Principles of Contracts: Material Interest

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Previous chapter: You CAN Fight City Hall
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I was beginning to think I’d never return to this series. Please bear in mind as you read the following that I am not a lawyer, and none of the below is legal advice. These are thoughts on business as it relates to contracts, based on my experience and the experience of others whose business affairs I have been privileged to be allowed access to. Always consult a proper lawyer when in any doubt about the language in a contract (or when not in doubt–language is sneaky).

A couple chapters back, I talked about the importance of being able to say “no” and walk away from a deal that you weren’t happy with. Recently, I was reminded of some interesting and more obscure reasons that might motivate a person to walk away from a deal that they otherwise really wanted to do.

Today, the obscure reason on my mind is what the IRS calls “Material Interest,” which is what a person has in a corporation when they own a significant percentage of the stock (I think it’s 20%, but I’d have to look it up) or holds a position as a corporate officer, or sits on its board with a certain percentage of governing power, etc.

It’s a useful concept to bear in mind when negotiating deals that include sublicense-ability, because both people and corporations (which, for legal purposes, are separate people) can have material interest in other companies than the one you’re negotiating with–and this material interest creates an opportunity for the unscrupulous business partner to really screw you over.

Straw Buyers and Self-Dealing
Let’s say you have a book, and you’re selling the publication rights to a company. Those rights will usually include the right to sublicense those rights–for example, if Big Sound Company buys your audiobook rights, they will probably get with it the right to sublicense the audiobook they produce for broadcast, or streaming, or distribution through any number of other channels. This is normal–in fact, in most businesses, it’s an essential part of making the deal financially viable for the producer/publisher/distributor, especially in an age in which the actual form of a property shifts several times through the distribution chain.

Now, if the license to produce is a “clean deal,” meaning you’re paid a flat fee up front, with no royalties due, there’s no problem. But if it’s a royalty-based deal, then there’s an enormous opportunity for mischief that can screw the creator out of any and all royalties due. It’s an old scam, and it’s been done before. It’s called “self-dealing” and it’s kissing cousins to “straw buying.” It can amount to a kind of fraud, but one that’s difficult to enforce due to the great latitude that contract law provides for people to set the terms of their own demise. Since minimizing ambiguity and wiggle room is a good approach to take when constructing a contract, writing language that explicitly prohibits it in the contract ain’t a bad idea.

Here’s how the scam works.

Bob the writer sells the rights for his book to Major Printers and Publishers Inc.
MP&P buys the right to produce and distribute the book in hardback, paperback, ebook, and audiobook formats. It will pay Bob a royalty for every unit sold, as per the royalty schedule in the contract. It also has the right to sublicense those rights to other publishers if it wants to. If it does sublicense, then Bob gets a percentage of the sublicensing income.
This is all standard, seems totally worth the trouble. Bob signs the contract.
Except that MP&P’s audiobook division, and their paperback division, and their ebook division, are all subsidiary corporations. Legally, they are separate entities.
Now, MP&P, wanting to make a good amount of money on the deal, sublicenses those rights to its subsidiary corporations for $500. Bob gets his cut of the $500.
The book then goes on to be a bestseller, selling gazillions of units in all those formats that were sublicensed—and Bob is not legally entitled to any of the fortune that his work is generating.

This happens all the time. It even happened to a guy named Bob (I’m not telling you which Bob, because I can’t remember the reference, and so am not going to publicly slag off the particular major corporation that screwed him).

One recent incident of this sort that I can talk about involves Harlequin, which attempted to avoid paying its authors properly by sublicensing rights to a sister company. In this case, Harlequin was forced to recompense the authors because the authors were able to prove self-dealing. Here’s how it went down (quoted from the above linked article):

That said, the authors including Barbara Keiler, Mona Gay Thomas, and Linda Barrett nonetheless get a huge victory because the 2nd Circuit decides to reverse the opinion of the lower court, with regard to a claim that the licensing fees that Harlequin Enterprises paid to its subsidiaries are not equivalent to “the amount reasonably obtainable from an Unrelated Licensee.”

So, the authors won some measure of relief–but it took them a long time, and it took an appeal upwards to the 2nd Circuit, which means this process took years and cost massive amounts of money to prosecute (most likely paid afterwards on contingency, but it’s still a lot of money and heartache to get relief from a bad contract.

Far better (in my opinion) to provide, up front and in ink, that sublicensing deals in which the fiduciary party (i.e. the publisher) has a material interest (or, in the language of the court above, the licensee is a related entity) must not be used to circumvent the fiduciary duties laid out in the agreement.

Learning the Principles of Contracts, and protecting yourself in negotiations, requires learning how innocent, reasonable language can be used against you by the heirs, assigns, and future custodians of the company/person you’re doing business with, and limiting those avenues through your contract language. Educate yourself–and, whenever you can, run your contracts by a competent lawyer.

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Next time: Horse Trading (how to deal with impasses).

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