Defining the Active Investor for Film Offerings
By John W. Cones, JD
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.
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