharecropper makes the minimum it takes to keep them and their families alive so they can work the land the next year and the next. As the sharecropper suffers in poverty, the landowner garners excess wealth.
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Call it a form of creative accounting.
Through alleged dubious accounting practices the record industry does the same to the musicians who make the music they sell. Just replace music videos and PR costs for feed and fertilizer and you get the idea. The details of those expenses are hidden too, forcing artists who feel they have been cheated to either pony up for a very expensive cross-audit or shut up. Since such an audit is prohibitively expensive they almost never occur.
But in this post-Enron world the rules have changed. That's because of a new law, born out of the Enron scandal, which will make dubious accounting practices MUCH more dangerous for the executive management of all publicly traded firms.
The Sarbanes-Oxley act was designed to protect investors by improving the reliability of corporate disclosures. It places very stringent reporting conditions with criminal penalties for executive management and the board of directors if they fail in their due diligence in providing accurate and fair information.
"Due diligence" is they key word here. Before Sarbanes-Oxley, one would have to prove outright fraud on the part of executive management before some legal action could be taken. With Sarbanes, the standard has been lowered greatly. The firm's books now have to be perfectly transparent and orderly. If they aren't, the CFO, the CEO and members of the board of directors will be in violation of the law and can go to jail.
And when the government says orderly it means orderly. Publicly traded corporations now have to account for every single penny and that accounting has to be perfect with easily accessible records for audit purposes. The point of all this is so that there is absolutely nothing hidden from investors who risk their savings nor are there any practices that might mislead them with regards to the actual income that the company honestly generates.
The real kicker of this law is section 404, which requires the CEO and CFO to sign off that they know - not think they know, but know for certain - that the numbers are accurate. This signature holds them personally responsible for any deficiencies in the company's financial statements..
The criminal penalties for executive managers and board members who fail in their due diligence are severe. The maximum fine ranges from $1 million to $5 million with a maximum prison term of from 10 to 20 years.
A lot of pensioners lost their money in the Enron scandal, pensioners who now become the wards of the federal government upon retirement. They wanted blood and the Sarbanes-Oxley Act gave it to them. Companies must begin to comply with the new amendments for their first fiscal year ending on or after Nov. 15, 2004.
The Record Industry and its Artists
There have been many accusations over the accounting practices employed by the record industry. If true, these practices will stop now for all of the publicly traded labels. Most likely, it will also stop for the one privately owned major label Bertelsmann. Even though technically Bertelsmann does not have to comply with the act (it only applies to publicly traded firms) and is not subject to its criminal penalties, Sarbanes-Oxley sets a standard known as best practice which potentially can be used against them in civil court down the road.
How can artists utilize this law? Let's take Courtney Love as an example. She has been battling the record labels for years, claiming they have been systematically cheating her of the full money owed to her.
After Nov 15th, her record label's books must be in order. Furthermore, upon demand they must be able to provide her with an accurate statement of the true revenues, expenditures and pay outs regarding her music. Automatically, her proper reimbursement should come in.
The good news is it probably will.
But what if it doesn't? Here is where it gets interesting.
Theoretically, Courtney can buy one share of stock in her label and then attend the next stockholders meeting. There, she can state that her experience with her own account with the company leads her to believe there is deception about. Then she accuses the entire board, the president and other executive managers of failure to comply with the Sarbanes-Oxley Act.
Remember, the requirement here is due diligence. Even accidental failure to comply subjects executive management to fines and jail time because they failed the diligence requirement. This requirement was a response to Enron's CEO's claim that he didn't know what was really going on. Today a CEO better know what's going on or they go to jail for recklessly exposing their company - and its stockholders - to unnecessary risk.
Once Courtney makes her claim she can demand an external audit at the company's expense to prove the accounting is solid. This will include an audit of her own account where she saw the symptoms that lead to her accusation.
If the numbers prove faulty, she as a stockholder can order the arrest of the entire board and executive management for failure to comply with the Sarbanes-Oxley Act. Furthermore, the Act may open it up for her to pierce the corporate veil and personally sue these same executives in civil court.
See how powerful the new law is. Now multiply Miss Love with the many other artists who feel they are being cheated and you have one heck of a class action suit. A suit that can go after the personal assets of each and every board member.
Corporations Will Comply
Needless to say, the top executives will not let it get that far. With the corporate protections stripped away, self-preservation will become the rule. The numbers that Love so desperately tried to pull from her label in the past should now become fully accessible as will those of other artists.
The crazy accounting that was business-as-usual for the record industry is already being re-evaluated and changed. General accounting principles are more conservative to a point where even innocent deviations can expose executive management to charges of impropriety.
All this is good news for all artists. Present practices, like not paying artists for albums sold through the record clubs, can now be challenged. Even if a CEO has a stomach to fight rather than capitulate, it is highly doubtful that the board members - who are frequently selected for reasons other than their expertise in the music industry - will allow him to. If he were to lose in court he can take them all down with him and they are not going to allow that.
Sabanes-Oxley is a new law, not yet two years old. It will take at least a decade of court cases to define the true parameters of the law, its scope, and its reach. This is what scares executive managers the most, that the law is new and its bounderies are not yet defined. No CEO wants to be the test case.
The rules have changed. Label artists who truly have been exploited stand to be vindicated.
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