Independent Distribution – Some Points to Consider

by David Crow on August 1st, 2005

With the recent bankruptcy of Distribution North America (“DNA”), many independent labels and artists (collectively referred to as “Artist or Artists”) are scrambling to secure independent record distribution. This column will discuss some of the deal points that Artists may want to consider when evaluating the merits of various distribution agreements. As a threshold matter, the Artist must decide whether to pursue a pressing and distribution agreement (i.e. an arrangement where the distributor manufactures the product for the Artist and distributes the product to various retail channels) or a traditional distribution agreement where the Artist manufactures the product and the distributor confines its activities to soliciting and fulfilling orders for the product. This column will focus on some of the key issues in the traditional distribution agreement.

Early in the negotiation, the parties must decide whether or not the right to distribute the Artist’s recorded product will be exclusive. In a traditional distribution agreement, many Artists will want to carve out sales via the Internet (i.e. via the Artist’s Website), video units (VHS/DVD), Christian Book Stores and/or direct mail sales (many Artists have a mail order division with a strong mailing list that they have developed over years). If the agreement is exclusive, Artists may want to consider exploring the possibility of an advance (particularly if the artist is having to front the manufacturing costs). The territory of the agreement needs to be considered. Is the agreement limited to the United States or is it a worldwide agreement? This is driven in part by the ability of the distributor to penetrate markets in different countries. Many Artists will initially agree to a worldwide territory provided, however, that the distribution rights in each foreign territory revert to the Artist in the event that the distributor fails to secure distribution in that particular territory within a certain number of days after the initial United States release. The term of independent distribution agreements varies widely-from termination upon thirty (30) days written notice by either party to a fixed term of three (3) years (or longer).

The structure of compensation (for the distributor) in independent distribution agreements ranges from a percentage of the gross sales (typically ranging from 18-35%) to a fixed price per unit sold by the distributor. Artists should pay particular attention to return fees per unit (sometimes as high as $0.25), scraping fees, refurbishing fees and excessive inventory charges. In addition, Artists are typically responsible for any co-op advertising (i.e. the cost of buying product placement and in-store advertisements) and sales programs offered by the distributor to retail accounts (i.e. so-called “restocking programs”). Artist are often expected to pay the insurance and shipping costs associated with getting the product to the distributor’s warehouse and the insurance and shipping costs of any returns.

Once the parties agree on the method and level of compensation, they must address accountings, payments and reserves. Specifically, the parties must decide if the distributor will account monthly, quarterly or semiannually. Will the distributor account monthly and pay quarterly? What level of reserves will the distributor hold back against monies otherwise payable to Artist to cover possible returns? Reserves run anywhere from 25% to 50%. Artists should pay particular attention to when such reserves will be liquidated. The Artist will want the reserves to be as low as possible (i.e. not to exceed the difference between units shipped and units scanned via SoundScan) and liquidated as quickly as possible.

The biggest lesson that many Artists learned from the DNA bankruptcy is that the distribution agreement must specify who owns the inventory that is in the distributor’s warehouse or at the retail outlets. Virtually all distribution agreements specify that the product is 100% returnable by retail to distributor and from distributor to Artist. In addition, distributors typically do not pay the Artist until they have been paid by the retail account(s). As a result, most people assume that records are sold on “consignment.” Put another way, many Artists assume that they own the records they ship to the distributor until the distributor actually pays for those records pursuant to the distribution agreement. However, as many Artists found out in the DNA bankruptcy, unless the distribution agreement uses the magic “consignment” language and unless the Artist perfects a security interest in the inventory in the possession of the distributor (by filing a UCC-1 in the appropriate locations to put the distributor’s creditors on notice that the Artist owns the inventory), it is not a “consignment” in the eyes of the bankruptcy courts. Why does this matter you ask-because if the distributor files for bankruptcy, the distributor’s creditors can auction off the inventory that the Artist sent to the distributor (for which the Artist has not been paid) and keep the proceeds from such a sale. Adding insult to injury, the sale at such an auction by the distributor’s creditors may trigger the Artist’s obligation to pay artist and mechanical royalties. As a result, Artist’s should carefully examine whether or not the relationship with the distributor is a true “consignment” and should review any language granting a security interest in the inventory. The Artist should also seek written assurances from the distributor that the inventory provided by Artist will not be pledged as collateral or otherwise encumbered by distributor. Lastly, the Artist should be wary of any language in the distribution agreement granting the distributor a security interest in “general intangibles” as that will include rights in the copyright to the master.

First published in Music Row Magazine, www.musicrow.com.