It is not uncommon for independent filmmakers to hope and seek that they can find a single investor from outside the film industry to fund the production costs of their film project. Notwithstanding the facts that many scam artists prey on that same hope and such investments rarely occur, filmmakers persist in their search. Even if found, reliance on a single investor to fund the entire budget of a film project comes with certain problems. As a practical matter, someone who puts up the entire budget for the production of a feature film will very likely want to have some say in the decisions made in relation to the project. In other words, the investor may want to be actively involved in helping to make the important decisions associated with the production and distribution of the film. That level of investor involvement can cause serious problems for the producer if disagreements arise. Considering the fact that the production and distribution of a feature film literally involves hundreds of decisions, it is very likely that disagreements between the filmmaker and the single active investor will occur. On the other hand, if the investor is not active (i.e., the investor is passive), then it is very likely that a security is being sold (even if there’s just one investor) and the producer will need to comply with the federal and state securities laws in order to remain legitimate and avoid the imposition of possible civil and criminal penalties.

Before going further, however, let’s pause to clear up some possible confusion regarding the financial terminology commonly used to describe certain investors. For example, there is a difference between the terms active investor and angel investor. In short, an active investor is someone who is regularly involved in helping make the important decisions associated with a business venture (but see the more detailed definition provided by the courts as set out below). On the other hand, angel investors typically fill the gap in start-up financing for companies between the so-called “friends and family” stage and the venture capital stage. In other words, angel investors typically provide the 2nd round of financing for what are perceived to be high-growth start-up companies. Angel investors may or may not be active investors. Angels typically invest their own funds as opposed to the pooled funds of venture capital. Both angel investors and venture capital funds tend to prefer the corporate structure, as opposed to the commonly used manager-managed LLC and limited partnership structures more often utilized for financing the production costs of an independent film. Venture capital tends to come at a third, growth stage for a company, after the firm is more established (i.e., it has a certain number of employees and is generating a significant level of revenue). In other words, venture capital is rarely invested in start-ups of any kind, and certainly not in one-off independent feature film projects. Thus, if you are an independent filmmaker intending to raise production financing for a single independent film, it is very unlikely that any such funds will be coming from a venture capital firm. So it is probably wise not to mention the term “venture capital” in the same sentence with film finance. It is possible that one or two angel investors may get involved in helping to fund such a high-risk venture, but as we’ll see, they may or may not be active investors.

So let’s now examine what the courts have said about who is an active investor and who is not. Where profits in any business venture including film, are expected to come from the joint efforts of partners (the typical case in a general partnership, joint venture or a member-managed LLC) the courts are likely to consider the investor(s) in such arrangements as active, and thus not likely to consider that arrangement a security. [Fundamentals of Securities Regulation, 4th Edition, Louis Loss and Joel Seligman, Aspen Publishers, 2007]. The leading federal case on when a general partnership interest (and by analogy a joint venture, a member-managed LLC or any other so-called active-investor investment vehicle) constitutes a security is the 1981 case of Williamson v. Tucker [Williamson v. Tucker, 645 F.2d 404, 5th Cir. 1981]. Basically, in the Williamson case, the federal Fifth Circuit Court of Appeals said that a general partnership or joint venture interest can be designated as a security if the investor can establish, for example, that:

(1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership (i.e., units in a limited partnership are always considered securities); or

(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or

(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

Further, California courts have supported the securities regulators’ view that an active investor must have some level of knowledge and understanding of the field in which he or she is investing. In the case of Consolidated Management Group, LLC versus the California Department of Corporations [Consolidated Management Group, LLC versus the California Department of Corporations, 162 CA4th 598, 75 CR3d 795, 2008] a California appellate court ruled that “the investor’s inexperience and dependence on a managing venturer served to establish that the joint venture interests were in fact securities.” The court further stated that these business promoters (in this case, selling investments in oil well drilling equipment using a joint venture as the investment vehicle) “were soliciting investments from people who would, as a practical matter, lack the knowledge to effectively exercise the managerial powers conferred by the joint venture agreements . . .” The court went on to say that “the success of the particular projects marketed was uniquely dependent on the efforts of the . . . managing venturer, and that investors would be relying on those efforts in making their investments.” Ultimately, the court observed that the “investments were solicited from persons with no experience in the oil and gas industry”.

Thus, if we consider such a ruling as it might be applied to an investment in an independent film, the court is saying that if the investments are solicited from persons with no experience in the film industry, such an investment is very likely to be considered to be a security (i.e., that investor would be considered a passive investor). Further, if the success of the particular project marketed is uniquely dependent on the efforts of the managing venturer (i.e., film producer) and that the investors would be relying on those efforts in making their investments, again, such investments would very likely be considered securities.

Note that the Consolidated Management case decided in California went beyond the requirement that an investor must be experienced and knowledgeable in business affairs generally, and cited with approval a line of cases from the Federal Courts’ Fifth, Ninth and Eleventh Circuits) which take into account the reality that general business sophistication does not necessarily equip an investor to manage a specialized enterprise. These cases have found that “Regardless of investors’ general business experience, where they are inexperienced in the particular business they are likely to be relying solely on the efforts of the promoters to obtain their profits.” [S.E.C. v. Merchant Capital, LLC, 483 F.3d 747, 11th Cir. 2007; Holden v. Hagopian, 978 F2d. 1115, 9th Cir. 1992 and the Williamson case cited above]. And, in those cases where investors are relying on the efforts of others to obtain profits, a security is probably being sold (i.e., the investor is not active but passive).

As noted in my earlier Baseline article “When You Don’t Need a Business Plan”, in those situations where the filmmaker is selling a security, he or she needs to comply with the federal and state securities laws if the offering is to be legitimate. Further such compliance requires, among other things, that a securities disclosure document (at least complying with the SEC’s anti-fraud rule) be provided to each prospective investor before they invest. And, contrary to what some in the film industry have consistently told filmmakers at seminars across the country, a business plan is not the same thing, nor is it used for the same purpose, as a securities disclosure document (although there may be some overlap in their contents).

Then, when we realize that both federal and state courts have defined the active investor to be someone who has knowledge and experience in the particular industry for which the investment is being sought, most reasonable people are forced to recognize that the pool of prospective investors out there in the real world, who may qualify as active investors, is much smaller than previously imagined. Thus, the task of finding someone who can actually qualify as an active investor pursuant to the law is more difficult than ever. That makes the alternative of spreading the risk of a high-risk investment like independent film amongst a larger group of passive investors and accepting the obligation to comply with the securities laws a much more viable option.

John Cones

In late April, the U.S. Securities and Exchange Commission (“SEC”) issued a warning to premature investment crowdfunders, and the SEC’s warning contains implications for filmmakers. In its warning, the SEC pointed out that on April 5, 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law. Among other thing, the Act requires the SEC to adopt rules to implement a new exemption that will allow investment crowdfunding (Title III of the JOBS Act, the so-called Crowdfund Act). Until then, the SEC is reminding issuers of securities that any offers or sales of securities purporting to rely on the investor crowdfunding exemption for the time being would be unlawful under the federal securities laws.

The SEC actually brought an enforcement case the week after the JOBS Act was signed. In that case, the SEC charged a Silicon Valley man who raised millions for two Internet start-ups by falsely promising investors that his companies were on the verge of undergoing successful IPOs and were well on their way to becoming the “next Google.”

The SEC alleged that Benedict Van, of San Jose, California, lured investors into web-based start-ups hereUare, Inc. and eCity, Inc. by falsely telling them that the companies would go public within a matter of months and generate millions in quick returns. In truth, Van had no plans to take the companies public and relied solely on investor funds to stay in business. Ultimately, when investor funds ran out by the end of 2008, Van was forced to shut down operations.

Marc Fagel, Director of the SEC’s San Francisco Regional Office stated that “Van played on the hopes of investors, tricking them into believing that his companies were on the verge of becoming the next Silicon Valley success stories.” He added that “investors should be wary of pitches promising IPO riches from companies with minimal operations and track records.”

According to the SEC’s complaint, filed in federal court in the Northern District of California, Van raised more than $6.2 million from investors for hereUare in 2007 and 2008, and raised $880,000 in investor funds for eCity in 2008. In presentations to prospective investors, chiefly in homes in Sacramento and Stockton, Van held himself out as a wealthy venture capitalist with prior IPO experience. Van told prospective investors that the companies had lucrative deals and patents, and that he had retained Goldman Sachs and an international law firm to help take the companies public within six months. According to the SEC, all of these representations were false.

The SEC’s complaint charges Van and hereUare violated the anti-fraud and registration provisions of U.S. securities laws, and charges eCity with violations of the anti-fraud provisions. Van, hereUare, and eCity have agreed to settle the charges against them without admitting or denying the SEC’s allegations and have consented to permanent injunctions. Van also consented to a district court order permanently barring him from serving as a public company officer or director, and hereUare has consented to an administrative proceeding order deregistering its stock with the SEC. The SEC waived any fine against Van based on his demonstrated inability to pay.

It is important for filmmakers considering raising funds from others to understand the difference between the more traditional donation or gift-based crowdfunding (e.g., through IndieGoGo and Kickstarter), and the new investment-based crowdfunding as authorized by Congress in the JOBS Act (see my three previous articles posted here at baselineintel.com in their “ResearchWrapBlog” relating to the JOBS Act provisions, including the section on the newer form of crowdfunding). Also, understand that this newer form of investment-based crowdfunding must be conducted through SEC registered “funding portals” or SEC registered broker/dealer firms and these funding portals are not yet available. Further, in the JOBS Act, Congress provided that the new crowdfunding law would not go into effect until after the SEC promulgates a set of rules designed to protect investors, and the SEC has until early 2013 to issue its rules. Until then, this new form of investment-based crowdfunding is not available, and filmmakers seeking to raise funds by selling securities online or through any form of general solicitation (including many of the postings we regularly see among the Facebook or LinkedIn film-related group blogs) may be subject to similar action by the SEC or any of the state securities regulatory authorities.

The new so-called crowdfunding exemption from the registration requirements of the Securities Act of 1933 (section 302 of H.R. 3606) – the Crowdfund Act) allows issuers of securities to raise up to $1,000,000 during a 12-month period. However, if either the annual income or the net worth of the investor is less than $100,000 the amount sold to such investor cannot exceed the greater of $2,000 or 5 percent of the annual income or net worth of such investor. If either the annual income or net worth of the investor is equal to or more than $100,000, such an investor can invest up to 10 percent of his or her annual income or net worth, as applicable, but such investments cannot exceed $100,000. In addition, the transaction must be conducted through a broker or funding portal that complies with further requirements of this legislation, and the issuer must comply with certain additional requirements. The income and net worth of a natural person are to be calculated in accordance with the rules of the Securities and Exchange Commission (“SEC”) relating to an accredited investor.

Required Disclosures – Clearly, the legislation contemplates the preparation of a securities disclosure document to be provided to each prospective investor before they invest, since the law requires that the issuer file with the SEC and provide to investors and the relevant broker or funding portal, and make available to potential investors, the following information:

(1) the name, legal status, physical address, and website address of the issuer;

(2) the names of the directors and officers (and any persons occupying a similar status or performing a similar function), and each person holding more than 20 percent of the shares of the issuer;

(3) a description of the business of the issuer and the anticipated business plan of the issuer; and

(4) a description of the financial condition of the issuer.

For offerings that, together with all other offerings of the issuer under this same law within the preceding 12-month period, have, in the aggregate, target offering amounts of $100,000 or less, the income tax returns filed by the issuer for the most recently completed year (if any) should be included in the disclosure document, along with the financial statements of the issuer, which must be certified by the principal executive officer of the issuer to be true and complete in all material respects.

If the amount described in the above paragraph is more than $100,000, but not more than $500,000, the financial statements must be reviewed by a public accountant who is independent of the issuer, using professional standards and procedures for such review or standards and procedures established by the Commission, by rule, for such purpose.

If the amount described in the above paragraph is more than $500,000 (or such other amount as the Commission may establish, by rule), audited financial statements are required.

Further Disclosures – The law also requires the issuer to include in its securities disclosure document to be provided to the Commission, brokers, funding portals and prospective investors, a description of the stated purpose and intended use of the proceeds of the offering sought by the issuer with respect to the target offering amount.

The issuer must also state the target offering amount, the deadline to reach the target offering amount, and provide regular updates regarding the progress of the issuer in meeting this target offering amount.

The issuer must also disclose the price to the public of the securities or the method for determining the price, provided that, prior to sale, each investor must be provided in writing the final price and all required disclosures, with a reasonable opportunity to rescind the commitment to purchase the securities.

The issuer must also provide a description of the ownership and capital structure of the issuer, including:

(i) terms of the securities of the issuer being offered and each other class of security of the issuer, including how such terms may be modified, and a summary of the differences between such securities, including how the rights of the securities being offered may be materially limited, diluted, or qualified by the rights of any other class of security of the issuer;

(ii) a description of how the exercise of the rights held by the principal shareholders of the issuer could negatively impact the purchasers of the securities being offered;

(iii) the name and ownership level of each existing shareholder who owns more than 20 percent of any class of the securities of the issuer;

(iv) how the securities being offered are being valued, and examples of methods for how such securities may be valued by the issuer in the future, including during subsequent corporate actions; and the risks to purchasers of the securities relating to minority ownership in the issuer, the risks associated with corporate actions, including additional issuances of shares, a sale of the issuer or of assets of the issuer, or transactions with related parties.

The issuer will also have to disclose such other information as the Commission may, by rule, prescribe, for the protection of investors and in the public interest. In addition, the issuer must disclose the information required to meet the anti-fraud provisions which are set out specifically in the law (see “Issuer Liability” below”).

Advertising – The law prohibits the issuer from advertising the terms of the offering, except for notices which direct investors to a funding portal or broker.

Finder Compensation – The issuer also cannot compensate or commit to compensate, directly or indirectly, any person to promote its offerings through communication channels provided by a broker or funding portal, without taking such steps as the Commission shall, by rule, require to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication.

Filing Obligation – The issuer must, not less than annually, file with the Commission and provide to investors, reports of the results of operations and financial statements of the issuer, as the Commission shall, by rule, determine appropriate, subject to such exceptions and termination dates as the Commission may establish, by rule; and comply with such other requirements as the Commission may, by rule, prescribe, for the protection of investors and in the public interest.

Possible Litigation – The law authorizes purchasers of securities in transactions exempted from registration by its provisions to bring lawsuits against the issuer and to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, or for damages if such person no longer owns the security.

Issuer Liability – The law also provides that an issuer may be liable in such lawsuits for making any untrue statement of a material fact or omitting to state a material fact required to be stated or necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading, provided that the purchaser did not know of such untruth or omission; and the purchaser does not sustain the burden of proof that such issuer did not know, and in the exercise of reasonable care could not have known, of such untruth or omission. This requirement is equivalent to the anti-fraud provisions that apply to all securities offerings.

Definition of Issuer – The law defines “issuer” to include any person who is a director or partner of the issuer, and the principal executive officer or officers, principal financial officer, and controller or principal accounting officer of the issuer (and any person occupying a similar status or performing a similar function) that offers or sells a security in a transaction exempted by the provisions of this law, and any person who offers or sells the security in such offering.

Restricted Securities – The law provides further that securities issued pursuant to its provisions may not be transferred by the purchaser of such securities during the 1-year period beginning on the date of purchase, unless such securities are transferred (a) to the issuer of the securities; (b) to an accredited investor; (c) as part of an offering registered with the Commission; or (d) to a member of the family of the purchaser or the equivalent, or in connection with the death or divorce of the purchaser or other similar circumstance, in the discretion of the Commission. Such sales are also subject to such other limitations as the Commission shall establish.

Combined With Other Funding Methods – The law specifically allows issuers to raise capital through other methods besides the Crowdfund Act.

Certain Persons Are Disqualified – People who have been convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the Commission (among others) are disqualified from relying on this new Crowdfund Act.

Commission to Promulgate Rules – The Commission is required to promulgate rules deemed necessary or appropriate for the protection of investors within 270 days (9 months).

Funding Portal Regulations – Other provisions of the law impose numerous requirements on the funding portals.

One of the most common questions asked in relation to raising capital from investors is: “Can I use finders?” There also appears to be a significant number of conflicting answers to that question floating around out there in the marketplace – hence a great deal of confusion exits. Part of that confusion occurs because the answer to the question differs somewhat depending on the following variables:

1. Does the transaction involve the sale of a security or is it a non-securities transaction?
2. If a security, does the transaction involve a public/registered offering, a public/private hybrid offering or an exempt/private offering?
3. Do both the federal and state laws apply to the transaction?
4. If a private/exempt offering, which exemption is being relied on at the federal level and which exemptions are being relied on at the state level?

A few points from a legal perspective with respect to finders:

1. The Rules Vary – The rules relating to the activities and compensation of finders will vary depending on whether you engage in a securities or non-securities transaction, and if a securities transaction, what type. So, if you do not know what sort of investor offering you are proposing to conduct, it is not likely that you will be able to determine what the rules are for your proposed transaction with respect to finders.

2. Non-Securities Transactions — If you are trying to raise money in a non-securities transaction (i.e., from a few active investors — people from outside the film industry who have knowledge and experience of the film industry and who are capable of and authorized to help make the project’s important decisions on a regular basis – the definition of active investors per federal case law) then the use of finders is not regulated, although they can still commit common law fraud on your behalf if you do not carefully limit what they say to prospective investors. Generally, you just want them to introduce you to such investors. They should not engage in any activity that may be fairly described as “negotiating” on behalf of the issuer, including the delivery of the business plan. You, of course, would want to disclose in the associated business plan what compensation will be paid to such finders.

3. Securities Transactions – If you are seeking to raise funds from passive investors, you are selling a security. And, if a securities offering is being undertaken, the general rule is that no transaction-related remuneration may be paid to persons not trained, licensed and supervised as broker/dealers. That, in effect, is what a finder is and how finders want to be paid (i.e., a percentage of the money raised). Generally speaking, finders are not trained, licensed and supervised as broker/dealers, and that is why securities regulators find it necessary to limit the activities of finders. The idea is to protect investors from untrained, unlicensed and unsupervised sales people who are only or primarily motivated by the desire to make money on the transaction.

Pursuant to the securities laws, finders are limited to merely introducing the producer and the prospective investors. For a public/registered offering (e.g., S-1, SB, Reg. A, SCOR) or the so-called public/private hybrid offerings (e.g., the Model Accredited Investor Exemption), that is not as much of a problem. There is no pre-existing relationship requirement between the issuer of the security (i.e., the film producer for purposes if this article) and the prospective investor in such offerings. However, for a private placement (i.e., exempt offerings like Regulation D Rules 505 or 506), the issuer of the security (or its upper-level management) must have a pre-existing relationship with the prospective investor. Thus, the finder’s introduction must occur prior to the start of the offering, so that when the offering actually begins, the upper-level management of the issuer has the required pre-existing relationship. In other words, the issuer of the security cannot rely on the pre-existing relationships of finders in private placements. Reg. D, Rule 504 is not recognized by most state securities laws for use in conjunction with their exempt offerings, thus it is of little use, except if used in conjunction with the MAIE mentioned above, or possibly the Small Corporate Offering Registration (SCOR). In either case, the use of finders is not problematic in those situations since the MAIE allows some limited advertising and SCOR is a small public offering. Also, in a securities offering, the compensation to be paid to finders must be disclosed in the securities disclosure document. In addition, in some instances, the total offering expenses including any selling expenses may be limited by state law.

Note further, that two states: Michigan and Texas, now require that finders be registered with the state’s securities regulatory authorities. So, if you plan to raise money in those states, be sure and review their respective finder regulations. Other states may follow.

4. SEC No-Action Letter – The narrow line between “finders”– who locate prospective investors in business ventures – and licensed broker/dealers in the securities world continues to get more difficult to walk safely. In No Action Letter, Brumberg, Mackey & Wall (May 17, 2010), the SEC just denied “No Action” assurance (i.e., that the SEC won’t take enforcement action against the requesting party) for a finder’s exemption from broker-dealer registration under Sec. 15(b) of the Securities Exchange Act. The finder (a law firm) proposed helping a company raise funds to finance its operations and development by introducing the company to individuals and entities that might invest in equity or debt instruments of the company. While the finder in this case apparently was to have played a fairly limited role, arguably consistent with that of a mere finder, what particularly triggered the broker/dealer registration requirement in the SEC’s view was the fact that the finder would receive transaction-based compensation in the form of a cash referral fee equal to a percentage of financing raised through the finder’s introductions, payable upon closing of the financing. The SEC declared that “a person’s receipt of transaction-based compensation in connection with these activities is a hallmark of broker-dealer activity.” The SEC was also concerned that the finder in this case would be pre-screening the investors, as well as conditioning the market by “pre-selling” to some extent, which further induced it to conclude that brokerage registration might be required. Thus, it is important once again to limit the finder’s activities to that of merely introducing the buyer and seller.

5. Further Resources – The finder question in Utah is discussed in an article entitled “Finding a Solution to the Problem with Finders in Utah” by Brad R. Jacobsen and Olympia Z. Fay, Utah Bar Journal, April 24, 2006. An article arguing that a category of finders ought to be regulated (“Legitimizing Private Placement Broker-Dealers Who Deal with Private Investment Funds:A Proposal for a New Regulatory Regime and a Limited Exception to Registration”) appears in Volume 40, page 703 of The John Marshall Law Review, 2006 (written by Robert Connolly). Another similar article making the same argument (“Improving the Efficiency of the Angel Finance Market: A Proposal to Expand the Intermediary Role of Finders in the Private Capital Raising Setting”) by John L. Orcutt, appears in Volume 37 of the Arizona State Law Journal at page 861 (2005). Also John Polanin, Jr. wrote “The ‘Finder’s’ Exception from Federal Broker-Dealer Registration” and it appears in Volume 40 of the 1990-1991 Catholic University Law Review at page 787. None of this is light reading, so good luck. In the meantime, just review the above brief summary of the contents of these authoritative articles, which the 2010 SEC No Action letter, confirms.

Recently, I went online and conducted a search for “film finance blogs”, to see what information was being offered to filmmakers regarding this somewhat difficult but necessary aspect of independent filmmaking. Most of the articles agreed that many independent films will find it necessary to cobble together financing from 4 to 5 different sources, and that a so-called “finance plan” needs to be created to guide the independent filmmaker through the process. This approach is not necessary, however, for many ultra-low budget and low budget independent films because they can rely either on crowd funding, investor equity or a combination of the two. In any case, these finance plans might indicate that varying percentages of a proposed film’s budget would come from sources such as crowd funding, equity investors, federal, state or international tax incentives, foreign pre-sales and possibly a small percentage from GAP financing.

There is actually no limit to the combinations of the forms of film finance involved in a film finance plan, after all, my own book “43 Ways to Finance Your Feature Film” discusses in some detail, at least 43 different ways of financing a feature or documentary film, and at last count some 62 different ways in the book’s third edition (additional information on the book can be found at https://www.filmfinanceattorney.com in the “Film Finance Books”. These online articles, however, all seemed to agree that the largest component of such a film finance plan is the so-called equity (investor) portion or component. None of the articles provided much information, however, about what is involved in this largest part of the independent film’s finance plan. So, let me sketch out something about one of the most important starting points in equity financing.

First, we have to organize our thinking to recognize that there are two different kinds of investors (i.e., the folks that provide equity financing). There are active investors and then there are passive investors. As a general rule, this distinction marks the critical difference between a non-securities offering and a securities offering. At first blush, most filmmakers would naturally like to avoid the cost and complications of a securities offering, so they may initially want to opt for the active investor route. Sometimes these active investors are referred to as “angel investors”. They may also call themselves “venture capitalists”, although as a general rule, independent film is typically too risky for most of the organized venture capital firms.

Unfortunately, the definition of an active investor is not as loosey-goosey as some filmmakers and their advisors would like for us to believe. The term has been carefully defined by several federal appellate courts in cases that dealt with the questions relating to what is a security and who can be an active investor. I discuss these definitions of a security and the active investor in some detail in my article published in the May 2010 Los Angeles Lawyer magazine, a copy of which appears at my above-cited website in the “Film Finance Articles” section under the title “Contingent Promissory Notes as a Film Finance Method – Are Filmmakers Being Misled?” In addition, the actual sources of the law on this issue are cited in this article.

Generally speaking, active investors must (1) have knowledge and experience in the relevant industry; (2) they must be regularly involved in helping to make the important decisions relating to the project, and (3) the filmmaker’s written agreement with them must clearly authorize them to be actively involved in that decision making. If these requirements are not met and the question goes to a court, the judge will consider the investment a security, and if the filmmaker made no attempt to comply with the federal and state securities laws, he or she may be guilty of selling an unregistered security, which of all the inconveniences, is a felony.

Of course, it would be great, if a filmmaker could easily find one, two or three active investors who would put up all of the money needed to produce the filmmaker’s film or meet the needs of the equity component of the film’s finance plan. But, several very important disadvantages of relying on active investors confront any filmmaker: (1) In the real world, there is a much smaller population of investors who are willing to or capable of investing large sums in a risky venture such as independent film. (2) There are fewer still who have “knowledge and experience” in the film industry, as required by law. (3) There is always the risk that someone who puts up a lot of money to produce a motion picture will start throwing their weight around and insist on different creative decisions than the filmmaker originally envisioned.

Quite often, filmmakers are attracted to active investor financing because it seems simpler — theoretically the filmmakers would be pitching their projects to fewer prospective investors, the business plan is the only document needed to provide information to the prospective investors, and although ultimately some form of investment vehicle will be needed (after all, a business plan is not an investment vehicle), many business plan consultants encourage the filmmakers to defer the decision relating to choice of investment vehicle until negotiations are underway with a serious investor prospect. It seems that few such advisors reveal to filmmakers that it is always difficult to determine whether a prospective investor is serious, and the filmmaker won’t know that for sure until an appropriate document is put in front of the prospective investor to sign (i.e., the kind of document typically associated with an active investor investment vehicle). Of course, if the filmmaker is not actually obtaining the prospective investor’s funds at the time of signing, there is always the possibility that the prospective investor will back out of the deal, and as noted in one of the online articles mentioned above, the filmmaker’s remedies in such a case are quite limited (for help in determining which informational document to present to prospective investors, see my article “Business Plans or Securities Disclosure Document” at my website.

An alternative to the active investor scenarios is to seek to raise money from a larger group of passive investors. The advantage is that passive investors do not interfere with the filmmakers’ creative decision-making. They are prohibited by law from doing so. A further advantage is that the filmmaker is asking each prospective investor to invest a smaller sum, thus it may be easier to convince an individual to part with a small amount of money. A third advantage is that there are a lot more small investors out there than there are large investors. One disadvantage is that the filmmaker will have to pitch the project to a larger number of prospective investors and a second perceived disadvantage is that the federal and state securities laws do apply, and compliance with those laws is difficult.

On the other hand, the filmmaker’s decision to hire a knowledgeable securities attorney who has specialized expertise with film offerings can significantly reduce the complexity of a securities offering, and that decision is not so different from hiring many other specialists who are brought on by the filmmaker to help in the development, financing, production and/or distribution of a feature film. The decision to hire the securities attorney just comes at an earlier point in the life of the project, when most independent filmmakers have limited funds (for tips on how to deal with such a situation see the article “Financing a Feature Film From the Ground Up”).

Thus, as stated in my book “43 Ways” there is no easy way to finance a feature or documentary film and each form of film finance has its own associated advantages and disadvantages. Just be careful. When someone starts aggressively pushing you toward the use of a business plan and the active investor approach to raising the equity component for your film’s finance plan, be sure to consider all of the advantages and disadvantages before using that approach. It may not be appropriate for your specific circumstances.

This article is limited to the important threshold question relating to whether a security is being sold. Additional information relating to this and other associated issues appears in the 16 articles posted on my website (https://www.filmfinanceattorney.com), in my six books about film finance (described at the website) and in the “Finance Forum” where I’ve been answering the questions of independent filmmakers regarding investor financing of independent film for more than fifteen years (see “Finance Archives”).

Good luck and be thorough in your investigation.

As we have noted in previous articles, if an independent filmmaker is seeking to raise money from passive investors, he or she is selling a security, thus in order to make the offering legitimate and prevent a cease and desist order from being issued by a securities regulator, it is important to comply with the federal and state securities laws. Usually, independent film offerings are structured as offerings of units in a manager-managed limited liability company (LLC) or limited partnership (LP), and sometimes, though less often, as corporate stock offerings.

These securities may be sold in three ways: (1) broker/dealer sales, (2) finder sales or (3) issuer sales. Unfortunately, broker/dealers are typically not that interested in raising money for independent films. Such investments are considered too risky. As discussed in my earlier article re finder sales, the activities of finders are limited to merely introducing the buyer and seller (i.e., the investor and the film producer for purposes of this article), and in private placements (i.e., Regulation D, Rule 505 or 506 offerings) that finder introduction must occur prior to the start of the offering. Thus that leaves us with the third option: issuer sales.

The SEC has a rule, commonly referred to as the “issuer exemption” or “issuer sales rule” (Rule 3a4-1 of the Securities Exchange Act of 1934), which sets out the parameters under which someone associated with the issuer of a security would be able to sell the securities for the issuer without being considered to be a broker and thus required to register as a broker. In other words, certain persons associated with an issuer (i.e., the film producer seeking to raise money from passive investors for purposes of this article) may help to raise money on behalf of the producer/issuer without having to register as a broker. The term associated person of an issuer means any natural person who is a partner, officer, director or employee of that issuer. Again, the securities issuer for purposes of this discussion is the independent film production company, or the actual investment vehicle (i.e., the LLC, LP or existing corporation).

Here is a summary of those parameters:

1. The associated person must not be statutorily disqualified – meaning he or she has not engaged in certain prohibited acts in the past five years (e.g., mail fraud). See section 3(a)(39) of the ‘34 Act for a more complete listing of the prohibited acts.
2. The associated person must not be compensated in connection with his or her participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities. In other words, no transaction-related remuneration is allowed.
3. The associated person is not at the time of his or her participation an associated person of a broker or dealer.
4. The associated person primarily performs, or is intended primarily to perform at the end of the offering, substantial duties for or on behalf of the issuer otherwise than in connection with transactions in securities.
5. The associated person was not a broker or dealer, or an associated person of a broker or dealer, within the preceding 12 months.
6. The associated person does not participate in selling an offering of securities for any issuer more than once every 12 months.

Thus under current law, when independent film producers seek to raise money from private investors in a private placement context (e.g., Regulation D, Rules 505 or 506) and they need to enlarge the pool of prospective investors with whom they have a pre-existing relationship, such producers may be able to bring persons meeting the above requirements on board, and then rely on the pre-existing relationships of such persons for purposes of expanding the available pool of prospective investors. Such an arrangement significantly increases the likelihood that the offering will be successful, and based on a experience, such an approach is more effective for the investor financing of independent films than either broker/dealer sales or finder sales.

But stay tuned! The “Final Report of the 2010 SEC Government-Business Forum on Small Business Capital Formation” (dated June 14, 2011), included a recommendation that the SEC should allow so-called “private placement brokers” to assist issuers in raising capital through private placements of their securities offered solely to “accredited investors” in amounts per issue of up to 10% of the investor’s net worth (excluding his or her primary residence), with full written disclosure of the broker’s compensation and any relationship that would require disclosure under Item 404 of Regulation S-K, in aggregate amounts of up to $20 million per issuer. As of this writing, the SEC has not yet acted on this recommendation.

In my work with independent film producers in the area of film finance over the past twenty years or so I have often observed that many such filmmakers do not have strong opinions about what form of film finance to pursue. They just want the money to produce their films and don’t really want to be bothered with the details. After all, most film schools do not offer courses in film finance and most independent filmmakers simply do not have the background or training in finance generally, or in film finance specifically. Partly due to this lack of experience and sophistication in finance on the part of the filmmakers, and partly because the costs associated with producing films are often significant, the film finance marketplace sometimes attracts unscrupulous promoters of various forms of film finance. These promoters of film finance repeatedly use bogus reasons in their attempts to persuade filmmakers to use whatever form of film finance they promote, not because it’s the best form of film finance for the specific film project, but because it is to the benefit of that particular film finance promoter. The advent and wider use of the Internet and its various subject matter oriented blog sites offer greater opportunities for these unscrupulous promoters of film finance methods to market their ideas and confuse filmmakers. Thus, independent film producers must be very cautious. Watch out for the overly aggressive promoters of any particular film finance method when they do not seem to be able to acknowledge that their form of film finance has not only some advantages in certain situations, but also some disadvantages.

In my book, 43 Ways to Finance Your Feature Film I took the position that there is no single best way to finance a feature or documentary film. Rather, there are quite a few different ways to accomplish this objective and each form of film finance has its own set of advantages and disadvantages. It is important that independent producers embarking on the film finance challenge develop a good solid understanding of which form or forms of film finance may be best suited for their particular project. This article focuses on the advantages and disadvantages of lender and investor financing, also known as debt versus equity.

In a general sense, debt involves borrowing money to be repaid, plus interest. Repayment is usually on a date certain. On the other hand, equity involves raising money by selling interests in the company. For a corporation, those interests would be stock. For a limited liability company (LLC) or limited partnership (LP) those interests are commonly referred to as “units”. The following table discusses the advantages and disadvantages of debt financing as compared to equity financing.

Advantages of debt compared to equity:

• A lender does not typically have a claim to equity (i.e., ownership) in the business and debt does not dilute the owner’s ownership interest in the company.
• A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business. If the company is successful, the owners may reap a larger portion of the rewards than they would if they had sold ownership interests in the company to investors in order to finance the venture.
• Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecast and planned for.
• Interest on the debt can be deducted on the company’s tax return, lowering the actual cost of the loan to the company.
• Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.
• The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions. These latter two considerations only apply to corporations. Manager-managed LLC and limited partnerships do not require the meetings and investor approval on most issues.

Disadvantages of debt compared to equity:

• Unlike equity, debt must at some point be repaid, and if not repaid, whatever assets were put up as collateral for the loan, will be taken by the lender.
• Interest is a fixed cost which raises the company’s break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt.
• Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the company.
• Debt instruments often contain restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities.
• The larger a company’s debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
• The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.

The bottom line is that debt must be repaid. If any form of collateral is put up for that debt, and the loan is used to produce an independent film, there is a really good chance that the independent producer will not be able to repay the loan principal and interest on the specified due date, thus whatever collateral is put up will be lost. That is not to say that there may be some situations where an individual producer may want to take that approach. That’s fine. As noted above, in investor financing situations (i.e., equity) there is more work involved in the offering and some burdensome regulations with which to comply (and with which securities attorneys are available to help), but the investor financing approach allows the independent producer to spread the risk amongst a large group of passive investors who know that their money may be lost. As pointed out in my article on investor motivation, there are quite a few reasons why people may want to invest in one or more independent films other than solely for profit, although in the back of their mind, there may always be the hope that the film will turn out to offer a significant upside potential.

Now, the above represents the more traditional pros and cons of a debt versus equity discussion, much of which is drafted for the context of corporate finance (not often used for independent films). The manager-managed LLC or the limited partnerships are the more common investment vehicles for such project financing.

In addition, the most common lender transactions in the film industry do not quite fall into any of the categories described above. They typically are not supported by hard assets, so to speak, rather by distributor contracts. Those transactions may take the form of worldwide negative pickups, domestic and international split rights deals or foreign pre-sales. If the film producer can obtain a distribution agreement and guarantee from a credit-worthy distributor, the producer may be able to use that agreement or those agreements as effective collateral for the loan. Unfortunately, this form of lender financing of feature films is not available for most of the films sought to be produced by independent film producers (see discussion of lender financing in my book “43 Ways to Finance Your Feature Film” (published by Southern Illinois University Press). Also see my article “Contingent Promissory Notes as a Film Finance Method – Are Filmmakers Being Misled?” at ArticlesBase.com.

Independent producers seeking to raise funds to produce a motion picture and conducting a so-called exempt or private placement type offering in reliance on the SEC’s Regulation D, often are asked the question by their prospective investors: “Can I resell these LLC units to someone else?” This brief article seeks to answer that question.

Units in a manager-managed LLC or limited partnership offering are securities. If the offering is not registered with the SEC (i.e., a public offering – and such independent film offerings rarely are) then it must qualify for an available exemption from the registration requirement. The SEC’s Regulation D is the most commonly used exemption. Units sold pursuant to Regulation D are considered restricted securities (i.e., one of the conditions imposed on the use of the Regulation D exemption is that the units cannot be resold unless certain other conditions are met).

The SEC’s Rule 144 sets out five conditions under which such restricted securities can be resold. The final three of those five conditions as set out below only apply to affiliates of the issuer. Purchasers of securities who are not affiliates of the issuer need only comply with conditions (1) and (2). An affiliate of the issuer is a person in a control relationship with the issuer of the securities. In this sense, “control” means the power to direct the management and policies of the company in question, either through the ownership of voting securities, by contract or otherwise.

Conditions That Apply to Non-Affiliates:

(1) Holding Period – Unless the entity that issued the securities is subject to the reporting requirements of the Securities Exchange Act of 1934, the investor must hold the securities for at least one (1) year (six months for the securities of reporting companies). The holding period begins when the securities were bought and fully paid for.

(2) Current Information – There must be adequate current information about the issuer of the securities before the sale can be made. As a practical matter, this means that the information provided to the original purchaser of the units (most likely in the form of a private placement offering memorandum – PPM), assuming it met whatever disclosure standard applicable to the original offering, needs to be brought current and made available for review by the this secondary investor before the sale is made.

Additional Conditions That Apply to Affiliates:

(3) Trading Volume — If the original investor was an affiliate of the issuer, the number of equity securities he or she may sell during any three-month period after the one year term, cannot exceed the greater of 1% of the outstanding units sold.

(4) Ordinary Brokerage Transactions – If the original purchaser is an affiliate of the issuer, and the resale is to be made through a broker/dealer, such sales must be handled in all respects as routine trading transactions, and the broker may not receive more than a normal commission. Neither the individual re-seller nor the broker can solicit orders to buy these restricted securities.

(5) Notice of Proposed Sale – If the original purchaser is an affiliate, such person must file a notice with the SEC on Form 144 if the sale involves more than 5,000 units or the aggregate dollar amount is greater than $50,000 in any three-month period. The sale must take place within three months of filing the Form and, if the securities have not been sold, an amended notice must be filed.

In situations where the issuer provides some form of certificate to the original investor with a legend stating that the securities are restricted, the legend has to be removed before re-selling the security.

The new crowdfunding law passed by both houses of Congress and signed into law by the President (H.R. 3606 – the Crowdfund Act) sets out specific requirements for funding portals at Section 304(b). The term “funding portal” means any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6) of the Securities Act of 1933, that does not:

(a) offer investment advice or recommendations;

(b) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal;

(c) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal;

(d) hold, manage, possess, or otherwise handle investor funds or securities; or

(e) engage in such other activities as the Commission, by rule, determines appropriate.

Registration – Funding portals must register with the SEC and with any applicable self-regulatory organization as defined in Section 3(a)(26) of the Securities Exchange Act of 1934.

Disclosures – Funding portals must also provide certain disclosures (i.e., written information given to each prospective investor before they invest), including disclosures related to risks and other investor education materials, as the SEC determines by rule, to be appropriate.

Investor Education – These funding portals must also ensure the following with respect to each investor utilizing their facility:

(a) reviews investor-education information, in accordance with standards established by the SEC rule to be promulgated;

(b) positively affirms that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss; and

(c) answers questions demonstrating the following:

(i) an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers;

(ii) an understanding of the risk of illiquidity; and

(iii) an understanding of such other matters as the Commission determines appropriate, by rule.

Background Checks – The funding portals must also take such measures to reduce the risk of fraud with respect to such transactions, as established by the SEC, by rule, including obtaining a background and securities enforcement regulatory history check on each officer, director and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by such person.

Providing Issuer Information to SEC – Then, not later than 21 days prior to the first day on which securities are sold to any investor (or such other period as the SEC may establish), make available to the SEC and to potential investors any information provided by the issuer pursuant to section of this law relating to issuer disclosure (i.e., Subsection (b).

Offering Proceeds – The funding portals must also ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than a target offering amount, and allow all investors to cancel their commitments to invest, as the SEC, by rule, determines to be appropriate.

Investment Limits – Further, the funding portals must make such efforts as the SEC determines appropriate, by rule, to ensure that no investor in a 12-month period has purchased securities offered pursuant to section 4(6) that, in the aggregate, from all issuers, exceed the investment limits set forth in section 4(6)(B) [see earlier article re the crowdfunding requirements for issuers) .

Privacy of Investor Information – In addition, the funding portals must take such steps to protect the privacy of information collected from investors as the SEC determines, by rule, to be appropriate.

Compensation – The funding portals may not compensate promoters, finders or lead generators for providing a broker or funding portal with the personal identifying information of any potential investor.

Financial Interests in Issuers – The funding portal’s directors, officers or partners (or any person occupying a similar status or performing a similar function) is prohibited from having any financial interest in an issuer using its services.

SEC Rules – The funding portal will have to meet such other requirements as the SEC may, by rule, prescribe, for the protection of investors and in the public interest.

JOBS Act (HR 3606) Title II – Removing General Solicitation Prohibition from Certain Reg. D, Rule 506 Offerings

SEC must promulgate rules

General solicitation and advertising restrictions do not apply to offerings conducted pursuant to Rule 506 under Regulation D, provided that the issuer takes reasonable steps to verify that each ultimate purchaser is an accredited investor.

As most independent film producers now know, on April 5, 2012, President Obama signed into law the so-called Jumpstart Our Business Startups (JOBS) Act (H.R. 3606). The new law combines several pieces of stand-alone legislation and refers to each section as a Title.

Title I relaxes certain offering, disclosure and compliance requirements for a class of companies categorized as emerging growth companies (EGCs) and institutes certain reforms relating to the initial public offering (IPO) process.

Title II requires the SEC to promulgate rules providing that general solicitation restrictions do not apply to offerings conducted pursuant to the SEC’s Regulation D, Rule 506 under certain circumstances. The Title II provisions are the subject of this article.

To continue, however, with a brief statement of the subjects addressed in the remaining sections of the new law, Title III creates a new exemption under the Securities Act for investment-based “crowdfunding.” Those provisions are discussed in my two earlier articles (“The New Crowdfunding Law As Applied to Filmmaker Issuers” and “Funding Portal Requirements Under the New Crowdfunding Law”) both of which were also previously posted here at BaselineIntel.com in their “ResearchWrapBlog”).

Title IV provides a new exemption from the registration requirements of the Securities Act of 1933 modeled on Regulation A, which is being referred to as “Regulation A+”. This new exemption increases the permitted size of Regulation A offerings to $50 million of unrestricted securities within a 12-month period to investors, who need not be accredited, subject to the annual filing of audited financial statements and other conditions to be prescribed by the SEC, including periodic reporting requirements.

Titles V and VI of the JOBS Act raise the shareholder thresholds under Section 12(g) of the Exchange Act before a private company is required to register as a public reporting company.

So, back to Title II – the removal of the general solicitation restrictions for Regulation D, Rule 506 offerings. This provision of the new law requires the SEC to promulgate rules within 90 days, providing that the general solicitation and advertising restrictions do not apply to offerings conducted pursuant to Rule 506 under Regulation D, provided that the issuer takes reasonable steps to verify that each ultimate purchaser is an accredited investor. The SEC will presumably provide guidance with respect to what steps are reasonable in its forthcoming rules.

The SEC’s Regulation D sets forth 8 different categories or individuals or entities that are considered “accredited”. Two of those apply to natural persons:

(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000 (exclusive of the primary residence of such person) and

(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

Title II of the JOBS Act also requires that the SEC amend Rule 144A to provide that securities may be offered by means of general solicitation or general advertising, including to persons other than qualified institutional buyers (QIBs), so long as the issuer reasonably believes that each ultimate purchaser is a QIB.

The SEC’s Rule 144 sets out the requirements relating to the re-sale of restricted securities, such as securities originally purchased pursuant to a Regulation D, Rule 506 offering. Those specific requirements are discussed in my article “Re-Selling Units of a Private Film Offering” (also posted at BaselineIntel.com in their “ResearchWrapBlog”).

The term qualified institutional buyer refers to institutions that manage at least $100 million in securities including banks, savings and loans institutions, insurance companies, investment companies, employee benefit plans, or an entity owned entirely by qualified investors. Also included are registered broker-dealers owning and investing, on a discretionary basis, $10 million in securities of non-affiliates.

As a consequence, in future Regulation D, Rule 506 transactions, the issuers of securities and/or their financial advisors would need to obtain detailed representations and warranties from potential investors regarding their accredited investor or QIB status. Without benefit of the SEC rules relating to this issue, it is presumed that such action on the part of the issuer will be sufficient to verify the status of each ultimate purchaser in the transaction. Thus, it is very likely that certain modifications will have to be made to the private placement offering memoranda and subscription documents used in marketing this new form of private placement.

It is important to keep in mind that the legislation did not change current law, since it is not effective until the SEC promulgates its related rules. Thus, until the SEC issues its new rules relating to these Regulation D, Rule 506 private placements, the existing rule mandating that a pre-existing relationship exist between the issuer and its prospective investors is still in effect.