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Category: Investor Financing Of Independent Film

NASAA’s Model Accredited Investor Exemption

In January of 1997, NASAA encouraged all states to adopt rules similar to, but simpler than, the one adopted in California. Though many states have now adopted legislation to allow those businesses trying to raise funds to “advertise”, most of the states promulgated laws limit sales to “Accredited” as opposed to the “Qualified Investors” as in the California version, and limited the amount of money that could be raised to $1 million, as opposed to the limit of $5 million, imposed on the California 25102(n) by federal law. Thus, for inter-state offerings, the California exemption is not all that useful.

Furthermore, the states other than California that adopted such a public/private “hybrid” exemption paired it with Regulation D, Rule 504 at the federal level as opposed to the intrastate exemption [Section 3(a)(11)] which was the federal exemption intended to be used in conjunction with the California exemption.

As a consequence, an issuer can make an offering of securities to accredited investors via a “General Announcement” in a significant number of, but not all states pursuant to the Model Accredited Investor Exemption and Regulation D, Rule 504. Notice filings are still required in each state under the MAIE.

Elements of the MAIE

NASAA adopted a Model Accredited Investor Exemption (MAIE) on April 27, 1997.

MAIE summary. The Model Accredited Investor Exemption exempts from registration and sales/advertising filing requirements those offers and sales of securities issued to accredited investors. The term “accredited investor” is defined at Regulation D, Rule 501, with a listing of entities and individuals possessing substantial assets and/or net worth. Pursuant to the MAIE, securities may only be sold to persons reasonably believed by issuers to be accredited investors who are purchasing for investment and not for resale. These state exemptions are generally not available to issuers in the development stage of their business or to issuers and affiliates who have been subject to various “bad boy” disqualifying provisions.

Issuers of such securities may use any means to generally announce the proposed offering but unless permitted by the state securities administrator, the information contained in the announcement has to be restricted to the (1) name, address and telephone number of the issuer; (2) name, price and aggregate amount of the offered securities; and (3) brief descriptions of the offered securities and issuer’s business. In addition, a statement must be included that indicates (1) the securities will be sold only to accredited investors; (2) no money or other consideration will be solicited or accepted by means of the general announcement; (3) the securities have not been registered with or approved by the SEC (or any other state agency); and (4) the securities are being offered and sold under an exemption to the securities registration requirement. To qualify for the exemption, states typically require issuers to file, within 15 days after the first sale of the securities in the state, a notice of transaction, a consent to service of process, a copy of the general announcement and a fee.

The MAIE was and is intended to serve as a model for state securities regulators to adopt in their respective states so that small businesses seeking to raise $1,000,000 or less can engage in a limited form of advertising without having to register their securities in the state. A majority, but not all states have since adopted a version of the MAIE. This state exemption is intended to be paired with a Regulation D, Rule 504 exemption at the federal level.

More specifically, the MAIE provides that any offer or sale of a security by an issuer in a transaction that meets the requirements of this rule is exempt from those sections of the state’s securities law requiring registration and filing of advertising materials. This allows a film producer to advertise, use the Internet and makes sales without the requirement of a preexisting relationship. The requirements to be complied with are:

Accredited investors only. Sales of securities must be made only to persons who are or the issuer reasonably believes are accredited investors. The term “accredited investor” is defined in the SEC’s Regulation D, Rule 501(a).

No development stage companies. The exemption is not available to an issuer that is in the development stage that either has no specific business plan or purpose or had indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person.

Not for resale. The issuer reasonably believes that all purchasers are purchasing for investment and not with the view to or for sale in connection with a distribution of the security. Any resale of a security sold in reliance on this exemption within 12 months of its original sale will be presumed to be with a view to distribution and not for investment, except a resale pursuant to a registration statement effective under the state’s law relating to the registration of securities to be sold in that state, or to an accredited investor pursuant to an exemption available under the state’s securities act.

“Bad Boy” provisions. The exemption is not available if certain persons associated with the offering have engaged in specifically prescribed conduct in the past five (5) years. Thus, the exemption is not available to an issuer if the issuer, any of the issuer’s predecessors, any affiliated issuer, any of the issuer’s directors, officers, general partners, beneficial owners of 10 percent or more of any class of its equity securities, any of the issuer’s promoters presently connected with the issuer in any capacity, any underwriter of the securities to be offered, or any partner, director or officer of such underwriter: (a) within the last five years, has filed a registration statement which is the subject of a currently effective registration stop order entered by any state securities administrator or the SEC; (b) within the last five years, has been convicted of any criminal offense in connection with the offer, purchase or sale of any security, or involving fraud or deceit; (c) is currently subject to any state or federal administrative enforcement order or judgment, entered within the last five years, finding fraud or deceit in connection with the purchase or sale of any security; or (d) is currently subject to any order, judgment or decree of any court of competent jurisdiction, entered within the last five years, temporarily, preliminary or permanently restraining or enjoining such party from engaging in or continuing to engage in any conduct or practice involving fraud or deceit in connection with the purchase or sale of any security.

The above-referenced “bad boy” disqualifying provisions do not apply if: (a) the party subject to the disqualification is licensed or registered to conduct securities related business in the state in which the order, judgment or decree creating the disqualification was entered against such party; (b) before the first offer under this exemption, the state securities administrator, or the court or regulatory authority that entered the order, judgment, or decree, waives the disqualification; or (c) the issuer establishes that it did not know and in the exercise of reasonable care, based on a factual inquiry, could not have known that a disqualification existed under this paragraph.

Limited advertising. A general announcement of the proposed offering may be made by any means, but the general announcement can only include the following information, unless additional information is specifically permitted by the state’s securities regulator:

  1. the name, address and telephone number of the issuer of the securities;
  2. the name, a brief description and price (if known) of any security to be issued;
  3. a brief description of the business of the issuer in 25 words or less;
  4. the type, number and aggregate amount of securities being offered;
  5. the name, address and telephone number of the person to contact for additional information; and
  6. a statement that: (a) sales will only be made to accredited investors; (b) no money or other consideration is being solicited or will be accepted by way of this general announcement; and (c) the securities have not been registered with or approved by any state securities agency or the SEC and are being offered and sold pursuant to an exemption from registration.

Use of the Internet. The issuer, in connection with an offer, may provide information in addition to the general announcement described above, if such information: (1) is delivered through an electronic database that is restricted to persons who have been pre-qualified as accredited investors; or (2) is delivered after the issuer reasonably believes that the prospective purchaser is an accredited investor.

Telephone solicitation. No telephone solicitation is permitted unless prior to placing the call, the issuer reasonably believes that the prospective purchaser to be solicited is an accredited investor.

Unqualified recipients. Dissemination of the general announcement of the proposed offering to persons who are not accredited investors will not disqualify the issuer from claiming the exemption under this rule.

Notice filings. The issuer must file with each state regulatory agency in the state’s in which sales occur a notice of transaction, a consent to service of process, a copy of the general announcement, and the prescribed fee within 15 days after the first sale in each state.

Even though no specific disclosure requirements are imposed, a film producer would still need to provide each prospective investor with a securities disclosure document that complies with the antifraud rule (i.e., disclose all material aspects of the transaction, do not omit anything that is important and state what is disclosed in a manner that is not misleading). On the other hand, such a disclosure document can be delivered electronically (i.e., through the Internet).

The two major differences between the two schemes (that adopted by California and that adopted by the other states pursuant to the NASAA model) is that (1) California requires and defines “Qualified Investors” whereas the other states require the less complicated “Accredited Investor” definition as already set forth in Regulation D, and (2) California allows up to $5 million to be raised, whereas the other states impose a ceiling of $1 million. So if a film producer believes he or she can raise all of the money in the one state of California, it may make sense to use the California Section 25102(n) exemption (but for the other limitations imposed by the Instrastate Exemption – see discussion at Chapter 11) While, on the other hand, if a film producer believes that he or she may need to raise money in more than the one state of California and can limit the amount of money raised from investors to $1 million, it may be worthwhile to investigate which states have adopted the NASAA model and use that approach, combined with an Internet announcement.

NASAA’s adoption of the MAIE was not actually a response to the California Section 25102(n) concept, but was rather in response to the Small Business Administration’s ACE-NET program (now defunct or at least in private hands). A majority of the states, the District of Columbia and Puerto Rico have adopted the MAIE which works in conjunction with the federal Rule 504 of Reg. D with its $1 million dollar limit. Even as to those states that have not adopted the MAIE, almost all have some form of exemption pertaining to accredited investors.

Use of the Internet. The use of the Internet as a means of disseminating the General Announcement and delivering the Offeree Questionnaire and Disclosure Document has been approved by the securities regulators for MAIE offerings. They have expressed the opinion that the downloading of such materials complies with the requirements of being “published by written document only.

The Internet may also provide a platform from which to obtain leads. However, the follow-up must be done rather precisely in order to “qualify” the purchaser. In addition, the producer or producer’s attorney must be sure to check with the securities regulator in each state where sales or proposed, to be certain that the conduct of the offering complies with the applicable state rule. Presumably, as the Internet attracts more investors looking for opportunities, the California Section 25102(n) and MAIE exemptions may become the preferred types of offerings for those who have limited access to “qualified” investors and who are only seeking a limited amount of funds (if it can be demonstrated that Internet offerings actually work).

On the other hand, that underlying assumption may never come true, in that investors rarely look for investment opportunities anywhere, much less on the Internet, and there is even less reason to believe that very many investors will set out specifically to find an investment opportunity in a high risk investment like independent film. It is more likely true that most securities are “sold”, not “bought”, meaning that the sale of a security, including interests in film LPs or LLCs are more likely to be sold through means of a face-to-face meeting with someone known to the producer and his or her upper level management, than through some Internet scheme.


Advertising and general solicitation. The MAIE allows a limited amount of advertising and general solicitation for non-registered offerings of $1 million dollars or less.


Of limited use. If an offering extends into other states that have not adopted the MAIE, the permitted general announcement in California would be “integrated” into the other states’ offering and this would prevent any private placement in those states, since the general announcement would be considered a general solicitation (public offering).

Smaller pool of prospective investors. Arbitrarily limiting the pool of prospective investors to only accredited investors that reside in the single state of California significantly shrinks the pool of prospective investors for the offering.

Internet sales. The ability to effectively sell film offerings to investors over the Internet has yet to be demonstrated.

Public/Registered Offerings

If a filmmaker believes he or she needs to seek to raise money from an even larger pool of prospective investors than that available for a private placement or a so-called public/private “hybrid” offering, one of the public/registered securities offerings to a large group of passive investors may be appropriate. The public/registered offerings typically allow the issuers to advertise and to conduct a general solicitation.

Manager-Managed Limited Liability Company

The manager-managed LLC is one of the more popular passive investor vehicles for project financing of feature and documentary films. Its formation is similar to the creation of a member-managed LLC, in that articles or organization need to be prepared and filed with the office of the Secretary of State in the state in which the LLC is being created. Generally, the form or articles used will provide a space for designating that the LLC is to be a manager-managed LLC as opposed to member-managed. In addition however, an LLC operating agreement must be drafted, approved by the members and signed, so that the LLC will have a set of rules by which to operate. And, the operating rules for a manager-managed LLC or significantly different, more lengthy and more complex than the corresponding LLC operating rules (agreement) for a member-managed LLC. The LLC operating agreement usually does not have to be filed with the Secretary of State, but is kept in the LLC’s files. Formation of the manager-managed LLC is neither the end of the task, nor the most significant portion of the work involved in using such a vehicle to raise capital (see discussion re “Choice of Securities Offering” below).

Limited Liability

Particularly of importance to low budget filmmakers, the manager-managed LLC offers limited liability protection to one or more individuals or a fictitious name company serving as the LLC’s manager without the time, trouble and expense of creating and maintaining another entity. This means that an individual or a fictitious name company (dba) can serve as the manager of the manager-managed LLC and enjoy limited liability protection, without creating and maintaining a corporation or a member-managed LLC to serve as the manager.

When to Form the LLC

In many instances, entertainment attorneys and accountants advise filmmakers to first go out and form a limited liability company, for example, without ever discussing whether it should be a member-managed LLC or a manager-managed LLC, or that there are securities law implications for the latter.

In addition, there exists differing opinions as to when to form a manager-managed LLC that is being used as the investment vehicle to raise money from a large group of passive investors. Some practitioners insist that forming the LLC must be the first step in the process. They suggest that investors will not invest in a company that has yet to be formed. However, hundreds if not thousands of successful manager-managed LLC securities offerings have been conducted in the U.S. selling what are termed “pre-formation units in an LLC to be formed upon funding”, thus the argument that investors won’t invest in a company to be formed is not based on an adequate sampling of real world experience.

The same is true of many corporate and limited partnership offerings over the years. The advantage of this deferred approach is that no out of pocket expense is incurred by the manager/producer until the investor funds are known to be in the bank, and therefore available for prompt reimbursement, as soon as the LLC is formed and a second bank account as been opened in the name of the newly formed LLC.

The liability most commonly associated with the production of films (negligence on the set or defamation) does not occur until after principal photography has begun or, in the latter instance, after the film is released, thus, so long as the manager-managed LLC is formed before principal photography begins, the manager will still enjoy the limited liability protection needed.

Bad Advice

Many independent film producers are either being misled by somebody or they are simply misunderstanding what they are being told about LLCs. These independent producers repeatedly indicate that they have been advised that all they need to do to raise money from passive investors using an LLC is to create the LLC, and that merely involves the preparation and filing of the articles of organization with the Secretary of State’s office in the state in which the LLC is to be formed. This is bad advice on several levels:

(1) There is another aspect to the actual creation of an LLC. Not only should the articles of organization be properly prepared and filed with the Secretary of State, but also an LLC operating agreement must be drafted, approved and signed. Without an operating agreement, there are no rules set out for operating the LLC, thus it cannot function effectively.

(2) When the articles of organization are filed and the operating agreement is drafted, the producer must be certain that he or she properly designates in the articles which form of LLC is being created, a member-managed or manager-managed LLC, and carry over this distinction into the LLC operating agreement, because the provisions associated with each different form of LLC are significantly different in the respective operating agreements. Before a producer can make that designation, he or she must understand the difference between the two LLC forms and to what purpose they will be devoted.

(3) Assuming the LLC is being created to serve as the investment vehicle for a large group of passive investors (the manager-managed LLC – the form of LLC being discussed in this chapter) the filing of the articles and the drafting of the LLC operating agreement amount to a small part of the tasks involved. Since the units or interests in a manager-managed LLC are securities, compliance with the federal and state securities laws is required. That involves an informed choice with respect to the appropriate form of registration or exemption, the proper drafting of a securities disclosure document and an understanding of and compliance with other applicable securities laws and rules.


Number of investors. There are no limits on the number of investors imposed by the LLC statutes, but such limitations may be imposed by the securities laws, although Regulation D, for example, permits 35 unaccredited investors and an unlimited number of accredited investors (see discussion of the SEC’s Regulation D below).

No creative control issues. Since the manager-managed LLC is controlled and operated (pursuant to statutory law and agreement) by the manager or managers, and the investor/members are passive, there are no conflicts with the investor/members over creative matters.

Less oversight. So long as the manager of a manager-managed LLC acts in the manner described in the securities disclosure document, the manager does not have to go back to any board of directors or the investor/members for approval to conduct the business. Significant departures from the original plan of business may need the approval of the investor/members, but provisions in the LLC’s operating agreement control this question.


Securities compliance required. Compliance with the applicable federal and/or state securities laws are required because manager-managed LLC interests are being offered and sold to passive investors (i.e., such interests are securities).

Keys to Finding Prospective Investors

The key factor that helps independent feature film producers in finding investors or other individuals who may help find investors is investor motivation. First do some brainstorming with your associates regarding what might motivate anyone with money to invest some of it in your high risk venture. There may be others besides those listed below that are unique to a specific film project, but a fairly good list of possible investor motivation follows. Some of these descriptions of investor motivation are closely related and may even overlap.


  1. Is interested in supporting the filmmaker’s career (career support);
  2. Is enamored with the glamor of the film industry (glamour of film industry);
  3. Feels the investment has a certain amount of “cocktail chatter” value, that is, it’s more interesting and fun to talk about than most boring investments (cocktail chatter value);
  4. Wants to be able to spend some time on the set and rub elbows with the cast and crew, although this needs to be carefully controlled so that it does not get out of hand (associate);
  5. Wants to use this investment as an opportunity to learn about how the film industry works, so that he or she can get more involved in the future (learning experience);
  6. Has a son, daughter, niece or nephew who can appear as an extra in the movie (film extras);
  7. May want to appear in the movie as an actor or actress (appear in movie);
  8. May (in rare and unusual circumstances) be allowed to direct the movie (directing);
  9. May thereby get his or her script produced (screenwriter);
  10. Realizes that by investing in the movie, it will help bring the movie to a specific locale which will benefit the local economy (local economy);
  11. Is very interested in one or more of the messages being communicated by the movie (movie message) and/or
  12. Is looking at the upside potential for making money on the investment even though the investor recognizes investing in independent films is highly risky.

Of course, enterprising filmmakers may be able to come up with other descriptions of investor motivation that could be added to this list.

Financial Projections for Film Projects

Financial projections are estimates of the future economic performance of a proposed business or venture. Financial projections are not required for investor offerings for film projects regardless of whether the selected investment vehicle involves the sale of a security or not. However, investors seem to prefer that a presentation of financial projections accompany whatever documentation is used to approach such investors. Financial projections provide the prospective investor and the film producer seeking investor financing with an additional point of discussion and they serve as an excellent exercise for the producer in helping him or her to understand how film revenues might flow back to the financing vehicle, the producer group and the investors. In all likelihood, a producer seeking investor financing will be subjected to questions from investors about how they will get their money back and make a profit, thus, it behooves the producer to do some research about this aspect of the transaction, to understand it and to be able to explain it as clearly as possible.

If the sale of a security is involved, the SEC has a position on financial projections and offers some guidelines for their preparation and use. These SEC guidelines may be helpful in the preparation of financial projections for both non-securities and securities offerings.

Pursuant to the SEC’s Regulation S-B, Part 228 (Integrated Disclosure System for Small Business Issuers) Section 228, Item 10(d) or Section 228.10(d) the SEC encourages the use of management’s projections of future economic performance that have a reasonable basis and are presented in an appropriate format.

From the SEC’s perspective, the following guidelines set forth the Commission’s views on important factors to be considered in preparing and disclosing such projections.

Basis for projections. A film producer (i.e., management) has the option to present its good faith assessment of a small business issuer’s future performance. Such a person or management, however, must have a reasonable basis for such an assessment. In other words, the calculations and numbers associated with financial projections must be based on assumptions, and those assumptions must be reasonable in light of current circumstances in the industry. Such assumptions cannot represent wild speculation on the part of the producer regarding the anticipated earnings of a proposed film.

Outside review. An outside review of the film producer’s (management’s) projections may furnish additional support in this regard. If a film producer (management) decides to include a report of such a review, it should also disclose the qualifications of the reviewer, the extent of the review, the relationship between the reviewer and the issuer, and other material factors concerning the process by which any outside review was sought or obtained.

Format for projections. Traditionally, projections have been given for three financial items generally considered to be of primary importance to investors (revenues, net income (loss) and earnings (loss) per share or unit), however, projection information need not necessarily be limited to these three items. On the other hand, a producer (management) should take care to assure that the choice of items projected is not susceptible to misleading inferences through selective projection of only favorable items. It generally would be misleading to present sales or revenue projections without any of the foregoing measures of income.

Period covered. The period that appropriately may be covered by a projection depends to a large extent on the particular circumstances of the company involved. For certain companies in certain industries, a projection covering a two or three year period may be entirely reasonable. Other companies may not have a reasonable basis for projections beyond the current year. For a film project, attempting to annualize (project expenses and revenues for each year) may create an unnecessary quagmire of information that cannot be understood by either the prospective investors or the producer.

Investor understanding. Disclosures accompanying the projections should facilitate investor understanding of the basis for and limitations of projections. The SEC believes that investor understanding would be enhanced by disclosure of the assumptions which in management’s opinion are most significant to the projections or are the key factors upon which the financial results of the enterprise depend and encourages disclosure of assumptions in a manner that will provide a frame-work for analysis of the projections. In other words, the assumptions on which the calculations and numbers are based not only should be reasonable, based on what is currently occurring in the industry, but they should be set forth in writing.

With the ideal of investor understanding in mind, and recognizing that it is impossible to predict with any accuracy how any independent feature or documentary film may perform in the marketplace, it would appear to be even more safe to offer several calculations (e.g., using a three-column format to show “Poor Performance”, “Good Performance” and “Excellent Performance”). That way, it is clear to prospective investors that the film producer, or whoever prepared the financial projections, is not attempting to predict the future performance of the film. Instead, they are simply illustrating how the film’s revenues may flow back to the investors and what deductions may be taken from the revenue stream at various stages along the way, while basing the projections on certain reasonable and written assumptions that accompany the actual numbers and calculations.

The amount of detail. Some film producers often make the mistake of trying to provide too much detail with respect to anticipated revenue streams when preparing financial projections associated with investor financing of a film project. In many such instances, neither the producer nor the prospective investors understand such complicated projections and the money paid for them is wasted. In any case, such elaborate projections do not come any closer to accurately projecting the financial results of a film project than the format recommended here. In addition, the film industry is notorious for failing to provide useful, relevant and accurate financial information regarding the prior performances of feature films, even more so for the markets and media beyond the theatrical marketplace and worse yet for the independent sector. For that reason, it may be a lost cause to attempt to find reliable information regarding anticipated revenues from each of the individual markets and media through which a film might generate income. Merely assuming a reasonable overall performance level for a film (as it is exploited in all markets and media throughout the world) and then deducting the expected (and reasonable) fees, expenses and percentage participations from the revenue stream as it flows back to the investor group may be a more rational approach.

Survey of Investor Financing of Indie Film Projects

The purpose of this article is not to provide details regarding securities compliance for filmmakers seeking to raise funds from groups of passive investors (see endnote # 1) but instead to set out and describe the various strategies independent filmmakers may employ as they utilize investor financing to enhance their chances for getting their vision on the screen.

In my 18 years of working with independent producers on investor financing of their entertainment projects, most producers have sought to raise funds from investors for ultra-low and low-budget feature films (see endnote #2), and the following strategies have been employed or are possible:

1. Funding the Startup Phase–There are actually three different stages in the life of a feature film that can be financed separately. We might call the first stage the startup phase. It includes the funding of acquisition costs, development costs and packaging costs. Actual production of the film is the 2nd phase that can be funded separately and distribution is the third phase, that can also be funded separately from the other two.

This first investor financing strategy involves seeking investor funds for the purpose of funding the costs associated with a film’s acquisition, development and packaging costs. Then the producer, on behalf of his or her investors seeks industry financing for the production and distribution costs either through:

(A) A Production-Financing/Distribution (P-F/D) deal with a major studio (studio loans production funds and studio affiliated distributor covers distribution expenses to be recovered from distributor gross receipts);

(B) A Worldwide negative pickup with a major studio (used to obtain production loan from entertainment lender or lenders)

(C) Domestic negative pickup with domestic distributor (to be used again to obtain production loan from entertainment lender)

(E) International negative pickup with independent distributor (also to be used to obtain production loan from entertainment lender or lenders)

2. Full Funding of Production Costs–Some independent feature film projects may be fully funded with investor funds. In addition, these offerings usually also authorize the producers to reimburse themselves for their out-of-pocket startup costs. As a practical matter, however, it is not likely that more than $1 or 2 million dollars can be raised in this manner, so its use may be limited to low and ultra-low budget projects. On the other hand, the willingness of investors to invest in such high risk deals as feature film will vary considerably from time to time depending on many factors including the general state of the economy, who the producer is and how he or she relates to the prospective investors, what the film is about, who makes up the production team and what creative attachments are in place, among other factors.

3. Partial Funding of Production Costs–It would be fair to say that a producer is almost always in a better position to make deals if he or she (or the production company) has some funds under his, her or its control, in the bank. In other words, it is much more persuasive when talking or negotiating with other possible funding sources to be able to say that: “We already have $500,000 in the bank”, for example, as opposed to saying, “We plan to raise $500,000 from investors”. An existing fund in the bank can then be used in several ways: (a) to attract co-financing from another production entity, (b) to combine with foreign pre-sales (a form of lender financing) to cover the full budget or (c) to combine with some mix of personal funds, foreign pre-sales, gap financing, blocked currency deals, foreign currency deals, foreign below-the-line or facilities deals, international co-productions, foreign tax shelters and incentives, foreign government grants or subsidies, foreign debt capitalization programs or foreign equity financing (again see 43 Ways to Finance Your Feature Film for further discussion of these possibilities).

The strategy here is to raise the first money from a group of investors, for the fully disclosed purpose of using that money to combine it with funding from a number of other specifically identified sources. It may be necessary to promise the investors that you will not use any of their money until the other funds needed to produce the film are also in place.

4. Funding of Distribution Costs–We are assuming in this situation that the startup costs covering acquisition, development and packaging, along with production have already been secured and that the film has been produced or is in the process of being produced, and that other distribution options are either not available or not desired. In this situation, it may be possible to raise distribution funds from investors. Let’s say for example, you need $300,000 to provide a platform release for your film in a small number of theatres, and you hope then to expand into other markets using some of the film’s own revenues after that initial release. It is possible then to conduct an offering to investors to raise the $300,000 in the form of a so-called P&A fund, and structure the deal so that some of the film’s revenues will flow back to the investment vehicle/distributor for further distribution. It is also possible to create and raise money for a P&A fund for multiple projects, in effect using investor financing to fund a small distribution company.

5. Funding of a Film Development Company–Some in the film industry enjoy and have the skills needed to work on film projects during a film’s early stages. They enjoy seeking out new writing talent and acquiring rights to underlying literary material, developing and polishing scripts and attaching talent to these projects. They would rather create a business model that engages in these limited activities than engage in actual film production and get involved in activities relating to distribution. If that is the case, it is possible to use investor financing to fund these film development activities.

The development company’s objectives are to raise a certain amount of money from a group of investors, use that money to acquire rights and development scripts, possibly to package some of these projects and/or sell them outright to others who may then produce the film(s) and make arrangements for distribution. The development company presumably adds value to its film projects along the way and is able to sell its rights to these film projects for more money than it invested, thus creating an opportunity for these development company owner/producers and their investors to make a profit and move on to other development projects.

6. Financing for a Completion Fund–Another possible option for filmmakers is to use investor financing to fund a so-called completion fund or finishing fund. The strategy here is to raise a certain amount of money from investors, disclosing to them the plan to identify independent films that are in various stages of completion and provide the money to finish the film and get them to the marketplace. Generally speaking, the last money invested in such situations is in the best position to negotiate the most favorable terms, so theoretically, there might be an advantage for a group of investors to utilize this strategy for investing in film. In addition, this approach allows a group of investors and the producer/management group to spread the risk of their investment amongst a number of film projects.

7. Funding of a Multiple Film Offering–Another way to spread the risk of investing in film is to invest in several films at once. With this strategy in mind, the filmmaker can acquire rights and put together a so-called multiple film offering. The hope of the investors in this situation is that even if one or two of the films in the package do not perform well at the box office, maybe one in the package will, and the revenues from that one will be enough create a profit for the entire investment. Once again, a producer seeking to fund a multiple film offering will run into the practical limits as to how much money can be raised from investors at any given time. So, this approach may only be useful for really low and ultra-low projects, possibly a series of digital video projects, for example, but there is still some merit to the “spread-the-risk” concept.

No one is suggesting here that investor financing is the best way to finance one or more feature films, or that it is an easy way to finance films. On the other hand, for some low and ultra-low budget film projects, investor financing may be the only way to get the filmmaker’s vision on the screen. Filmmakers simply need to be realistic and select a strategy that appeals to him or her, and that is likely to attract investors along with the amount of money needed.

1. For that information see 43 Ways to Finance Your Feature Film and “Feature Film Limited Partnerships: A Practical Guide Focusing on Securities and Marketing for Independent Producers and Their Attorneys”, Loyola of Los Angeles Entertainment Law Journal, Vol.12, No. 1, 1992.

2. Other projects that have been financed using investor financing techniques include production company startups, documentaries, television pilots, live stage plays, music ventures and infomercials.

Internet Film Offerings

It is important to understand that for purposes of raising money from investors, the Internet is nothing more than a new form of communication. The technological creation of a new way to communicate with prospective investors does not in and of itself change long established federal and state rules and regulations that apply to investor financing of film or other entertainment projects. Thus, it is extremely important in analyzing whether funds for the acquisition, development, production and/or distribution of a feature film project can be raised via the Internet, that we understand clearly whether or not a security is involved, and therefore, whether the federal and state securities laws and regulations will apply to the transaction.

To simplify, a security is being offered or sold if the investors are going to be “passive”. If, on the other hand, the investors are somewhat knowledgeable in the industry being invested in and are going to be regularly involved in helping the film’s producer make important decisions, such investors may be considered “active” (i.e., non-passive), and under such circumstances, it is not likely that a security offering is being conducted, although again, this is an over-simplification and each case should be considered on its specific facts. There are, of course, very good reasons in a creative endeavor like film production not to want to raise money from “active” investors, whose opinions you have to deal with in putting your vision on the screen.

Next, we must recognize that any communication put on the Internet for the purpose of raising money from passive investors will be properly characterized as an “advertisement” or “general solicitation” by the federal and state securities regulatory authorities. As a general rule, the advertising or conduct of a general solicitation relating to a security is prohibited unless the security is registered with the Securities and Exchange Commission (SEC) at the federal level, and with the appropriate state regulatory authority in each state in which the security is being offered, prior to the start of the offering.

Low budget filmmakers may consider the use of the Regulation A public/registered offering (combined with state registration in each selected state) for amounts below $5 million. Another possibility is the SCOR offering (a state level public offering of corporate stock for up to $1 million, combined with the federal Regulation D, Rule 504 exemption from federal registration).

A third possibility that is even more complex than these other two involves securities offers being made over the Internet to a pre-screened and qualified group of accredited or sophisticated investors in the form of a private placement (i.e., a non-public offering that is exempt from the securities registration requirements because all conditions and limitations imposed on the use of the exemption have been complied with). In this scenario, the required pre-existing relationship already exists between the prospective investors and an online service, that has created an investor list through an online questionnaire designed to permit both the securities firm and any potential issuer to reasonably believe that the individual is an accredited or sophisticated investor for purposes of a Regulation D or other private placement offering. Qualified investors receive a password allowing access to a web page listing these private and other offerings. An SEC no-action letter sent to such a company essentially permits Internet solicitation of pre-qualified investors similar to solicitation by brokerage firms of pre-cleared customer lists. On the other hand, just because such companies exist online and their investors are pre-screened, that does not mean they are any more inclined to invest in a high risk investment such as independent film as any other group of prospective investors. And, the online service usually charges a fee upfront to permit access to their investors.

Another use of the Internet involves the posting of a generic business plan (or an executive summary of such a business plan) on the Internet and designing the business plan specifically for the limited purpose of attracting one or just a few “active” and sophisticated investors only. Under the right circumstances, such a business plan is not considered a security, thus the securities rules noted above are not involved. Such business plans can be communicated to anyone (i.e., a general solicitation via the Internet is perfectly permissible with an active investor business plan).

However, a business plan, by itself is not an investment vehicle. If the response to the business plan is positive, the producer may then choose to structure the investment as an investor financing agreement or a joint venture, and possibly as an initial incorporation or an active-investor (member-managed) limited liability company (all possible non-securities investment vehicles). If, on the other hand, the business plan attracts significant interest from investors, but they do not have sufficient means to finance the amount of money needed on a true active-investor basis, then it is still possible to stop the use of the generic business plan seeking active investors, wait a period of time (3-4 weeks is the suggested guideline by the SEC) and start a traditional (non-Internet) private placement securities offering (i.e., conduct a corporate stock offering, a limited partnership offering or a passive-investor limited liability company offering) making offers to these same prospective investors with whom the securities issuer/film producer now has established a pre-existing relationship for purposes of this subsequent securities offering. In other words, the required pre-existing relationship needed for purposes of conducting a private placement offering was established by means of the earlier general solicitation conducted through the use of the generic business plan seeking active investors. Of course, the pre-existing relationships with prospective investors of registered SEC/NASD securities broker/dealer firms can also be relied on for these purposes, if the film producer can interest such firms in film offerings.

Before any film producers expend a considerable amount of money seeking state approval for a SCOR or Regulation A offering and creating a Web site for marketing such offerings on the Internet, however, it would be wise to determine as much as possible just how successful these offerings have been. Film offerings of any kind are considered highly risky investments for investors. Merely putting them on the Internet will not reduce the risk to investors, thus, this new form of communication, may, in effect, merely be shifting producer monies to the pockets of Internet service providers, without creating a favorable track record for success in raising funds. Just as with all other film financing schemes, the producer must exercise reasonable caution.

For more information see:

California Department of Corporations Release No. 100-C “Offers of Securities Made on the Internet”, November 5, 1996.

“Direct Public Offerings/Raising Equity Capital via the Internet”, Internet Equity Consultants, at http://www.internetequity.com/intro.html.

“Financing on the Internet” by Dr. Jeffrey J. Moffie at http://www.ipoexchange.com/ipo-art2.htm.

43 Ways to Finance Your Feature Film, John W. Cones, Southern Illinois University Press (800/346-2680).

Film Finance and Distribution–A Dictionary of Terms“, by John W. Cones, Silman-James Press, 800/822-8669.

IPONet SEC No Action Letter re “Electronically Transmitted Indications of Interest and Posting of Notices of Private Offerings on Password-Protected Page”, July 23, 1996.

“The Internet and Financial Markets”, written by James E. Grand and Gary Lloyd for Upside Magazine” at http://www.ipoexchange.com/ipo-art.htm.

“SCOR Registration” by Mark J. Astarita, at http://www.e-ipoet.com/scorlaw.htm.

SEC Release No. 33-7289 “Use of Electronic Media for Delivery Purposes”, October 6, 1995.

Indie Film Securities Offerings

As an 18-year Los Angeles based securities/entertainment practitioner focused primarily on what I refer to as investor-financing of independent feature films (one of many ways to finance indie films), I was horrified recently to witness a prominent entertainment attorney telling an audience of filmmakers that when it comes to equity financing, “there are no rules”. I am certain that the U.S. Securities and Exchange Commission, the California Department of Corporations and all of the other state securities regulatory authorities would be shocked and surprised to learn that some entertainment attorneys are carelessly leading filmmakers to believe that the Hollywood-based film industry is somehow exempt from all of the existing rules and regulations relating to equity or investor-financing of feature films.

That sort of gross misinformation is apparently responsible for the many instances in which filmmakers decide without benefit of accurate advice to post their offerings on the Internet and advertise or conduct what, in effect, or general solicitations for investors online. From an enforcement standpoint, the securities regulatory authorities actually love this because they can easily spot such online solicitations and issue the cease and desist orders to offending filmmakers. After all, the federal and state securities laws clearly state that when selling a security (i.e., trying to raise money using some sort of securities investment vehicle) the offering must be registered with the SEC at the federal level and with each of the state securities regulatory authorities in which the security is being offered or sold. Typically, the only alternatives are (1) to identify available exemptions from the registration requirement (at both the state and federal levels) and comply with all of the conditions and limitations imposed on the use of such exemptions (i.e., private placements or combinations of private placements and public offerings), or (2) don’t offer a security (i.e., utilize some form of active investor vehicle that is not considered a security, for example, investor financing agreements, joint ventures, initial incorporations with a small group of founding shareholders or active-investor limited liability companies).

Of course, for filmmakers, one of the principal disadvantages of getting money from investors who are actively involved on a regular basis helping to make important decisions (a good working definition of an active investor) often brings about a severe compromise in creative control and all of the headaches that go along with it. Compared with filmmaking by committee, including a few individuals who contribute lots of money to the deal, compliance with the securities laws may not be so bad after all.

An overly simplistic but quite useful way for the practitioner and the filmmakers to quickly recognize whether a securities offering is contemplated by a proposed film financing scheme is to ask the question: “Are one or more of the investors going to be passive, (i.e., not regularly involved in helping to make important decisions relating to the management of the project)?” If one or more passive investors are involved in the deal, you have, more than likely, created a security whether it is properly labeled or not. So, it is time to either review the securities laws or bring in a specialist to help with that narrow aspect of representing the independent feature film producer. Many informed entertainment law practitioners choose the latter alternative while still reserving all of the remaining more purely entertainment law transactional work relating to acquisition of literary rights, packaging and employment agreements, production documentation, serving as a producer’s representative and negotiation of distribution deals for themselves.

The securities law specialist can then focus on advising the producer on choice of entity questions, legitimate techniques for expanding the available pool of prospective investors (and thereby helping to insure the success of the offering), preparation of the required disclosure document, proper use of the Internet, federal and state notice filings, preparation of financial projections and other matters more specifically associated with securities offerings. Such offerings in California, most commonly occur as limited partnership or passive-investor limited liability company offerings.

Some of the information that either needs to be disclosed in film offerings or is typically presented with such offerings, includes the title of the screenplay, screenwriter name and biography, descriptive phrase regarding the film’s genre, a screenplay synopsis, production schedule and shooting locations, box office comparables, name of the investment vehicle (entity), the entity’s address and phone, name of the management entity or individual(s), narrative bios and screen credits for all key people committed to the project; total amount of the offering (including offering expenses), number of investment units and cost of each unit, revenue sharing ratio as between the producer/management group and investors, subscription agreements, along with a budget topsheet or estimated use of proceeds (again, including offering expenses). Some of this information is best developed in consultation with the securities attorney.

With this sort of information regarding the film project and the offering, an experienced securities attorney can generally produce a first draft of the disclosure document in short order and that creates a good working document on which the team can focus. Quite, often an independent producer and associates can be on the street selling a feature film private placement offering within two to three weeks of the start of the process, if all goes well.

Indie Film Business Plans

Technically speaking, the business plan is not a financing vehicle or entity but can be used in conjunction with several other investor-financing techniques to raise money for independent feature film projects. For example, a business plan can be used with an investor-financing agreement to raise money from one or two active investors. It can be used with a joint venture agreement to raise money from another entity also acting as an active investor/joint venture partner. In limited circumstances, it may also be used as a means of identifying possible founding shareholders for the initial incorporation, a strategy discussed elsewhere in the book 43 Ways to Finance Your Feature Film (Southern Illinois University Press).

Another important use of the business plan is helpful in establishing a preexisting relationship with prospective investors for a subsequent securities offering. Thus, the business plan becomes a method for conducting a general solicitation while looking for active investors, and if the active investor campaign does not prove successful, then the use of the business plan can be halted, a three or four week interim waiting period can be observed and then the information in the business plan can be converted into a private placement securities offering memorandum for the purpose of seeking investments from a larger group of passive investors. If the private placement approach is used for the subsequent securities offering, those persons contacted during the active investor general solicitation (using the business plan) may be approached as prospective investors for the private placement since the initial contact with those prospective investors is likely to be sufficient to establish the preexisting relationship which, although not technically required by the federal securities laws, still is an important element in proving that no general solicitation occurred.

The film production company business plan can be very similar to the producer’s package except that it is usually bound and may be presented in a more organized fashion. The business plan is often the first step in procuring investor financing, whereas the producer’s package is more commonly used for similar purposes in obtaining funding from a distributor or other industry sources. The producer’s package might include, for example, a screenplay, a list of credits for key persons attached to the project and a proposed budget, whereas a business plan might include a synopsis of the screenplay, narrative biographies of the key persons attached to the project and a use of proceeds section, which corresponds closely to the budget top sheet. A business plan can be as simple or as sophisticated as the producer and his or her advisors choose to make it.

Like other forms of film finance, using the business plan has inherent advantages and disadvantages. The advantages of the business plan approach include: (1) No securities laws involved–So long as the business plan is associated with an active investor form of financing (i.e., investor-financing agreement, joint venture or initial incorporation), producers using a business plan may approach any prospective investor without fear of violating the securities law prohibitions relating to private placements, which in turn (as a practical matter) limit offers and sales to persons with whom the producer or other upper-level management of the issuing entity have a preexisting relationship. (2) No formal rules–There are no formal rules promulgated by any governmental authority regulating the contents of a business plan; thus, producers have considerable freedom in drafting such a document. There still may be some liability, however, for inaccurate or misleading statements. (3) Relatively easy to assemble–

In the context of the film business, a business plan is merely a specific adaptation of the producer’s package, which in turn contains many of the documents a producer would ordinarily generate in the preplanning stages of putting together a film project. (4) General solicitation permitted–The business plan, properly handled, allows the producer to go out into the marketplace and conduct a general solicitation for a single active investor or other possible combinations, and if not successful in raising the necessary monies using the business plan, the producer may convert his or her offering into a securities offering and then go back and call on those same investors within the context of a securities private placement.

Disadvantages of the business plan approach include the following: (1) May be unneeded step–If the producer already knows that he or she is going to use the limited partnership or limited liability company as the financing vehicle, for example, and already has a sufficient pool of prospective investors available, the business plan is just another step in the financing process that might be eliminated. (2) Inadvertent securities sales–Producers who are not aware of the important distinction between active and passive investor offerings may confuse the two in using a business plan and thus inadvertently be guilty of selling an unregistered security, a law violation raising the possibility of both civil and criminal penalties. Thus, producers beware: ignorance of the law is no excuse.

The following is a sample outline of a business plan to be used in promoting a feature film production company:

Business Plan

  • Executive Summary
  • Introduction (Setting of the Stage)
  • Status of the Independent Producer
  • General Company Description
  • Management and Organization (narrative biographies)
  • The Proposed Film
    • Film Synopsis/Treatment
    • Screenplay Rights
    • Comparable Box Office Performances (or distributor rentals)
    • Production of the Picture
    • Budget/Use of Proceeds
    • Distribution Approach
    • Funding of the Picture and Cofinancing

Industry Overview

  • Résumés of Principals
  • Literary Property Option/Acquisition Agreements
  • Financial Statements
  • Letters of Interest/Intent
  • Industry Articles
  • Press Coverage
  • Financial Projections

The following are other possible exhibits (depending on the stage at which financing is sought) that may be included as part of the business plan: title report, copyright search report, chain of title documents including a certificate of authorship for the screenplay, copy of the copyright registration, copyright assignment, distribution agreement(s), completion bond commitment letter, corporate resolution authorizing the producer to negotiate and sign a financing agreement, final screenplay and shooting script, cast and production credits, synopsis of the script, biographies of key people, feature stories on lead actors and the director, production stills, casual cast photos, agreements relating to the film’s music, the MPAA ratings certificate (if available) and the E&O certificate of insurance.

Reg. D, Rule 506(c) Final Rules

Abstract – The SEC’s final rules to eliminate the prohibition against general solicitation and general advertising in certain Regulation D, Rule 506 offerings are effective as of September 23, 2013.

On July 10th, 2013, the federal Securities and Exchange Commission (“SEC”) adopted final rules to implement the Congressionally mandated Jumpstart Our Business Startups Act (“JOBS Act”) provision [Section 201(a)(1)] that eliminates the prohibition against general solicitation and general advertising in certain Regulation D, Rule 506 offerings. The amendment permits a securities issuer to engage in general solicitation or general advertising in offering and selling securities pursuant to Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors. The amendment also includes a non-exclusive list of methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons. The amendment also revises Form D to require issuers to indicate whether they are relying on the provision that permits general solicitation or general advertising in a Rule 506 offering. At the same time, the SEC adopted amendments to disqualify issuers and other market participants from relying on Rule 506 if “felons and other ‘bad actors’” are participating in the Rule 506 offering (the so-called “bad boy” rule).

Effective Date – The final rule and form amendments are effective 60 days after publication in the Federal Register, which turned out to be September 22, 2013, since the final rules were published in the Federal Register on July 24, 2013.

Prior to the implementation of this new SEC rule, the Regulation D, Rule 506 exemption from securities registration was conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of “general solicitation or general advertising”. Through its own interpretations, the SEC has confirmed that uses of publicly available media, such as unrestricted websites constitute general solicitation and general advertising.

To implement Section 201(a) of the JOBS Act, the SEC amended Rule 506 to add new paragraph (c), under which the prohibition against general solicitation contained in Rule 502(c) would not apply, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors. For the notice filing Form D, the SEC added a check box to indicate whether an issuer is claiming an exemption under Rule 506(c).

The new rule affects only Rule 506, and not Section 4(a)(2) offerings in general, meaning that even after the effective date of Rule 506(c), an issuer relying on Section 4(a)(2) outside of the Rule 506(c) exemption will be restricted in its ability to make public communications to solicit investors for its offerings because public advertising will continue to be incompatible with a claim of exemption under Section 4(a)(2) of the 1933 Securities Act.

The new rule 506(c) permits the use of general solicitation to offer and sell securities under Rule 506 provided the following conditions are satisfied:

Ø all terms and conditions of Rule 501 (definitions) and Rules 502(a) (integration) and
502(d) (limitations on resale) must be satisfied;

Ø all purchasers of securities must be accredited investors; and

Ø the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors.

Note that the requirement that issuers take reasonable steps to verify that purchasers of the offering’s securities are accredited investors is separate from and independent of the requirement that sales be limited to accredited investors, and must be satisfied even if all purchasers happen to be accredited investors.

Offerings under Rule 506(c) are not subject to the requirement to comply with Rule 502(c), which contains the prohibition against general solicitation. While the SEC’s new rule 506(c) enables issuers to use general solicitation in Rule 506 offerings, the SEC also preserved, in the existing Rule 506(b), the ability of issuers to conduct a Rule 506 offering that is subject to the prohibition against general solicitation. So, issuers actually now have two Rule 506 options:

Ø conduct a traditional Regulation D, Rule 506(b) offering to accredited and non-accredited investors with whom the issuer, its upper level management and employees have a pre-existing relationship, or

Ø conduct an offering pursuant to the new Regulation D, Rule 506(c) to accredited investors only.

As noted above, the SEC also included a non-exclusive list of methods that issuers may use to verify the accredited investors status of natural persons.

Disclosure – Offerings under Rule 506(c) are not subject to the specific information (disclosure) requirements of Rule 502(b) for non-accredited investors, since all purchasers in the Rule 506(c) offerings are required to be accredited investors. However, as noted in Preliminary Note 1 of Regulation D, the anti-fraud rule (a general underlying disclosure requirement) still applies, and according to the SEC General Counsel’s Office, the document used to promote such offerings must be a securities disclosure document. A business plan is not adequate.

Further, an ongoing offering under the traditional Rule 506 that commenced before the effective date of Rule 506(c), the issuer may choose to continue the offering after the effective date in accordance with the requirements of either Rule 506(b) or Rule 506(c). If an issuer chooses to continue the offering in accordance with the requirements of Rule 506(c), any general solicitation that occurs after the effective date will not affect the exempt status of offers and sales of securities that occurred prior to the effective date in reliance on Rule 506(b).

Reasonable Steps to Verify Accredited Investor Status

Section 201(a)(1) of the JOBS Act mandated that the SEC’s amendment to Rule 506 require issuers using general solicitation in Rule 506 offerings to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the SEC.

Principles-Based Approach – On the one hand, the SEC has chosen to take a fairly flexible so-called “principles-based” approach, in which issuers would consider a number of factors when determining the reasonableness of the steps to verify that a purchaser is an accredited investor, such as:

• the nature of the purchaser and the type of accredited investors that the purchaser claims to be;

• the amount and type of information that the issuer has about the purchasers; and

• the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

In the alternative, the SEC has provided a non-exclusive list of verification methods that would function as a safe harbor for compliance with the verification requirement.

Generally speaking it is the SEC’s position that after consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investors, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa.

As an example, the SEC says that if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.

Regardless of the particular steps taken, because the issuer has the burden of demonstrating that its offering is entitled to an exemption from the registration requirements of Section 5 of the Securities Act, it will be important for issuers and their verification service providers (if used) to retain adequate records regarding the steps taken to verify that each purchaser was an accredited investor.

As noted above, in determining the reasonableness of the steps to verify accredited investor status, an issuer may consider three categories of information:

• the nature of the purchaser,

• information about the purchaser and

• the nature and terms of the offering.

Nature of the Purchaser – The definition of “accredited investor” in Rule 501(a) includes natural persons and entities that come within any of 8 enumerated categories in the rule, or that the issuer reasonably believes come within one of those categories, at the time of the sale of securities to that natural person or entity.

Some persons may be accredited investors based on their status, such as:

• a registered broker or dealer, or

• a registered investment company.

Some purchasers may be accredited investors based on a combination of their status and the amount of their total assets, such as:

• a plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5 million, or

• a 501(c)(3) organization, corporation, business trust or partnership not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million.

Natural persons may be accredited investors based on either their net worth or their annual incomes:

• a natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1 million, excluding the value of the person’s primary residence; or

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

Since Rule 501(a) sets forth different categories of accredited investors, an issuer should recognize that the steps that will be reasonable to verify whether a purchaser is an accredited investor will vary depending on the type of accredited investor that the purchaser claims to be. For example, the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a registered broker-dealer, such as by going to FINRA’s BrokerCheck website, will necessarily differ from the steps that may be reasonable to verify whether a natural person is an accredited investor.

Information About the Purchaser – Again, as a general rule, the more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it may have to take, and vice versa. Examples of the types of information that issuers could review or rely upon – any of which might, depending on the circumstances, in and of themselves constitute reasonable steps to verify a purchaser’s accredited investor status – include without limitation:

• publicly available information in filings with a federal, state or local regulatory body; (for example, the purchaser is a named executive officer of an Exchange Act registrant, and the registrant’s proxy statement discloses the purchaser’s compensation; or the purchaser claims to be a 501(c)(3) organization with $5 million in assets, and the organizations’ Form 990 series return filed with the IRS discloses the organization’s total assets);

• third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition (for example, a purchaser who is a natural person and provides copies of pay stubs for the two most recent years and the current year; or specific information about the average compensation earned at the purchaser’s workplace by persons at the level of the purchaser’s seniority; or verification of a person’s status as an accredited investor by a third party, provided that the issuer has a reasonable basis to rely on such third-party verification).

Nature and Terms of the Offering – The nature of the offering, such as the means through which the issuer publicly solicits purchasers, may be relevant in determining the reasonableness of the steps taken to verify accredited investor status. An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated e-mail or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party. The SEC goes on to say that an issuer will be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification. The SEC takes the position that an issuer will not have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, require only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.

Non-Exclusive Methods of Verifying Accredited Investor Status

In addition to the principles-based method of verification, the SEC included in its new Rule 506(c), four specific non-exclusive methods of verifying accredited investor status for natural persons that, if used, are deemed to satisfy the verification requirement of Rule 506(c), except that none of these methods will be deemed to satisfy the verification requirement if the issuer or its agent has knowledge that the purchaser is not an accredited investor.

1. Income – In verifying whether a natural person is an accredited investor on the basis of income, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of any IRS form that reports income for the individual and/or spouse from the two most recent years, along with obtaining a written representation from such person(s) that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.

2. Net Worth – In verifying whether a natural person is an accredited investor on the basis of net worth, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing one or more of the following types of documentation, dated within the prior three months, and by obtaining a written representation from such person and/or spouse that all liabilities necessary to make a determination of net worth have been disclosed.

• For assets, that documentation may include bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties;

• For liabilities, that documentation may include a credit report from at least one of the nationwide reporting agencies.

3. Third-Party Confirmation – An issuer is deemed to satisfy the verification requirement in Rule 506(c) by obtaining a written confirmation at the time of the sale from any of the following:

• a registered broker-dealer;

• an SEC-registered investment adviser;

• a licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or

• a certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office

that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor.

The SEC goes on to say in its July 10 Release 33-9415 that while third-party confirmation by one of these parties will be deemed to satisfy the verification requirement in Rule 506(c), depending on the circumstances, an issuer may be entitled to rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that any such third party takes reasonable steps to verify that purchasers are accredited investors and has determined that such purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification.

4. Existing Investors – For existing investors who were accredited investors in a traditional Rule 506(b) offering prior to the effective date of the new Rule 506(c), a self-certification at the time of sale that he or she is an accredited investor will be deemed to satisfy the verification requirement of Rule 506(c).

The SEC recognizes that a person could provide false information or documentation to an issuer in order to purchase securities in an offering made under the new Rule 506(c). Thus, even if an issuer has taken reasonable steps to verify that a purchaser is an accredited investor, it is possible that a person nevertheless could circumvent those measures. If a person who does not meet the criteria for any category of accredited investor purchases securities in a rule 506(c) offering, the SEC takes the position that the issuer will not lose the ability to rely on Rule 506(c) for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of sale. [Source: SEC Release No. 33-9415, July 10, 2013, 116 pages]

Proposed Rules – In addition to adopting the new final rule for Reg. D, Rule 506(c), the SEC also voted to approved a rule proposal requiring issuers to provide additional information about such offerings to better enable the SEC to monitor the market with the general solicitation ban now lifted. The proposal also provides for additional safeguards as this market changes and new practices develop. This proposal, subject to a 60 day comment period, would require issuers using the new rule 506(c) to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. In addition, this proposed rule would require that the issuer update the information contained in the Form D and indicate that the offering has ended within 30 days of completing such an offering.

Further, under this proposed rule, issuers would be required to provide additional information to the SEC including:

• Identification of the issuer’s website;
• Expanded information on the issuer;
• The offered securities;
• The types of investors in the offering;
• The use of proceeds from the offering;
• Information on the types of general solicitation used;
• The methods used to verify the accredited investor status of investors.

In addition, under the proposal, issuers would be disqualified from using the new Rule 506(c) exemption in any new offering if the issuer or its affiliates do not comply with the Form D filing requirements. Also, the proposal would require issuers to include certain legends and specific disclosures in any written general solicitation materials and to submit any written general solicitation materials to the SEC. [SEC “Fact Sheet – Proposing Amendments to Private Offering Rules”, SEC Open Meeting, July 10, 2013; www.sec.gov/news/press/2013-124-item3.htm]