The Pooh Papers: DISNEY LOSES KEY RULING IN POOH CASE
by Joe Shea
American Reporter Corresondent
LOS ANGELES, June 18, 2002, 5:35pm PDT -- In a tentative ruling handed down late today, Los Angeles Superior Court Judge Ernest M. Hiroshige fired a controversial forensic accounting firm, threw out most of a court-appointed auditor's findings and awarded the owners of commercial rights to children's favorite Winnie The Pooh a 12.5 percent error rate in their Walt Disney Co. royalty payments that may yield as much as $200 million for them, the plaintiffs say.
Disney spokeswoman Michelle Bergman said the studio would have no comment on the ruling. Bertram Fields, the lead attorney for the plaintiffs, Stephen Slesinger Inc., was unable to respond to queries by press time due to a deposition in which he was involved, his firm said.
A member of the Slesinger family said the ruling could amount to a $200 million payday for the small, privately-owned family firm, which has owned commercial rights to Pooh for more than 70 years and licensed them to studio founder Walt Disney in 1961. An American Reporter review of the ruling, however, suggests that Disney may end up paying about $32.5 million.
"It's a big win for us," the family member said, declining to be identified. If so, it was certainly a big loss for accountants, too, except that they were paid $800,000 for work that according to the court was deeply flawed and badly biased in favor of Disney.
"SSI contends that the Audits did not comply with GAAP [generally accepted acounting principles], were procedurally and logically flawed, applied inconsistent and unfair standards, and involved pervasive absence of documentation and separate character accounting. "...[M]ajor errors committed in the sampled years were not included in the error rate extrapolated," Hiroshige said, "and when documentation was missing that was necessary to show whether revenue was from Pooh or not, the income was treated as non-Pooh. The Court agrees," the judge said.
"The evidence presented indicates that Miskei, Costello and the Accountants held weekly meetings with Disney personnel in which Disney provided guidance to the Accountants on the problems they encountered and attempted to convince the Accountants to take a different position on these issues," Hiroshige noted.
"By simply focusing on the information that they were given by Disney, the Accountants limited their gaze to the trees of the forest while missing sight of the forest itself," he wrote. "The Accountants thus rewarded Disney for its failure to provide adequate documentation and to separately report and ensure that its licensees separately report Pooh revenues."
Patricia Slesinger, who with her mother is contesting the revenues, said she believed the complex decision nonetheless may shortchange the family firm if it is an indication that the court believes Pooh characters amounted to only 12.5 percent of revenues from commingled character-revenue streams, which she said Disney estimated at 3 percent and which she estimates at 30 percent of such revenues.
"If that's what it means, I think it's disgusting," she said, adding that she had not yet read the ruling. She said Disney had publicly indicated Pooh was as much as a third of the revenue stream from uses of Pooh that were not attributed to a single character, such as products that show many Disney cartoon figures rather than one. "The revenue was 1,000 percent [of what Disney claimed]," she said. The percentage, however, was based on a suggestion from Dr. Douglas Carmichael, SSI's expert witness, the judge noted. Carmichael's credibility was greater than that of Disney's experts, he ruled.
In the ruling obtained exclusively by The American Reporter from the court late this afternoon, Judge Hiroshige says his "dissatisfaction" with forensic accounting firm Gursey Schneider LLP stemmed from a number of arbitrary decisions and procedural errors accountants made that might have cost the plaintiffs millions of dollars.
"The 'judgmental approach to extrapolation' adopted by the Accountants lacks theoretical consistency, is illogical, and above all, is inherently unfair to SSI," Hiroshige wrote in the complex ruling, which was almost 10 months in preparation.
Among the many errors, Judge Hiroshige said, were "exclusion of SSI from many of the meetings of the Accountants with Disney personnel, counsel, and expert accountants, and the failure to involve SSI in each step of the process during the Audits resulted in the absence of SSI's position on how to deal with various important issues such as missing and inadequate documentation, undifferentiated and unidentified product reporting, whether catchup payments should be excluded from the extrapolation error rate, and whether to use a simple or weighted average for extrapolation of the 1988 and 1994 audits, to name a few."
There will not be any more audits until the next phase of the case, the judge said, and the error rate as modified by the court will govern the extrapolation procedure in which a set percentage based on estimated underreporting by Disney will be used to determine amounts due Stephen Slesinger Inc. of Tampa, Fla., founded by branding pioneer Stephen Slesinger, who purchased rights to the Pooh properties from British author A.A. Milne in 1931.
In another blow to Disney, which had argued that the error rate should be applied to just the 11 years between 1983 and 1994 that were audited, Judge Hiroshige ruled that the error rate of 12.5 percent will be applied from the date of the 1983 agreement "until the day of judgment in this action," which may not come for years. Efforts to resolve the case out of court have failed, and it now appears both sides are determined to go before a jury in two parts next February.
Disney will also not be able to credit "any undocumented catchup adjustment or over-reporting" when determining extrapolated revenues with the 12.5 error rate, Hiroshige said. He said $2,160,808 of underreported theme park revenues will be included in the 1988 error rate without reference to a 1991 catchup payment by Disney, but that payment can be deducted from the total due SSI.
"For the purpose of determining the theme park error rate in both Audit periods, there shall be an assumption that Pooh products constituted 12.5 percent of theme park multi-character and unidentified product sales in 1988 and 1994," Hiroshige said.
Disney will also have to pay SSI based on a 5.8 percent error rate for catalogue sales, and the 12.5 percent error rate will apply to international licensing, the 1988 and 1994 domestic licensing error rate, and the Disney Stores error rate. A 15 percent error rate will be applied to domestic book publishing, and all the payments will be ""extrapolated to the entire long account," he ruled.
Disney argued that the judge should apply a "weighted average extrapolation error rate methodology" to reflect the fact that a 1994 sample showed fewer errors than in a sample 1988 period, and because it earned 94 percent of the revenues under the contract after 1994. A document called the Wolinksy Report that Disney introduced in support of a better error rate for later years of the contract was was "largely unreliable and totally unauthenticated," the judge wrote.
Hiroshige found extrapolation theory badly flawed and inconsistent with both the theory and principle of extrapolation. "There is no justification for deviating from this established and essential sampling principle" that error rates occurring in one period should be applied to all periods in question, he said.
Hiroshige said he decided to apply the principle of judicial estoppel to such arguments when Disney changed its opinion of the methodology upon learning the court would modify it "to bar Disney from maintaining such inconsistent positions."
Virtually all of the rates are far higher than Disney lawyer Daniel Petrocelli argued for during a four-day hearing in Dept. 54 of the downtown courthouse between Aug. 13 and 16, 2001. Disney had argued that it owed the plaintiffs "nothing." The Slesingers sought about $35 million in past-due royalty payments, plus interest.
The interest issue was not decided today, but it appears that the final sum awarded to Slesinger may be close to what they sought. They seek hundreds of millions in the part of the case that has yet to go to trial, which deals with payments Disney says it does not have to make to the Slesingers.
The judge said the long delay in ruling on the case was in part due to an agreement between the two parties, apparaently to try to seek a settlement, an effort which failed. The case was filed in 1991 and is the longest-running civil matter in the county, officials say. Records of it were only revealed to the public after an extraordinary effort to unseal them was mounted by the Los Angeles Times and this newspaper earlier this year.
Judge Hiroshige, as detailed in an American Reporter exclusive earlier this year, was unhappy with the performance of both the accounting referee and the Gursey Schneider firm.
The American Reporter said on February 25 that the accounting was likely to be thrown out after the judge reportedly told lawyers in his chambers that he never wanted to see the firm in his courtroom again. After their appointment, Hiroshige learned from the plaintiffs that Disney's then-lawyer, Skadden, Arps litigator John Donovan, used the firm as forensic accountants in his divorce proceedings. There was no reference to that issue in today's 28-page ruling, however, nor to the role of Arthur Andersen & Co. senior partner Christopher Paskach of Los Angeles, who appeared at least 17 times for Disney during accounting hearings in 1994 and 1995. Paskach has not returned numerous calls requesting comment.
"Due to the highly contentious nature of this Hearing and the Audits surrounding same, the Court finds it necessary to relieve Accounting Referee Costello, [forensic accountant Michael] Miskei, as well as the accounting firm of Gursey Schneider & Co. LLP from their duties in this matter as of today," the court ruled.
Hiroshige also noted that other disputed revenue streams from DVDs, videos, computer software and other merchandise will be at issue in a trial set for February 2003. Today's ruling only affects Pooh items such as plush dolls and licensing arrangements that Disney agrees it must pay Slesinger royalties for. The trial court will be asked to find that Disney agreed and then failed to pay hundreds of millions in royalties on disputed items.
The two audits, covering a six-month period in 1988 and 1994, cost $800,000, excluding attorney fees and discovery referee fees, Hiroshige said. Auditors found $1 of underpayments for every $13 spent on the audit, he noted.
Both sides came under fire for the judge over the volume of paperwork in the accounting hearing. In violation of the California law on such filings, he said, in response to his request for a 10-page offer of proof the plaintiffs submitted a 45-page unsolicited brief that got yet another unsolicited 40-page answer from Disney.
As a courtesy, the judge said, he read all of it, "amounting to 155 pages of points and authorities [italics in original] in the moving, opposition and reply papers along with two boxes of documents consisting of direct testimony, declarations and exhibits attached thereto, as well as several boxes of documents consisting of Hearing Exhibits" and transcripts of complex oral testimony from four days of hearings.
In what may be a wry understatement, Judge Hiroshige said "The Court has devoted substantial time and resources to resolution of this matter."
The court said Disney's arguments that the accounting referee's report should be treated as as though it were a special jury verdict under California law was "clearly erroneous" becaue it referenced the rules of the wrong code section.
At the same time, he rejected an SSI claim that payment for accounting errors should be based on the plaintiff's "100% Rule," which argues that if it cannot be determined what percentage of revenues from a particular use is attributable to Pooh, all of it should be.
Future audits of disputed payments prior to the trial will be conducted by a new accounting referee and a new forensic accounting firm that SSI and Disney agree on. Alternatively, the court will name accountants from a list of three prepared by both the plaintiffs and the defendants. Briefing on some of those issues is scheduled for June 29 in Los Angeles. In the meantime, Slesinger is free to exercise its regular audit options under the 1983 contract.