An equity investment can be structured in a number of ways. For example, an investor could be a stockholder in a corporation, a non- managing member of a Limited Liability Company (LLC), or a limited partner in a partnership.
An investor shares in potential rewards as well as the risks of failure. If a movie is a hit, the investor is entitled to receive his investment back and share in proceeds as well. Of course, if the movie is a flop, the investor may lose his entire investment. The producer is not obligated to repay an investor his loss.
The interests of individuals and companies that do not manage the enterprise they invest in are known as securities. These investors may be described using a variety of terms including silent partners, limited partners, passive investors and stockholders. They are putting money into a business that they are not managing (i.e., not running). State and federal securities laws are designed to protect such investors by ensuring that the people managing the business (e.g., the general partners in a partnership or the officers and directors of a corporation) do not defraud investors by giving them false or misleading information, or by failing to disclose information that a reasonably prudent investor would want to know.
In a limited partnership agreement, for example, investors (limited partners) put up the money needed to produce a film. Investors usually desire limited liability. That is, they donʼt want to be financially responsible for any cost overruns or liability that might arise if, for instance, a stunt person is injured. They want their potential loss limited to their investment.
Because limited partnership interests are considered securities, they are subject to state and federal securities laws. These laws are complex and have strict requirements. A single technical violation can subject general partners to liability. Therefore, it is important that filmmakers retain an attorney with experience in securities work and familiarity with the entertainment industry. This is one area where filmmakers should not attempt to do it themselves.
Registration and Exemptions
The federal agency charged with protecting investors is the U.S. Securities and Exchange Commission (SEC). Various state and federal laws require that most securities be registered with state and/or federal governments. Registration for a public offering is time- consuming and expensive, and not a realistic alternative for most low-budget filmmakers. Filmmakers can avoid the expense of registration if they qualify for one or more statutory exemptions. These exemptions are generally restricted to private placements, which entail approaching people one already knows (i.e., the parties have a pre-existing relationship). Compare a private placement with a public offering where offers can be made to strangers, such as soliciting the public at large through advertising. Generally, a public offering can only be made after the U.S. Securities and Exchange Commission (SEC) has reviewed and approved it.
There are a variety of exemptions to federal registration. For example, there is an exemption for intrastate offerings limited to investors all of whom reside within one state. To qualify for the intrastate offering exemption, a company must: be incorporated in the state where it is offering the securities, and it must carry out a significant amount of its business in that state. There is no fixed limit on the size of the offering or the number of purchasers. Relying solely on this exemption can be risky, however, because if an offer is made to a single non-resident the exemption could be lost.
Under SEC Regulation D (Reg D) there are three exemptions from federal registration. These can permit filmmakers to offer and sell their securities without having to register the securities with the SEC. These exemptions are under Rules 504, 505 and 506 of Regulation D. While companies relying on a Reg D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file a document known as Form D when they first sell their securities. This document gives notice of
the names and addresses of the companyʼs owners and promoters. State laws also apply and the offeror will likely need to file a document with the appropriate state agency for every state in which an investor resides.
An “offering” is usually comprised of several documents including a private placement memorandum (PPM), a proposed limited partnership agreement (or operating agreement for an LLC, or bylaws for a corporation), and an investor questionnaire used to determine if the investor is qualified to invest. A PPM contains the type of information usually found in a business plan, and a whole lot more. It is used to disclose the essential facts that a reasonable investor would want to know before making an investment. The offeror may be liable if there are any misrepresentations in the PPM, or any omissions of material facts.
State registration can be avoided by complying with the requirements for limited offering exemptions under state law. These laws are often referred to as “Blue Sky” laws. They were enacted after the stock market crash that occurred during the Great Depression. They are designed to protect investors from being duped into buying securities that are worthless — backed by nothing more than the blue sky.
The above-mentioned federal and state exemptions may restrict offerors in several ways. Sales are typically limited to 35 non- accredited investors, and the investors may need to have a pre- existing relationship with the issuer (or investment sophistication adequate to understand the transaction), the purchasers cannot purchase for resale, and advertising or general solicitation is generally not permitted. There is usually no numerical limit on the number of accredited investors.
A “pre-existing relationship” is defined as any relationship consisting of personal or business contacts of a nature and duration such as would enable a reasonably prudent purchaser to be aware of the character, business acumen and general business and financial circumstances of the person with whom the relationship exists.
Other documents may need to be filed with federal and state governments. For example, a Certificate of Limited Partnership may need to be filed with the Secretary of State to establish a partnership. In California, a notice of the transaction and consent to service of process is filed with the Department of Corporations. If the transaction is subject to federal law, Form D will need to be filed with the Securities and Exchange Commission (SEC) soon after the first and last sales. Similar forms may need to be filed in every state in which any investor resides.
In the independent film business, PPMs are usually: a Rule 504 offering to raise up to $1,000,000, or a Rule 505 offering which allows the filmmaker to raise up to $5,000,000, or a Rule 506 offering which doesnʼt have a monetary cap on the amount of funds to be raised. A 506 offering also offers the advantage of preempting state laws under the provisions of the National Securities Markets Improvement Act of 1996 (“NSMIA”)
All security offerings, even those exempt from registration under Reg. D, are subject to the antifraud provisions of the federal securities laws, and any applicable state anti-fraud provisions. Consequently, the offeror will be responsible for any false or misleading statements, whether oral or written. Those who violate the law can be pursued under both criminally and civilly. Moreover, an investor who has purchased a security on the basis of misleading information, or the omission of relevant information, can rescind the investment agreement and obtain a refund of his/her investment.
In a pre-sale agreement, a buyer licenses or pre-buys movie distribution rights for a territory before the film has been produced. The deal works something like this: Filmmaker Joe approaches Distributor Dan to sign a contract to buy the right to distribute Henryʼs next film. Joe gives Dan a copy of the script and tells him the names of the principal cast members.
Dan has distributed several of Joeʼs films in the past. He paid $50,000 for the right to distribute Joeʼs last film in Europe. The film did reasonably well and Dan feels confident, based on Joeʼs track record, the script, and the proposed cast, that his next film should
also do well in Europe. Dan is willing to license Joeʼs next film
sight unseen before it has been produced. By buying distribution rights to the film now, Dan is obtaining an advantage over competitors who might bid
for it. Moreover, Dan may be able to negotiate a lower license fee than what he would pay if the film were sold on the open market. So Dan signs a contract agreeing to buy European distribution rights to the film. Dan does not have to pay (except if a deposit is required) until completion and delivery of the film to him.
Joe now takes this contract, and a dozen similar contracts with buyers to the bank. Joe asks the bank to lend him money to make the movie with the distribution contracts as collateral. Joe is “banking the paper.” The bank will not lend Joe the full face value of the contracts, but instead will discount the paper and lend a smaller sum. So if the contracts provide for a cumulative total of $1,000,000 in license fees, the bank might lend Joe $800,000. In some circumstances banks are willing lend more than the face value of the contracts (so-called gap financing) and charge higher fees.
Joe uses this money to produce his film. When the movie is completed, he delivers it to the companies that have already licensed it. They in turn pay their license fees to Joeʼs bank to retire Joeʼs loan. The bank receives repayment of its loan plus interest. The buyers receive the right to distribute the film in their territory. Joe can now license the film in territories that remain unsold. From these revenues Joe makes his profit.
Danʼs commitment to purchase the film must be unequivocal, and
his company financially secure, so that a bank is willing to lend Joe
money on the strength of Danʼs promise and ability to pay. If the
contract merely states that the buyer will review and consider purchasing the film, this commitment is not strong enough to borrow against. Banks want to be assured that the buyer will accept delivery of the film as long as it meets certain technical standards, even if artistically the film is a disappointment. The bank will also want to know that Danʼs company is fiscally solid and likely to be in business when it comes time for it to pay the license fee. If Danʼs company has been in business for many
years, and if the company has substantial assets on its balance sheet, the bank will usually lend against the contract.
The bank often insists on a completion bond to ensure that the filmmaker has sufficient funds to finish the film. Banks are not willing to take much risk. They know that Danʼs commitment to buy Joeʼs film is contingent on delivery of a completed film. But what if Joe goes over budget and cannot finish the film? If Joe doesnʼt deliver the film, Dan is not obligated to pay for it, and the bank is not repaid its loan.
To avoid this risk, the bank wants an insurance company, the completion guarantor, to agree to put up any money needed to complete the film should it go over budget. Before issuing a policy, a completion guarantor will carefully review the proposed budget and the track record of key production personnel. Unless the completion guarantor is confident that the film can be brought in on budget, no policy will issue. These policies are called completion bonds.
First-time filmmakers may find it difficult to finance their films through pre-sales. With no track record of successful films to their credit, they may not be able to persuade a distributor to pre-buy their work. How does the distributor know that the filmmaker can produce something their audiences will want to see? Of course, if the other elements are strong, the distributor may be persuaded to take that risk. For example, even though the filmmaker may be a first-timer, if the script is from an acclaimed writer, and several big name actors will participate, the overall package may be attractive. The terms of an agreement between the territory buyer (licensor) and the international distributor can be quite complex.
Parties may disagree about the meaning of terms used in their agreements. The following terms are standard AFMA definitions, which are generally accepted in the industry. They are used to interpret whatever document they are attached to.