MLC Financial Audit: Uncovering Key Questions [Chris Castle]

The MLC’s latest financial audit reveals surprising details that raise crucial questions about its operations. Discover what the audit uncovered and why it matters for the music industry.

by CHRIS CASTLE of Music Tech Policy

The sainted Title I of the Music Modernization Act is the part of the voluminous bill that established the government’s compulsory mechanical license and baked in the governance rules that spawned the mechanical licensing collective. One of those rules requires a financial audit of the MLC, Inc., the organization created by the smart people to execute Job One (hiring HFA), administer the blanket license, and, to hear them tell it, invest the hundreds of millions in unmatched funds aka the black box.

What is a financial audit? A financial audit is not the same thing as a royalty compliance examination often referred to as an “audit.” In a nutshell, the term “financial audit” typically refers to the annual examination of an organization’s financial statements. You’ve probably heard the term “audited financial statements”, so this is that. Independent auditors review these records to ensure they accurately represent the organization’s financial transactions. The audit includes the income statement, balance sheet, and cash flow statement and underlying ledgers, etc., aiming to provide reasonable assurance of the company’s future performance, essentially for the benefit of the public. In this case, for the benefit of the Congress, the Copyright Office, and especially for songwriters who are compelled by government fiat to allow these people to handle their money.

Financial audits are complicated and are usually conducted by certified public accountants (CPAs) not royalty auditors. CPA licensure is all about financial statements and usually includes nothing about royalty compliance examinations, so having the CPA license is no assurance that the CPA knows anything at all about royalties. That’s why the smart people who drafted the MMA for Congress included a requirement that royalty audits must be conducted by CPAs, certainly one of the top 10 stupid things in the MMA. But I digress.

“auditors…never once mentioned the black box, never mentioned the MLC’s bogus investment policy”

The MLC published their first auditor report for 2023 conducted by the Withum firm, which I’m sure is a very competent, very reputable CPA firm. One of the reasons I think that is because the company uses the MLC’s audit report to do some blatant self-promotion (and were allowed to do so by the MLC): “Our firm is nationally-recognized, including recognition in 2022 and 2023 on the Forbes list of America’s Best Tax and Accounting Firms, as well as Inside Public Accounting’s Top 25 Accounting Firms.” The auditor’s letter is not the place to be marketing the auditors in my view, and if they worked for me I would have told them to remove that sentence–just the facts, please. But God knows they don’t work for me.

I find it very odd that the auditors, who Congress mandated as the songwriters’ last line of defense in many ways, never once mentioned the black box, never mentioned the MLC’s bogus investment policy, never mentioned whether they thought it was perfectly acceptable for the organization to be running hundreds of millions in unmatched and holding close to a billion dollars in publicly traded securities. 

Maybe I’m missing the CYA memo, but I find it hard to understand how anyone, much less a CPA, could conduct a financial audit without examining the effectiveness of the organization being audited in doing their essential job as clearly mandated by Congress. Remember, the main reason the MLC exists is to do the job of collecting and paying statutory royalties. That’s it. Not flying around the world to conferences on the DSPs’ dime, not investing the black box with trading risks and benefits assigned to God knows who, not running up expense accounts, or remote working from exotic locales.

For example, the auditors tell us:

The MMA Audit Provision directs the qualified auditor retained by MLC to further prepare a report for the board of directors addressing the implementation and efficacy of procedures of MLC:

• for the receipt, handling, and distribution of royalty funds, including any amounts held as unclaimed royalties; 
• to guard against fraud, abuse, waste, and the unreasonable use of funds; and
• to protect the confidentiality of financial, proprietary, and other sensitive information

But in the next sentence, the auditors say “Our audit was solely designed to audit the financial statements of the MLC.” So that’s not the same thing. That switch in language is an attempt to redefine the purpose of the audit and the task of the financial auditor as defined in Title I.

Understand that part of the auditor engagement science is being very clear about what the auditor is and is not responsible for. So by limiting the scope of the auditor’s report to “the financial statements” that’s not quite the same thing as what Congress required. It’s an open question as to who that requirement falls on, the collective or the auditor, but I think a good case can be made that it falls on both, and also on the Copyright Office to raise any questions.

Although I believe the statute is clear about this one, let’s ask the legislative history. The joint report on the MMA (at p.6) echoes the statutory language, possibly because the intent was so obvious that it did not require explication:

“The auditor’s report shall address the implementation and efficacy of procedures of the collective’s 1) receipt, handling and distribution of royalty funds, including any amounts held as unclaimed royalties…”

The point is clear–Congress, i.e., songwriters and the American people, relies on the auditor to review “the implementation and efficacy of procedures…including any amounts held as unclaimed royalties”. Why? Because the auditor is supposed to be neutral and independent and is the only one–the only one–who is independently reviewing the MLC’s internal “procedures”. In fact, a copy of the auditor’s report is to be delivered to the Copyright Office in its oversight role. Congress had a very good reason to task the auditor with reviewing “the implementation and efficacy of procedures.” I think this could even include a review of metadata practices, dispute resolution and other items that have a material effect on royalty reporting and payments or at least an explanation of why not.

It is also not an accident or surplus words that Congress mandated a review of “any amounts held as unclaimed royalties.” How can an auditor’s report that is compliant with the law fail to address the black box or the MLC’s policy of investing black box money for the benefit of…who? That would be an answer that the auditors could have known, but by the looks of it scrupulously avoided knowing anything about. As is known to happen. Which is why when you sit down to read one of these things, the first question you should ask is what are they not telling us? Forbes notwithstanding.

For example, the CPA audit rules state (AU-C Sec. 240.03): “Two types of intentional misstatements are relevant to the auditor — misstatements resulting from fraudulent financial reporting and misstatements resulting from misappropriation of assets.” I’m not saying that anyone misappropriated black box funds, partly because in order to misappropriate property the owner of that property likely has to be deceived. And of course the reason why money is in the black box is that the owner doesn’t know their money has been put there.

But is the money misappropriated if it is being “invested” by the MLC at the direction of the board of directors? Particularly when, as Chairman Issa noted at a recent Congressional hearing on the MLC, the MLC is not a rulemaking body that certainly acts like a rulemaking body. Did the auditors take this issue into account?

As required by generally accepted auditing standards, the auditors tell us that they got smart about the MLC and the world it operates in: 

In performing our audit in accordance with GAAS, we gained an understanding of MLC and its environment in accordance with AU-C Section 315 Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (“AU-C Section 315”), as issued by the American Institute of Certified Public Accountants (“AICPA”). As part of obtaining an understanding of controls that are relevant to the audit, we evaluated the design of those controls and determined whether they have been implemented by performing procedures, in addition to inquiry of MLC’s personnel. 

What Section 315 actually says is “This section provides guidance to the auditor in understanding specified aspects of the entity and its environment, and components of its internal control, in order to identify and assess risks of material misstatement, and in designing and performing further audit procedures.” 

“$804,555,579”

Would it be a “material misstatement” if the MLC was investing black box funds to the tune of hundreds of millions? For example, according to Part X, Line 11 of the MLC’s 2022 IRS Form 990, the MLC held $804,555,579 in stocks as of the end of 2022. That money presumably did not disappear on January 1, 2023 so some part of it and any subsequent inflows and outflows were covered under the audit report (and in any event prior years also audited by the same firm as they footnote). 

That $804,555,579 is a material amount for an entity that has no revenue. Would it be a material misstatement to reflect investment activity of other people’s money on the MLC’s books if the investment activity was not permitted? Did the auditors know about the investment policy issue being raised by Representative Cline at a Congressional hearing and in subsequent questions for the record? Were they aware that the lawfulness of the MLC’s investment policy was also raised in several comments to the Copyright Office in the MLC’s redesignation? Did the auditors know about gains from trading and the fact that The MLC, Inc. had to be disclosed as a “Control Person” to the Securities and Exchange Commission by Payton Limited Maturity Fund SI (PYLSX) because the MLC, Inc. owns 25% or more of PYLSX’s $1.9 billion net asset value?

I could go on. But fortunately, the auditors tell us “we evaluated MLC’s culture of honesty and ethical behavior.” Aha. Please point me to where that evaluation is required (or even appropriate) under GAAS?

So if the auditors did review all these investment policy issues, did they discuss the issues with the MLC’s personnel? Were those discussion reflected in their field work or other working papers? If they complied with Section 315’s requirements to get smart about the client, but did not review the investment policy, gains/losses from trade or other financial statement entries or discuss same with MLC personnel, why didn’t they?

I guess we may never find out, although the Copyright Office may want to revisit these compliance issues with the auditors or wait for a judge to do so. Because you can’t find what you don’t look for.