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Defining the Active Investor for Film Offerings

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

SEC Issues Warning to Investment Crowdfunders

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 Crowdfunding Law As Applied to Filmmaker Issuers

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.

The Use of Finders in Investor Financing Transactions

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.

That Pesky Equity Component of Independent Film Finance Plans

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.

Selling Independent Film Offerings To Passive Investors

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.

Debt vs. Equity in Film Finance

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.

Creating and Maintaining a Clean Chain of Title for a Feature Film

The phrase “chain of title” within the context of the film industry refers to a series of documents or agreements that establish proprietary (ownership) rights in a motion picture and all its parts. It is a collection of all of the documents that relate to the creation of and transfers of title to any property used in the making of the film.

The chain of title seeks to protect all original works used in the film, while also establishing that there is appropriate documentation in relation to rights assigned or licensed by third parties to the filmmaker. The ownership rights may include copyrights, trademarks and/or rights of publicity. The so-called “chain” runs from the current owner at any given time, back to the original owner of such property rights. Thus, this collection of documents may continue to grow over time. It is typically maintained in chronological order and contained within some flexible file folder, portfolio, briefcase, banker’s box or other suitable carrying case. Typically, the chain of title presented to others for their review would consist of copies of the original documents.

A “clean” chain of title is that same sequence of documents without gaps in time or other issues that may cloud the title (i.e., raise unresolved questions regarding ownership). For filmmakers, a clean chain of title is essential. No matter whether the filmmaker is approaching a studio executive seeking to obtain a production-financing/distribution deal (P-F/D), approaching another production company seeking a co-production deal, approaching a distribution executive seeking to obtain a negative pickup, split rights or foreign pre-sale agreement or ultimately approaching a distributor for the purpose of negotiating an acquisition distribution agreement, all of these transactions will require a clean chain of title (for further discussion of these various forms of film finance or distribution see my book 43 Ways to Finance Your Feature Film, Southern Illinois University Press).

In other words, when a filmmaker is seeking some form of film finance or distribution, each of the individuals representing a major studio/distributor, an independent production company or an independent distributor, will at some point ask “Who owns the rights”? or “What is the state of your chain of title?” If the filmmaker does not even know what the phrase chain of title means, or does not have a clean chain of title, the odds of closing that deal are quite severely limited (not to mention the likelihood that the filmmaker will be viewed as unprofessional or uninformed). It is part of the independent filmmakers job to know about chain of title. The preferred response to that inevitable question is to say: “Sure, here it is.”

In a hypothetical situation, let’s say Filmmaker A and Filmmaker B both produce an independent film with investor financing, with no obligation to any particular distributor. Filmmaker A’s film is slightly more commercial in the view of the distributors and is well made. Filmmaker B’s film is slightly less commercial but still well made. The distributor is trying to acquire the rights to a film to complete its annual slate, and it just has the one additional slot to fill. Unless the distributor’s representatives believe that whatever chain of title problems associated with Filmmaker A’s film can be easily and quickly resolved to their satisfaction, it is more likely that the distributor will acquire the rights to distribute Filmmaker B’s film, since it has a clean chain of title. Another way to say this is, unless the filmmaker is just making a home movie, he or she must be able to present a clean chain of title to film financiers and distributors.

Filmmakers should not wait until the film is completed to begin assembling the film’s chain of title. This activity should be ongoing throughout the process of creating both the script and the subsequent film. In other words, copies of whatever documents relating to the ownership of rights in the script or film should be added to the chain of title documents as they are created.

So let’s be more specific regarding what documents should be included in a film’s chain of title:

  • Acquisition of Underlying Rights – A film script may be based on a copyrighted story that has already been published in some form. This story may come from an existing book, article, essay, short story, life story, poem, song, comic book, stage play, television show or prior film. In any event, the filmmaker will need to acquire the rights to the story. This is usually done by way of an option/acquisition agreement. This is effectively an agreement that gives the filmmaker the option to purchase the rights to that underlying material for a specific period of time, after which the filmmaker may purchase the motion picture rights to the work for an agreed price. The filmmaker should also ensure that the agreement by which he or she acquires the motion picture rights includes a warranty from the author that he or she is the true owner and an indemnity that he or she will he will be liable for any loss the filmmaker may incur in the event of a breach of this warranty. These agreements relating to the acquisition of the underlying rights should be included with the film’s chain of title documents.
  • Treatment – In many instances, a screenplay is not the first document relating to a film that may be copyrighted. A treatment may precede the drafting of the script, and the treatment may be the first document to be filed with the U.S. Copyright Office. In those situations where a screenplay is derived from a treatment, the screenplay is considered a derivative work of the treatment, and as such, the treatment could be the first element in the chain of title. Without the written permission of the author of the treatment to create a screenplay based on it, the chain of title would be clouded (i.e., not clean and/or broken).
  • Copyright Registration of Script – If an original script is being written (i.e., no underlying rights are involved) and there is no treatment, a film’s chain of title may also begin with the screenwriter’s copies of the script’s registration with the U.S. Copyright Office, including both the registration form and the receipt sent back from the copyright office. Placement of such documents in the chain of title depends on the dating of such documents (i.e., again the documents in the chain of title should be placed in chronological order).
  • Certificate of Authorship – If there is no treatment that was copyrighted, another of the early documents to be found in a film’s chain of title may be a certificate of authorship signed by the script’s author. A certificate of authorship is a signed statement executed by the script’s author or authors attesting to the fact that the script was original with that writer or those writers. A sample copy of a certificate of authorship can be downloaded for a small fee at https://www.filmfinanceattorney.com in the “Film Industry Contracts” section under “Product Categories”.
  • Option/Acquisition Agreements – Next, any option, option/acquisition or acquisition agreements relating to that script should be included, along with any associated short form copyright assignments filed with the copyright office. If, for any reason, the film was not produced pursuant to those agreements and rights revert back to the screenwriter, documentation reflecting that reversion of rights should also appear in the chain of title.
  • Releases – Other documents that should be included in the chain of title for a specific film script may be generated in situations where many people have contributed to the project, thus potentially acquiring authorship rights. In such situations, the agreements with such persons should contain releases or some form of relinquishment of rights, so again the ownership question remains clear. And the document should be placed in the chain of rights folder in chronological order. Similarly, documents containing releases, licenses or permissions from other copyrighted materials used as a source for something written in a script should also be included.
  • Title of Film – While there is generally no copyright in the title of a film, a filmmaker may also need to obtain a clearance to use a proposed film title. Where the title includes the name of a place, musical group or product the filmmaker should conduct or have conducted on his or her behalf, a search of the trademarks registry to ascertain whether the name is trademark protected. It will also be necessary to do searches of the trademark registries in other markets in which the film will be distributed. If the name is registered, then the filmmaker may need to contact the trademark owner and enter into a licensing agreement for use of the name, and that agreement should be included in the film’s chain of title.
  • Talent agreements – Such agreements should include a release from the talent, whether actors, actresses, directors, cinematographers, costumers, set designers, illustrators, sketch artists, graphic designers, costume designers, choreographers, or others, to use their works, images, likeness and other personality rights in the film. For chain of title purposes it is important that employment agreements for talent include a legal release which ensures that the individual consents to his or her performance being used in the film. Then, of course, each of such agreements are included with the chain of title documents.
  • Crowd and extra releases – Make sure that every individual appearing in the film has signed a release or show evidence of proper notice in crowd sequences.
  • Music Clearances – Documentation relating to copyright clearances on music, including master use licenses from the owners of pre-recorded sound recordings, composer agreement, songwriter agreement and synchronization license. This last license to synchronize music with visual images in the film is obtained from the owners of the copyright protected work and should be included in the chain of title folder.
  • Film Clip Clearances – Copyright clearances on footage from other films used in the current film should be obtained from copyright owners. Film clips may also include music which needs to be cleared separately.
  • Trademark Clearances – Clearances or licenses from the owners of any trademarks appearing in the film.
  • Design rights – Clearances or licenses relating to any rights associated with the design of any property that appears in the film should be included with the film’s chain of title documents.

Other agreements, that may have an impact on the ownership of rights relating to the production of a movie and copies of which may appear among a film’s chain of title documents include the following, samples of which are available at the “Film Industry Contracts” section on the https://www.filmfinanceattorney website:

  • Life Rights Consent and Release
  • Literary Acquisition Agreement
  • Literary Assignment
  • Literary Property Acquisition Letter of Intent
  • Quit Claim Agreement
  • Screenwriter Services Agreement
  • Script Option and Development Agreement
  • Shopping Agreement
  • Waiver of Limited Use of Characters
  • Actor Loanout Agreement
  • Casting Director Agreement
  • Director Agreement
  • Producer Agreement
  • Writer/Director Agreement
  • Composer Employment Agreement
  • Consultant Agreement
  • Crew/Cast Agreement
  • Crew Employment Agreement
  • Extras Release
  • Film Clip License
  • Group Release
  • Location Agreement
  • Makeup and Special Effects Agreement
  • Master Recording License
  • Minor Release
  • Model Release
  • Music Co-Administration Agreement
  • Personal Release
  • Property Release
  • Recording Artist Agreement
  • Recording Producers Agreement
  • Stills and Excerpts License Agreement
  • Stunt Performers Agreement
  • Synchronization and Master Use Licenses
  • Trademark Clearance Letter

This discussion makes it clear there may be a significant number of documents involved with a film’s chain of title (i.e., a film project is document intensive). It is thus important that someone on the film producer’s team be assigned primary responsibility for seeing that all copies of the appropriate documents are placed in the chain of title folder, in chronological order, and that all of the language in such documents clearly show that the production company has all of the necessary ownership rights with respect to that movie.

It is essential that filmmakers take the necessary steps to ensure that they have obtained the requisite licences and permissions for all copyright and trademark protected material used in their film. Creating and clearing copyrights and trademarks represents the very essence of protecting the property rights associated with the production of motion pictures. The final step associated with such protection and clearance, is creating and maintaining that collection of chain of title documents in an orderly format.

Errors and Omissions Insurance – To further protect a film financier and/or distributor, the filmmaker will be required to show proof of errors and omission insurance coverage on the project. E&O insurance is a special form of insurance for motion picture producers which covers omissions in obtaining adequate chain of title.

As noted above, one of the most important reasons why independent film producers want to create and maintain a clean chain of title is to avoid the situation where they have a great film but no distributor will touch it for fear of ending up in a dispute or litigation over some of the rights involved in making the film. Distributors will want the producer to provide assurances in writing (i.e., in the distribution agreement) that all rights to the film have been properly secured. Distributors will also require the film’s producer to make specific representations and warranties relating to the ownership of the film. In other words, the distributor will likely require the producer to represent and warrant that the film does not violate or infringe, among other things, any agreement with any third party, trade-mark, trade name, copyright, moral right, patent, literary right, dramatic right or rights of privacy and publicity. If any of these representations and warranties turn out to be untrue, the producer may have to indemnify and hold harmless the distributor for any breach of the such representations, warranties or any covenants under the distribution agreement.

Much of the work associated with creating and maintaining a clean chain of title falls within the expertise of an entertainment attorney, thus all along the way the filmmaker may want to at least consult with an experienced entertainment attorney regarding chain of title questions and what to include in the collection of documents. It may also prove helpful to have the entertainment attorney review any such documents to make sure the appropriate language is contained therein. In some instances, the entertainment attorney will be asked to negotiate and/or draft the documents.

These chain of title documents form part of the clearance process, one of the important legal services an entertainment attorney provides for independent filmmakers. For a better understanding of the clearance process see www.gerdeslaw.com/practice-areas/clearance/. For a more comprehensive listing of this and the many other business and legal tasks (not creative) associated with the production of a feature film, go to www.filmfinanceattorney.com under the heading “Legal Affairs Checklist”.

Re-Selling Units of a Private Film Offering

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.

Film Offerings to Foreign Investors

Since filmmaking is typically a business venture that seeks to generate revenues on a worldwide basis and an increasing percentage of such revenues for many films appear to be coming from the international markets as opposed to the domestic marketplace (U.S. and Canada), it is not uncommon for U.S. based filmmakers to seek out opportunities to raise money to develop, produce and/or distribute one or more motion pictures exclusively from investors who reside in other countries. In those instances where a security is being sold (e.g., when units in a limited partnership or manager-managed LLC are offered) such offerings may be conducted pursuant to the SEC’s Regulation S.

Regulation S allows U.S. issuers to sell securities to foreign investors without regard for the sophistication, number of purchasers or dollar amount of the offering. In addition, Regulation S permits issuers to advertise the offering offshore, an activity that may be prohibited in a Regulation D, private placement offering conducted under current law.

The SEC’s Regulation S is found in the Code of Federal Regulations (“CFR”) at 17 Code of Federal Regulations Sections 230.901 through 230.905. These regulations are also known as Rules 901 through 905. Regulation S provides another “safe harbor” to issuers of securities from the registration requirements of the 1933 Securities Act (similar to Regulation D), as long as the offer and sale of securities occurs exclusively “offshore”. In other words, so long as the issuer complies with the rules set out in Regulation S in making offers and selling securities overseas, the offering can be safely conducted without having to register the securities with the SEC.

Even though the phrase “offering materials” is mentioned, Regulation S does not specifically address disclosure issues (i.e., the information that must be provided to the investors in advance of their purchase). Presumably that’s because if the offering is otherwise properly conducted pursuant to the provisions of the regulation the SEC does not have jurisdiction over the offering. However, it is important to keep in mind that other countries, the countries where the offering’s investors reside, may have securities regulations of their own. So, to be safe, some inquiry ought to be made into what disclosure requirements, if any, exist in those subject countries. Unfortunately, that may be difficult and/or expensive to do.

In the alternative, it may be good practice to provide each investor with a disclosure document (i.e., a private placement offering memorandum) similar to the same PPM provided to investors in Regulation D, Rule 505 or 506 offerings, just to cover your bases with respect to the regulators in those other countries. At minimum, the SEC’s anti-fraud rule standard for disclosure with which to voluntarily comply. That standard requires the disclosure of all material facts relating to the proposed transaction, that no material facts be omitted and everything stated in the disclosure document be set out in a manner that is not misleading in a material way. In addition, you will want your securities attorney to include language in the subscription agreement to be signed by the foreign investors certifying that they have inquired and are in compliance with the rules of their own countries regarding investment in a U.S. securities offering. The two above suggestions, however, are not a substitute for knowing that the offering is in compliance with whatever laws exist in the foreign country. And, U.S. issuers must be forewarned that non-compliance with the laws of another country in the sale of securities to their residents can, in some cases, subject the U.S. issuer to severe penalties including arrest and incarceration if you actually visit the other country.

An issuer that wants to conduct a Regulation S offering through an Internet website may do so without putting the exemption at risk by including prominent statements on the web pages indicating that the offer is directed only to persons outside the U.S. and by taking steps to preclude sales to what are defined as “U.S. Persons”. U.S. Persons are defined as U.S. residents or citizens, U.S. companies and persons living in the U.S. regardless of nationality, or U.S. residents living abroad [Rule 902(k)].

No SEC filings are required for a private Regulation S offering.

Another important set of issues to consider before embarking on a Regulation S offering are the so-called homeland security issues. For example, certain individuals and countries identified by the federal government are prohibited from investing in U.S.-based entities. To see the list of such prohibited individuals and/or countries go online to:


An issuer of securities to foreign investors will be held to a standard of strict liability and failure to comply may subject the issuer to civil and/or criminal penalties. In order to avoid the possibility that such penalties will be imposed, the issuer must determine whether its prospective investors are prohibited from investing in U.S. companies.

In addition, the issuer must determine whether the proposed investment is the result of pooled funds, in which case, the issuer is obligated to determine whether the individual investors in the pooled fund are prohibited investors. In either situation, the issuer must not only verify such information but keep written records on hand to demonstrate compliance.

Any issuer seeking to conduct such an offering should seek out securities counsel familiar with Regulation S and carefully review the text of the law which is available online at the SEC’s website.