Contingent Promissory Notes as a Film Finance Method – Are Filmmakers Being Misled?
By John W. Cones
Some entertainment attorneys recommend that independent producers seeking to finance the production costs of an independent film, raise the money through use of contingent promissory notes. These attorneys suggest that such notes are considered “debt” and therefore are not securities. Thus, according to these attorneys, compliance with the securities laws is not required. In other words, their advice appears to be partly motivated by either the attorney or the client’s desire to avoid what they consider to be the burdensome and potentially costly task of complying with the federal and state securities laws. Such promissory notes are typically either not collateralized, not adequately collateralized, not guaranteed, not insured or otherwise secured. The repayment of such notes is dependent upon the financed film earning sufficient revenues to repay the note or notes.
Unfortunately, this advice is extremely risky and overlooks most of a significant body of both federal and state statutory and case-made law regarding the question of whether promissory notes are securities. And, of course, if the promissory notes being offered by an independent film producer are securities, he or she would need to comply with the federal and state securities laws, including the antifraud rule, in order to avoid potential criminal or civil liability.
Part of the problem for the practitioner, however, is knowing in advance which interpretation of the law will apply to a particular client’s situation, and the standard used does vary, with at least three distinctive tests being applied. It is particularly problematic because independent film producers from other states commonly do seek entertainment law advice from Los Angeles-based attorneys. The problem becomes even more complicated when one relaizes that this issue can be raised, in federal or state court, civil or criminal proceedings.
Because there are three separate standards, and because it is not clear which standard may be applied years into the future, the better practice may be to avoid running afoul of any of these three commonly used tests. The respective tests for determining which financial transactions involve the sale of a security are commonly referred to as:
1. the “family resemblance” test;
2. the “Howey” test; and
3. the “risk capital” test.
The “family resemblance” test is used uniformly in Federal law situations.1 The “family resemblance” test is also the primary test used in state civil and administrative cases.2 The “Howey” test is primarily used in state criminal cases.3 The “risk capital” test is purportedly the primary test being used in the state of California for both civil and criminal proceedings,4 although the actual language of the courts in certain of those cases (as discussed below) appears to mix the “risk capital” test with the “Howey” test.
At the federal level, the 1933 Securities Act definition of a security,5 specifically includes “notes,” “bonds,” “debentures” and “evidences of indebtedness”. Thus, at first blush it would appear that all notes are securities, although the ‘33 Act also excludes from the securities registration requirement some notes with maturities no longer than nine months.6 On the other hand, a promissory note with a maturity date of less than nine months is of little use in the production financing of a feature film, although such short-term notes may be helpful for the bridge financing associated with the development and packaging of a film project.
For many years, the various federal appellate courts produced confusing and inconsistent standards with respect to the question as to what kind of notes were to be considered securities and which were to be exempt from the securities registration requirement. In 1990, the U.S. Supreme Court resolved much of the conflict for federal courts by excluding from securities coverage, debt instruments that resemble standard commercial, as opposed to investment, transactions.7
The leading federal case (Reves v. Ernst & Young), dealt with uncollateralized, uninsured demand notes. The Court held that the 1933 Act creates a presumption that any note in excess of nine months is a security.8 The Court, however, did not suggest that notes less than nine months were not securities. In point of fact, earlier case law has rather uniformly held that short-term notes are securities, as well, if they have investment characteristics. As an example, in the Briggs v. Sterner case,9 short-term demand notes, offered to obtain risk capital, were held to be securities. Thus, it would appear that even the short-term promissory note being used to raise funds for the development and packaging of a feature film may also have to be considered to be a security.
The Court in Reves went on to adopt the so-called “family resemblance” test that allows the above-noted presumption (that a note is a security) to be rebutted if the issuer of the note (i.e., the independent producer) can show that the note bears a “strong family resemblance” to items on a list of exceptions created by the courts. The notes in that list include the following:
1. notes delivered in consumer financing;
2. notes secured by a home mortgage;
3. short-term notes secured by a lien on a small business or some of its assets;
4. a character loan to a bank customer;
5. short-term notes secured by an assignment of accounts receivable;
6. open-account debt occurred in the ordinary course of business; and
7. a loan by a commercial bank for current operations.10
Readers should note carefully that the contingent promissory note typically used by independent film producers to finance the production costs of their films are not listed, and therefore, once again, must be considered to be a security. Thus, compliance with the federal and state securities laws is required for the issuance of such promissory notes.
However, the Supreme Court in the Reves case offered another narrow possibility. It held that the above list could actually be expanded if certain standards were met. The Court stated that the following four factors should be considered in determining whether another form of note should be added to the list:
1. Motivations of the Buyer and Seller – If the purpose of the seller of the notes (i.e., the film producer) is to raise money for the general use of a business enterprise or to finance substantial investments (e.g., the production costs of a feature film), and the buyer of the note is interested primarily in the profit the note is expected to generate, the instrument is very likely to be considered a security. On the other hand, if the money is used to acquire a minor asset or consumer good, to correct the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, the note is less likely to be a security.
2. Plan of Distribution – If there is general, widespread distribution of the instrument, it is more likely to be a security.
3. Reasonable Expectations of the Investing Public – The Court will consider instruments to be “securities” on the basis of the reasonable expectation of the investing public.
4. Risk-Reducing Factors – If the application of the Securities Act is rendered unnecessary due to the existence of risk-reducing factors, thus eliminating the need for the application of the Securities Acts. As an example, bank certificate of deposits are not considered securities because of the elimination of risk through federal insurance.11
This four-factor federal “family resemblance” test has been criticized in a law review article for being ambiguous and for not making clear whether all four factors have to be present.12 However, Professor Stuart Cohn of the University of Florida College of Law expresses the opinion that not all four factors must be present. He writes specifically with respect to factor #3, that the perceptions of unsophisticated investors, unaware of whether an instrument is a security, would not control the question if other factors indicated that a security was in fact being issued.13
Once again, however, it is highly likely that a contingent promissory note used to provide the financing the substantial costs associated with the production of a feature or documentary film, without the presence of significant risk-reducing factors, would be considered a security using this test, regardless of what the investor’s expectations were or whether there was widespread distribution of the instrument. Thus, pursuant to the “family resemblance” test, it is not likely that such notes would be added to the list of instruments that are not considered securities.
As noted earlier, many state court decisions on this issue, based on definitions of securities that mirror the federal definition, have been consistent with the Supreme Court’s view (applying the “family resemblance” test), while others, including California, have not. In an effort to bring about more uniformity amongst the states with respect to the regulation of securities generally, Congress enacted the National Securities Markets Improvement Act (“NSMIA”) in 1996.14 NSMIA however, allowed states to continue to rely on their own definitions of what notes should be considered securities. Thus, state law is still the final authority on state law questions.15 Although, as seen below, the state courts often look to federal case law for guidance.
California does not follow the “family resemblance” test of Reves. Instead, California courts are known for using the so-called “risk capital” test which was first established (although not explained very clearly) in the Silver Hills Country Club v. Sobieski case in 1961.16
California and other states have also recognized that not every note is a security. As early as 1939 the California Supreme Court observed that “it plainly was not the legislature’s intent that ‘every’ note or evidence of indebtedness, regardless of its nature and of the circumstances surrounding its execution, should be considered as included within the meaning and purpose of the [securities] act.”17
The California Supreme Court has also consistently held that substance prevails over form in such transactions. In its Silver Hills case the Court conceded that the substance of a transaction is more important than its form by saying: “To effectuate this purpose the courts look through form to substance.”18 More recently, in the 1986 California Supreme Court case of People v. Figueroa19 the Court stated that “ . . . it is not the label affixed to a particular instrument which determines whether it constitutes a ‘security’. [In] searching for the meaning and scope of the word ‘security’ in the Act, form should be disregarded for substance and the emphasis should be on economic reality.”20 In addition, the Court in People v. Figueroa stated further that it would look to federal decisions for guidance on the issue of what constitutes a security.21 Meanwhile, back at the federal level, the U.S. Supreme Court reaffirmed its commitment to the principle that substance governs over form in 1985.22
California’s Silver Hills case, concerned the sale of country club memberships. The California Supreme Court stated that Section 25008 of the California Corporations Code “defines a security broadly to protect the public against spurious schemes, however ingeniously devised, to attract risk capital.”23 The Court went on to say in Silver Hills that “ . . . [The] objective [of the Corporate Securities Laws] is to afford those who risk their capital at least a fair chance of realizing their objectives.”24 The Court said the country club in this case was “ . . . soliciting the risk capital with which to develop a business for profit. The purchaser’s risk is not lessened merely because the interest he purchases is labeled a membership. Only because he risks his capital along with other purchasers can there be any chance that the benefits of club membership will materialize.”25 The Court held that the state’s corporate securities act was “clearly applicable” to the sale of the promotional memberships, and went on to add that “otherwise it could to easily be vitiated by inventive substitutes for conventional means of raising risk capital.”26
In at least two other California cases, promissory notes have been held to be securities because in the view of the court the transactions fell within the regulatory purpose of the law (i.e., to protect the public against spurious schemes to attract risk capital). In People v. Leach,27 upheld by In re Leach28 the Court of Appeals held that undersecured notes on real property were securities because they were “[unloaded] upon a trusting public . . . for a consideration far in excess of their reasonable value” and, therefore did not “protect the public against the imposition of [an] unsubstantial scheme . . .”29 Also, in People v. Walberg30 the Court found that unsecured, interest-bearing promissory notes that were issued for loans solicited for the purpose of refurbishing a hotel were in fact, securities. The court partly reasoned that the scheme “was quite as dangerous to investors as the typical blue-sky promotion of mining stocks and royalties31 In these and other similar cases, the courts have kept in mind that the general purpose of the state’s securities laws is to protect the public against fraudulent investment schemes.32
Subsequently in the 1986 case of People v. Figueroa, the Court considered the question of whether promissory notes were securities within the meaning of the Corporate Securities Law.33 Although the Court cited the Silver Hills “risk capital” test with approval, it also went on to analyze both federal and state cases and actually applied something more akin to a mix of California’s “risk capital” test with elements of the long-standing federal “Howey” test for investment contracts.34
The federal landmark Howey case (involving an investment contract) held that if a scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others, that would be a security.35 Subsequently in United Housing Foundation, Inc. v. Forman36 the U.S. Supreme Court revised and restated the “Howey” test slightly by holding that “The touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
Incidentally, it makes no difference whether the expected profits are expressed as a percentage participation or as interest. The California Supreme Court in People v. Figueroa stated that: “The return on any investment which has not been secured with adequate collateral depends on the success of the business. This is true whether the investment contemplates a percentage of the profits or a fixed return.”37
On the other hand, the California Supreme Court in People v. Schock pointed out that “The mere expectation of a return on an investment, together with the right of repayment, does not – without more – subject the transaction to security regulation.38 As an example, the sale of a security was not involved in the case of Hamilton Jewelers v. Department of Corporations 39 which dealt with the offer for sale of a diamond with a right of return for the full purchase price plus five percent interest. The court reasoned that no risk capital was placed with the jeweler and the diamond itself served as adequate collateral. California courts have further held that in promissory note situations where an investor receives adequate collateral and no risk capital is subject to the managerial efforts of the promoter of the investment scheme, such a business transaction is not likely to be considered to involve the sale of a security.40
However, inadequacy of collateral is a problem. The Court in People v. Schock, also stated: “ . . . a finding of inadequacy of collateral, in addition to the investors’ dependency on the promoter’s success for a return on the investment, will subject the superficial loan transaction to security regulation.41 Inadequacy of collateral is thus an important factor in determining whether promissory notes are securities. However, inadequacy of collateral is not the only factor to be considered. As noted in Silver Hills42 “ . . . a passive position on the part of the investor; and the conduct of the enterprise by the issuer with other people’s money . . .” are factors that also should be considered.43
There is one reported California case involving promissory notes and the film industry in which the court determined that the transaction was not a security.44 However, if the same or similar circumstances were considered today, the outcome is likely to be different. In People v. Syde,45 the transaction (held not to be a security) was between a purported film and television production company and the parents of children who were to be given acting training and featured in the film along with other children. The cast members were to be paid for their services and receive a percentage participation in the company’s gross receipts upon the sale or distribution of the completed movie. The court reasoned that it is settled that the state’s securities laws “ . . . were not intended to afford supervision and regulation of instruments which constitute agreements with persons who expect to reap a profit frm their own services or other active participation in a business venture. Such contracts are clearly distinguished from instruments issued to persons who, for a consideration paid, stipulate for a right to share in the profits or proceeds of a business enterprise to be conducted by others; and the court will look through form to substance to discover whether in fact the transaction contemplates the conduct of a business enterprise by others than the purchasers, in the profits or proceeds of which the purchasers are to share.46
Unfortunately, the court did not distinguish between the parents (the actual investors) and the children who cannot, by any stretch of the imagination, be considered to be active in the sense that they are involved in management in any meaningful way. Also, even though the parents accompanied the children to their rehearsals, they were not permitted in the rehearsal studio, much less given any say with regard to management of the project.
It is true that where profits 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 not likely to consider that arrangement a security.47 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. Tucker48 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:
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 Corporations49 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 (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”.
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.”50
Thus, if the circumstances of the 1951 People v. Syde case were revisited today, it is very unlikely that the decision would be the same. Because of the subsequent refinements created with respect to who may be considered to be an active investor in an investment transaction, it is clear that neither the parents, nor the children in People v. Syde would qualify pursuant to the standards established in Williamson v. Tucker or Consolidated Management.
Consequently, a film producer issuing one or more promissory notes to finance the production of a motion picture when the maturities for such notes exceed nine months, would have to presume that such notes are securities. And, even in situations where the notes are short-term demand notes, if they are offered to obtain risk capital (which is typically the case in independent film finance), those notes would also be securities.
If the transaction is questioned and the federal “family resemblance” test applies, the producer may seek to rebut the presumption that the note he or she is issuing bears a strong “family resemblance” to one or more of the notes listed by the courts as not being securities. But that does not appear to be likely. Further, the producer may also seek to convince a court that a new category of note not considered a security, needs to be created. But, once again, it appears that the contingent promissory note could not meet its burden of persuasion to be added to the list of excluded instruments. It would appear that such transactions are motivated for the purpose of raising money to finance substantial investments (i.e., the production of a feature film), that the reasonable expectation of the investing public is that the transaction is a security and there are no risk-reducing factors such as collateral or insurance. So, even if the transaction is limited in its distribution (sold to only a few investors), for all practical purposes, such notes would very likely still be recognized as securities.
If California state law applies, and either the “risk capital” test, or elements of the federal “Howey” test are used, the producer will need to make sure the promissory notes are adequately collateralized, insured or otherwise secured, or that the investor is not only actively involved in management of the project but capable of being involved in management in a meaningful way because of his or her knowledge and experience in the film industry. Of course, for most independent filmmakers, putting their own assets at risk in the hopes that their return on an independently produced film will adequately cover that risk is usually not a good idea. In most instances, it is better for such creative ventures, to spread the risk amongst a large group of passive investors (who are prohibited from interfering with the producer’s creative control), avoid putting the producer’s assets at risk, recognizing that a security is being offered and complying with the federal and state securities laws.51
1. “Is a Note a ‘Security’? Current Tests Under State Law”, Kenneth L. MacRitchie, South Dakota Law Review, Vol. 46, at 409, Summer 2001.
7. Securities Counseling for New and Developing Companies, Stuart R. Cohn, Clark Boardman Callaghan, Chapter 3, at 6, 2000.
8. Reves v. Ernst & Young, 494 US 56, 108 L Ed 2d 47, 110 S Ct 945 (1990)
9. Briggs v. Sterner, 529 F Supp 1155 (SD Iowa 1981).
10. Notes 1-6 were listed in Exchange Nat. Bank of Chicago v. Touche Ross & Co., 544 F2d 1126, 1138 (CA2 1976). Note 7 was added by Chemical Bank v. Arthur Andersen & Co., 726 F2d 930 (CA2 1984), cert den 469 US 884 (1984).
11. Marine Bank v. Weaver, 455 US 551, 71 L Ed 2d 409, 102 S Ct 1220 (1982).
12. Reves Revisited, Janer Kerr and Karen M. Eisenhour, 19 Pepp. L. Rev. 1123, 1153-62 (1992).
13. Securities Counseling for New and Developing Companies, Stuart R. Cohn, Clark Boardman Callaghan, Chapter 3, at 9, 2000.
15. Erie R. Co. v. Tompkins, 304 US 64, (1938).
16. Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811, 361 P.2d 906 (Cal. 1961).
17. People v. Davenport 13 Cal. 2d 681 at 686; 91 P.2d 892, 1939.
18. Domestic & Foreign Petr. Co., Ltd. v. Long, 4 Cal.2d 547, 555; 51 P.2d 73; Oil Lease Service, Inc. v. Stephenson, 162 Cal. App.2d 100, 107-108; 327 P.2d 628; Securities & Exchange Com. v. Howey (W.J.) Co., 328 US 293, 298; 66 S.Ct. 1100, 90 L Ed 1244, 163 ALR 1043.
19. People v. Figueroa, 715 P.2d 680 (Cal. 1986).
20. Tcherepnin v. Knight 389 US 332, 336 (1967) and United Housing Foundation, Inc. v. Forman 421 US 837, 848-852 (1975).
21. People v. Figueroa, supra.
22. Landreth Timber Co. v. Landreth 471 US 681, 686-687; 105 S.Ct. 2297, 2302, 2306, 1985.
23. Citing People v. Syde, 37 Cal.2d 765, 768; 235 P.2d 601, 1951.
24. Silver Hills Country Club, supra.
25. Silver Hills Country Club, supra.
26. Silver Hills Country Club, supra.
27. People v. Leach 106 Cal. App 442; 290 P. 131, 1930.
28. In re Leach 215 Cal. 536, at 536; 12 P. 2d 3, 1932.
29. People v. Leach, supra at 450.
30. People v. Walberg 263 Cal. App. 2d 286; 69 Cal. Rptr. 457, 1968.
32. People v. Syde, supra.
34. S.E.C. v. Howey, supra at 1251.
35. S.E.C. v. Howey, supra.
36. United Housing Foundation, Inc. v. Forman, 421 US at 852; 44 L Ed 2d at 632, 1975.
37. People v. Figueroa, supra at 697.
38. People v. Schock 152 Cal. App.3d 379, 384-385; 199 Cal. Rptr. 327, 1984, and citing People v. Davenport, supra, at 690.
39. Hamilton Jewelers v. Department of Corporations, 37 Cal. App.3d 330, 333; 112 Cal. Rptr. 387, 1974.
40. People v. Schock, supra.
41. Citing People v. Leach, supra.
42. Silver Hills Country Club, supra.
43. Dahlquist, Tom, Regulation and Civil Liability Under the California Securities Act, 33 Cal.L.Rev. 343, at 360, 1945.
44. People v. Syde, supra.
45. People v. Syde, supra.
46. People v. Syde, supra.
47. Fundamentals of Securities Regulation, 4th Edition, Louis Loss and Joel Seligman, Aspen Publishers, 2007.
48. Williamson v. Tucker, 645 F.2d 404, 5th Cir. 1981.
49. Consolidated Management Group, LLC versus the California Department of Corporations, 162 CA4th 598, 75 CR3d 795, 2008.
50. 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.
51. For a discussion of various film finance methods see Forty-Three Ways to Finance Your Feature Film, Third Edition, John W. Cones, Southern Illinois University Press, 2007.