43 Ways to Finance your Feature Film

43Ways to

Finance Your Feature Film A Comprehensive Analysis of Film Finance

John W. Cones

Third Edition

43Ways to Finance Your Feature Film

Cones Frontmatter.indd 1

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43

Ways to Finance Your Feature Film A Comprehensive Analysis of Film Finance Third Edition

John W. Cones

Southern Illinois University Press Carbondale


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Copyright © 2008 by John W. Cones All rights reserved. First edition 1995 Third edition 2008 Printed in the United States of America 11 10 09 08 4 3 2 1 Library of Congress Cataloging-in-Publication Data Cones, John W. 43 ways to finance your feature film : a comprehensive analysis of film finance / John W. Cones.—3rd ed. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-8093-2693-8 (pbk. : alk. paper) ISBN-10: 0-8093-2693-0 (pbk. : alk. paper) 1. Motion picture industry—Finance. I. Title. II. Title: Forty-three ways to finance your feature film. PN1993.5.A1C64 2007 384'.83—dc22 2007016176 Printed on recycled paper. The paper used in this publication meets the minimum requirements of American National Standard for Information Sciences— Permanence of Paper for Printed Library Materials, ansi z39.48-1992. ∞


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To Donna, without whose support, encouragement and cooperation this book could not have been completed


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Contents Preface xi Introduction: No Single Best Way PART ONE. Subsidies 1 2

9

Gifts and Grants 11 Domestic Government Subsidies and Tax Incentives 21

PART TWO. Investor Financing 39

active investor vehicles 3 4 5 6

47

The Investor-Financing Agreement 49 General Partnerships and Joint Ventures The Initial Incorporation 59 The Member-Managed LLC 64

52

passive investor vehicles 67 7 8 9

The Manager-Managed LLC Limited Partnerships 74 Corporate Finance 80

71

securities compliance 95 private (exempt) offerings 10 11 12

Statutory Exemptions of the 1933 Securities Act, Section 4 96 Intrastate Offering Exemption 103 Regulation D 105

public /private (hybrid) exemptions 13

Public/Private (Hybrid) Exemptions

115

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Contents

public (registered) offerings 14 15 16 17 18

Small Corporate Offering Registration 128 Regulation A 131 Regulation S-B 135 S-1 Public Offerings 138 Over-the-Counter, NASDAQ and Stock Exchanges

141

PART THREE. Lender Financing 147 19 20 21 22 23 24

Lender Financing without Distributor Contracts Negative Pickups and the Artificial Version 157 Presale Financing 166 Gap and Supergap Financing 177 Insurance-Backed Schemes 184 Securitization 188

PART FOUR. Studio/Industry Financing 25 26 27 28 29 30 31 32 33 34 35

149

193

Studio Development and In-House Production 195 Studio Production-Financing/Distribution Agreements 199 Studio-Based Production Companies 204 Independent Distributors 207 Domestic Studio Facilities 210 Film Laboratories 213 Talent Agencies 215 Actor Financing 217 Product Placements 221 End Users 225 Completion Funds 227

PART FIVE. International Finance Options 231 36 37

Foreign Equity 233 International Coproductions

244

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Contents

38 39 40 41 42 43

Foreign Tax Shelters and Tax Incentives 256 Blocked Currency or Blocked Funds 275 Foreign Currency 279 Foreign Below-the-Line or Facilities Deals 281 Foreign Government Subsidies 283 Foreign Debt Capitalization Programs 289 Conclusion: The Broader Film Finance Environment 291 Appendix A: Finding Investors 297 Appendix B: Limited-Use Business Plans 299 Appendix C: Financial Projections 304 Appendix D: Securities Marketing Considerations Sources and Further Reading 331 Index 359

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Preface This book is published with the understanding that the author is not herein engaged in rendering legal, accounting or other professional services. For those readers seeking legal advice or other expert assistance, the services of a professional should be engaged for that specific purpose. All opinions expressed in this book are those of the author. The earliest drafts of this book were used as texts and as a basis for discussion in the author’s “Independent Feature Film Financing and Distribution” class in the graduate-level Independent Producers Program at the University of California at Los Angeles and in a lecture on film finance and distribution for the University of Southern California School of Cinema-TV. Other parts of this book evolved from seminar handouts developed for lectures sponsored by the American Film Institute, UCLA Extension, IFP/West, American University (Washington, D.C.), the Nashville Bar Association, the Cal Western School of Law, the University of Texas Entertainment Law Institute, the “Semester in Los Angeles” program of Columbia College Chicago, the North Carolina School of the Arts and other film industry organizations. I am grateful for the useful comments I received from many of the graduate and undergraduate students in those schools’ writing, directing, producing, business and law programs as well as others who attended my seminar presentations—an aggregate audience of more than 5,000—that included certain filmmakers, attorneys, accountants, broker/dealers, film commissioners, film students, government officials and others. I have truly benefited from their participation.

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Introduction: No Single Best Way This book has been written to meet a need within the American film industry for a balanced and objective overview of information relating to the numerous film-financing options and their respective advantages and disadvantages. The book is for those people, whether they are producers, executive producers, attorneys, screenwriters, investors or others, who are thinking about developing, producing, distributing or even investing in one or more feature or documentary films and trying to determine the best way to go about financing the costs of their project or projects. The need exists for several reasons: (1) Each year in the United States, thousands of filmmakers are confronted with the question, how can I finance the costs of producing my feature (or documentary) film? (2) None of the currently available books, articles, or seminar presentations provides a comprehensive overview of the subject. (3) Much of the information presented through books, articles, or seminars is biased in one way or another. (4) And, unfortunately, some of the information available is simply inaccurate. This book seeks to provide an overview of film finance and is dedicated to the proposition that • there are a variety of ways to finance one or more feature films; • often a combination of methods may have to be used; • there is no single “best” form of film finance for all motion pictures at all times; • there are advantages and disadvantages associated with each form of film finance; and • one of the most important responsibilities of the producer or someone on the producer’s team is to be generally aware of the advantages and disadvantages of each form of film finance so that the method or methods chosen for a particular project are more likely to succeed in raising the money needed.

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Introduction

Thus, the focus of this book is on film finance, primarily for feature films and documentaries, as opposed to short films, videos and other types of entertainment or informational projects, although much of the information presented may be useful in financing those kinds of projects as well. The emphasis is on financing the production of such films, although, again, some of the financing techniques discussed here can be applied to the development and distribution phases. These three major phases in the life of a film (development, production and distribution) can be financed separately. Film Finance versus Distribution As a practical matter, it is pointless, and even misleading, to attempt to discuss film finance without also discussing certain aspects of film distribution; namely, those aspects that help to determine how revenues generated from the exploitation of a motion picture in all markets and media flow back to the owners, contingent-compensation participants, financiers and investors. Nevertheless, this book will strive to emphasize as much as possible the front side of the transaction (film finance) instead of the back side (financial aspects of film distribution) and keep references to distribution to a minimum. (For additional information relating to film distribution, see The Feature Film Distribution Deal: A Critical Analysis of the Single Most Important Film Industry Agreement.) An Overview This book also does not attempt to provide an in-depth discussion of each of the forms of film finance covered. If in-depth coverage were the goal, a series of books would be needed to adequately cover the main areas of film finance: (1) gifts, grants, subsidies and tax incentive programs; (2) investor financing; (3) lender financing; (4) studio and industry financing; and (5) international financing options. For that reason, the Sources and Further Reading in the back of the book provides numerous suggestions for readers interested in a particular form of film finance to find additional and more complete information on that topic. New Additions and Order of Presentation The contents of this new edition of the book have been expanded substantially to include the following new topics: gifts and grants; foreign and domestic state subsidies; the manager-managed LLC (limited liability company); public-private hybrid exemptions; securitization; product placement; gap and supergap financing; and insurance-backed schemes. In addition, the order of presentation has been reversed from 2

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Introduction

that used in the previous edition: instead of starting with a discussion of studio and industry financing (the least likely to be accessible to the first-time producer) and then proceeding to lender financing, investor financing and foreign financing options, this new edition starts with those forms of film finance that may, of necessity, have to be considered first by a U.S.-based independent feature film producer because they are likely to be more accessible, even if they offer the least amount of funds. The book then proceeds to discuss other forms of film finance that may provide a greater amount of money or that may become available as the producer’s career matures. Thus, the new order of the topics covered is (1) gifts, grants, subsidies and tax incentive programs; (2) investor financing; (3) lender financing; (4) studio and industry financing; and (5) international financing. For many film producers, the natural order of progression for the last two broad categories may be reversed; after all, there is no law requiring that filmmakers proceed in this fashion. They are free to pursue whatever financing is available for a particular project at any given time. Some forms of film finance simply make more sense for particular filmmakers at a given stage in their career. Independent Film Finance With the exception of the section relating to studio film finance, most of the film-financing methods presented in this book are considered more appropriate for the production of independent feature films and documentaries. But just what is an independent film? The Independent Film and Television Alliance (IFTA, formerly known as the American Film Marketing Association, or AFMA), a trade association for the independent film and television industry, sets forth an easily applied definition. Most important for the purposes of this book, the IFTA definition focuses on how the film is financed: It states that a film should be considered an independent film if “more than fifty percent of its financing comes from sources other than the . . . major U.S. studios.” The IFTA definition goes on to indicate that independent productions cover all budget ranges and genres and are aimed at wide, as well as niche, audiences. Another industry association, not so directly tied to film finance and production, uses a less objective and more difficult to apply definition. The Film Independent group (FIND—formerly IFP/West or IFP/LA) takes the position that an independent film is one that exhibits uniqueness of vision; contains original, provocative subject matter; was produced using an economy of means (with particular attention paid to total production cost and individual compensation); and derived some unstated percentage of its financing from independent sources. That means that, 3

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Introduction

at the discretion of FIND, films financed by the major studios or their subsidiaries can compete for FIND awards, which may be the purpose of such a vague definition: It allows FIND to include more well-known stars in their annual awards ceremony, thus making the organization appear more glamorous. In the process, however, FIND is literally inviting the major studio/distributors to gobble up even more of the attention and market share desperately needed by independent filmmakers. Thus, as an organization, FIND can hardly be said to effectively represent the interests of independent filmmakers. To some extent, both of these definitions seem to be succumbing to the power of the Hollywood major studio/distributors. After all, if a film is 50 percent financed by a major studio/distributor or one of its affiliates, it is most likely also going to be released, at least in the domestic marketplace, by a major studio/distributor or affiliate, which will have exerted a considerable amount of influence over both the production and the distribution; thus, for all practical purposes, it is not an independent film, in the ordinary sense of the word. When major studios put up half of the production financing for a film, they tend to have a say in how the film is made. To be more precise in determining whether a given film is an independent film, it may be relevant to determine which of the three phases in the life of a film have been financed without the aid of any of the so-called major studio/distributors. In other words, if an independent producer has been responsible for raising the funds to develop, produce and distribute a motion picture, that is clearly an independent film. If, on the other hand, an independent producer has financed the development phase but has used the assistance of a major studio/distributor or one of its subsidiaries in financing the production phase in addition to the distribution of the film, it would not be accurate to call that an independent film. Still further, if an independent producer raised the financing for the development and production phases and then merely looked to a major studio/distributor or to an affiliate or subsidiary of one to release the picture (i.e., the distributor was only responsible for the costs of distribution and acquired the rights to distribute the film as a pure acquisition), that may be considered an independently produced film that was merely released by a major studio/distributor, affiliate or subsidiary. The Internet In this new era of the Internet, a book also has to be written in a way that complements the information available online. Thus, the extensive bibliography (i.e., Sources and Further Reading) appearing at the end of 4

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Introduction

the book not only includes articles and books but also online sources. Readers must recognize, however, that websites tend to come and go. In addition, since anyone can put up a website or post an article, the quality of the information relating to film finance appearing online is not consistent, and some of it may not be reliable. Thus, readers are advised to proceed cautiously. Never rely on any single source for film-financing information. Learn from as many different sources as possible. And don’t hesitate to check out the credibility of sources. If you find that someone is pushing too hard for your acceptance of their point of view, consider their motives. Many film finance practitioners do not even know what a conflict of interest is, much less how to appropriately handle such a situation. Bad Advice A new feature added to this revised and updated edition of the book is entitled “Bad Advice.” Independent filmmakers are often given misinformation about film finance, and some of that bad advice has been noted here so that future filmmakers can recognize and avoid it. Why Forty-Three? The choice of forty-three as the number of ways to finance a film is somewhat arbitrary, but it is based on an early analysis of the question and an estimate of the number of possible solutions. A number smaller or larger could have been chosen. In fact, by one count, as many as sixty-two distinct types of financing methods are explored in this presentation, and an even greater number of combinations could be used on a given film. Thus, the various forms of film finance could have been presented as the “Major Types of Film Finance.” Certain forms of film finance that were covered as separate chapters in the earlier edition (e.g., the three exemptions under Regulation D) are now covered in one chapter. It just so happens that forty-three was my original estimate of the number of forms of film finance that could be reasonably discussed in a book of this nature—a number not so large as to be overwhelming, but large enough to suggest the great range of film-financing options—and although during the actual writing of the book, various editorial decisions were made, splitting, combining, adding or omitting chapters, forty-three stayed on as a comfortable, if not catchy, number. Availability Analysis Finally, a book that focuses on providing an analysis of the advantages and disadvantages of various forms of film finance, as this one does, will overlook one of the most important advantages or disadvantages, 5

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Introduction

as the case may be, if it does not discuss the availability of such forms of film finance; that is, whether a particular form of film finance would realistically be available in the marketplace for a particular filmmaker on a particular project at a given time, regardless of what other advantages might attract the filmmaker to that form of film finance. Different forms of film finance may be more, or less, available to some people than others, depending on the specific project, its budget and other film elements, along with the relationships and other resources that such persons bring to the table, and so forth. In addition, reliable availability information is difficult to come by in the film industry, if for no other reason than there is no organization that routinely develops and makes objective, comprehensive film-financing information available to those who need it (another missed opportunity for the professional associations purportedly representing the interests of independent producers). Thus, before a producer ultimately determines which form of film finance is best for a particular film project at a given time, it is important to objectively analyze whether that form of film finance is realistically available for that person and that project at that particular moment. Overview and Order of Use In the normal course of events, a filmmaker might start off as a sole proprietor and might choose to operate the sole proprietorship under a fictitious name (or dba—“doing business as”). The filmmaker may next choose to bring some start-up funds into the business by seeking gifts, grants or investment funds through an investor-financing agreement or a joint venture agreement. Eventually, the filmmaker may choose to create an entity to serve as the production company, either a corporation (so-called regular C corporation or S corp) or a member-managed limited liability company (LLC). In either case, the creation of such an entity will provide another opportunity for the filmmaker to raise some additional start-up funding for the production company’s operations. The next level of finance might come from a privately placed securities offering of corporate stock (long-term corporate finance) or a privately placed securities offering through a manager-managed LLC or a limited partnership (project financing). Such project financing may be for a single motion picture project or a series of films. It may be combined with other forms of film finance, such as gifts, grants, coproductions (joint ventures), lender financing, or state, federal and foreign subsidies and tax incentives. In the alternative, the filmmaker may want to conduct a public (registered) securities offering for LP or LLC units. If the venture continues to 6

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Introduction

be successful, the filmmaker may choose to take the production company public as a corporation by conducting a public (registered) offering of corporate stock. Eventually, the publicly held corporation may want to offer its shares over-the-counter, on the NASDAQ exchange or on one of the other stock exchanges. All of these options are treated here. A Collaborative Process A film producer should not try to finance a feature film alone, unless his or her intention is simply to produce a home movie. Just as in producing the film, the financing part is also a collaborative venture, and it is very common these days for producers to use several different forms of film finance to fund the production of a single motion picture—an arrangement sometimes referred to as “combo-financing.” Thus, it makes sense to utilize the services and expertise of individual associates, executive producers, attorneys or consultants who know the terrain for each specialized form of film finance because it is highly unlikely that any one individual adviser will have bona fide expertise with respect to all the forms of film finance. As examples only, here are several suggested combinations of forms of film finance for putting together the needed financing for an independent film: • Get someone to make a start-up gift of $10,000 (see chapter 1). • Get a grant for another small amount of money (see chapter 1). • Get several people to invest in a start-up production company organized as a regular C corporation, or as an S corp, or as a member-managed LLC (but only if the owners are people with whom the producer can work harmoniously and effectively). The producer invests scripts he or she has written, acquired or optioned, and the investors invest the production company’s start-up funds (see “Choice of Investment Vehicles and Entities” in the introduction to part two). • Raise development and packaging funds or some portion of the production funds through an investor offering to a large group of passive investors to spread the risk (see part two, Investor Financing, “Passive Investor Vehicles” and “Securities Compliance”). • Raise the balance needed with a domestic negative pickup deal, an international negative pickup, foreign presales, state subsidies or international tax incentives (see chapter 2, chapters 19–24, and chapters 36–43).

Again, the order in which a filmmaker moves through the various available forms of film finance is not set in stone. The choices will depend on the filmmaker’s own background, resources and notions regarding 7

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Introduction

the advantages and disadvantages of each form of finance as applied to that filmmaker’s current circumstances. Also, somewhere along the way, the filmmaker may choose to become vertically integrated and not only engage in production but set up a subsidiary development company, or an affiliated distribution arm, and eventually, maybe even an exhibition company. That’s what the major studio/distributors did. The company may also expand horizontally, engaging not only in film production but the production of television shows and other media and entertainment activities. Good luck with all of that!

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PART ONE Subsidies This first section of the book brings together several forms of film finance that are not generally considered stand-alone financing methods, in the sense that such methods are not likely to raise enough money to finance the entire production of a single motion picture, unless the budget is in the ultra-low-budget category. However, such film-financing methods may work well in supplementing one or more of the other forms of film finance described in later parts of the book. In fact, the various domestic tax incentive programs described in this part, by their very definition, are generally used in conjunction with investor financing techniques so that investors may benefit from the tax incentives.

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1

Gifts and Grants

Financing Films through Gifts Although it is not likely that a filmmaker will be able to successfully solicit one or more gifts adequate to fund the entire budget of a feature film (unless the budget is extremely low), the filmmaker may want to start his or her film-financing activities by soliciting one or more gifts. After all, a gift is a voluntary transfer of cash, an asset or other property made without consideration. In other words, nothing of value has to be paid back to the donor in return for that transfer. From a legal point of view, the essential elements of a valid completed gift of personal property are • • • • • •

the donor is competent and understands the nature of the action taken; the donor’s intent is to make a voluntary gift (i.e., donative intent); either actual or symbolic delivery of the property occurs; the property is accepted, either actually or imputedly; the donor completely divests himself/herself of all control; and there is no consideration for the gift.

It is important for the filmmaker seeking gifts to understand that such a transfer of personal property may have tax consequences. For example, receipt of a gift may be excluded from the gross income of the recipient filmmaker, but the transferor (donor) may be subject to an estate or gift tax. The relevant Internal Revenue Code provisions need to be considered, or alternatively, an accountant ought to be consulted. Note that the federal estate tax has been reduced for the moment, but the issue is politically active and thus the tax is subject to change. Estate Tax As just noted, the status of the federal estate tax is in flux for the moment and may continue that way for some years to come. In 2001 a tax package was signed into law that included a repeal of the estate tax, but that provision was not designed to start until the year 2010. In the meantime, 11


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Subsidies

the size of estates eligible for the tax exemption increased from $675,000 in 2001 to $1 million in 2002 and 2003, $1.5 million in 2004 and 2005, $2 million in 2006 through 2008 and $3.5 million in 2009. When the year 2010 arrives, the estate tax is supposed to end. The heirs of people who die in 2010 may be able to avoid the estate tax altogether. However, the repeal is temporary. The legislation contained a so-called sunset provision that would bring the current estate tax rules back in force in 2011. At that time, the debate over the estate tax may resume. In the meantime, some proponents of estate tax repeal have been advocating passage of a law that would make such tax cuts permanent. Gift Tax As a general rule, in the United States a federal gift tax is imposed on transfers of property by gift during the transferor’s lifetime (IRC Section 2501), but most states do not impose such a tax. The gift tax is imposed on every gift except those subject to specific exclusions under the law. For example, charitable gifts are excluded from the tax. On the other hand, gifts to a spouse are not excluded but are entitled to a deduction that results in there being no tax on gifts between citizen-spouses. Generally, the gift tax rate ranges from 37 to 49 percent of the value of the gift. However, there is a provision in the law that allows donors to make gifts each year up to a certain amount to any person, and there is no limit on the number of persons who can receive those gifts. Formerly the limit was $10,000 each year per person, but the limit has now been increased to $11,000. In other words, a donor can now make as many $11,000 gifts as he or she desires each year without incurring any gift tax obligation, as long as no one person receives more than $11,000 from the same donor in any one calendar year. That means, of course, that a donor could give a filmmaker $11,000 in late December and another $11,000 in early January without being subject to the gift tax in either year. By taking advantage of this annual exclusion provision in the law, the federal gift tax law permits donors to reduce the size of their estates by making $11,000 gifts each year to as many people as they wish. Such gifts can be made to children, grandchildren, great grandchildren, other relatives, friends or anyone else—including filmmakers. The relationship between the donor and the recipient does not matter. The value of the gift is the amount of money given away or the fair market value of any property given away calculated as of the date of the gift. This technique of making annual exclusion gifts can result in substantial savings of federal estate taxes for the donor’s family, assuming the donor’s estate would be subject to the estate tax. 12


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Gifts and Grants

Filmmakers need to know that in addition to helping filmmakers get started, making gifts can be an excellent way for donors to reduce taxes, and tax reduction may be the motivation for such gifts. The basic principle involved is that when donors give something away while they are alive, it will not be a part of their estate when they die and therefore their heirs will not have to pay taxes on it. On the other hand, if the estate tax is finally and permanently abolished, this motivation to make gifts will disappear. As is often the case, this area of the law is quite technical and may change from year to year; thus, if a filmmaker is placing significant reliance on gifts for funding some of the development or production costs of a film, an attorney or accountant should be consulted for a review of the current status of such laws. In any case, filmmakers may want to talk to wealthy individuals about helping to finance their film through gifts that reduce the size of the donor’s estate and avoid any gift tax. Advantages No obligation to return or pay back. The recipient does not have to pay a gift back to the donor. Current enjoyment. Recipients can currently enjoy the benefits of the gift (i.e., use the gift to help produce a film). Tax advantages for donor. A donor may be able to avoid federal estate tax on gifted property. The estate or inheritance tax on appreciation in value after the date of the gift may also be avoided. Tax advantages for recipient. Income from the gifted property may be taxed at a lower income tax rate (assuming the recipient’s income is substantially less than the donor’s). Disadvantages Loss of control. Donor loses control over the gifted property. Loss of income. Donor cannot retain income from the gifted property. No return. Donor cannot demand return of the gifted property. Creditors’ claims. Gifted property may be subject to claims of the recipient’s creditors. Divorce proceedings. Gifted property may be subject to divorce proceedings of the recipient. Medicaid eligibility. The donor’s eligibility for assistance from Medicaid for nursing home expenses may be affected. Financing Films with Grants Grants for filmmakers may come from foundations, government agencies, large corporations, film festivals, arts organizations and other groups. 13


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Subsidies

Grants may be intended to fund and encourage screenwriters, students, women or minority directors, or the production of films relating to certain subjects of interest to the grantor. They may be intended to fund controversial or experimental films or specific ideas or causes, such as strengthening organizations that address poverty and injustice or promote democratic values, international cooperation and human achievement. They may be specifically designed to cover the costs of development, production or postproduction, or may be used as so-called finishing funds, or even to cover the cost of distributor delivery items. They also may be targeted at specific populations or residents of certain cities or states. Most grants are cash awards, but some may be for materials or equipment. Other sources may characterize their grants as so-called recoverable grants, loans or loan guarantees. In some instances, the grant organization may require the production company to match the grant with funds from other sources. Some grant-making organizations require that activities supported by grants and program-related investments be charitable, educational or scientific, as defined under the appropriate provisions of the U.S. Internal Revenue Code and Treasury Department regulations. Seeking one or more grants can be extremely competitive. Grant source funds are limited in relation to the great number of worthwhile proposals received. Some grant-making organizations will receive as many as 40,000 grant requests in a given year. Research Phase Asking a foundation or any organization for money and actually getting it may be more overwhelming for a filmmaker than actually producing the film. The initial task is to identify one or more sources of grants that may benefit the planned production. That means going online, going to the library or going to the bookstore to locate sources of information on organizations that make grants. Then the grant research portion of the project has to be narrowed to grants relating to films. That research has to be focused even more: to find organizations that make grants for the specific kind of film the producer intends to produce. Be encouraged by the fact that many foundations are specifically created for the purpose of giving away money. The producer’s objective is to persuade one or more of these organizations to award that money to a particular film project instead of to competing projects. Most experts in the field recommend that this research phase be handled very carefully, and that is why it is so time-consuming. It is essential to learn which organizations may show serious interest in the subject matter of the proposed film. On the other hand, many foundations and 14


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Gifts and Grants

other organizations do not have specific funding programs for films, but often they have mission statements that will provide useful guidance. A producer seeking a grant must study the foundation, its grant program, the program’s guidelines, the organization’s annual report and any other information that will aid in the evaluation of how a proposed film may advance the mission of the organization. The Grantsmart.org website, http://www.grantsmart.org, provides a searchable database with more than 480,000 tax returns filed by more than 95,000 private foundations and charitable trusts. The data are supplied to the site in raw form by the IRS and are updated on a continuing basis. By law, these tax returns are public records, and they may prove useful in the filmmaker’s search for a grant source. Another valuable online resource may be found at the website for the New York Foundation for the Arts, http://www.nyfa.org. The site provides information on helpful articles, online resources, books, funder directories and writing guides. The resource page may be found at http://www. nyfa.org/leve13.asp?id=209&fid=1&sid=51. Once such a match is identified, the producer may want to contact the organization directly to gain more insight into the nature of its interest. It may even become necessary to embark on a campaign to persuade the organization that the proposed film would be a good way to advance the organization’s mission statement. That sometimes means getting involved with people in the organization. That is where the filmmaker’s social skills and politics sometimes come in to play. This type of research and personal involvement is all designed to help the film producer develop a tailor-made application for an available grant. Using the shotgun approach of sending out generic proposals to many possible grant sources is not generally recommended. It is important to review the grant organization’s requirements regarding rights to the results of a grant (i.e., so-called grant products) to make sure that those rights are consistent with the producer’s planned use of the film production. Some programs will require an acknowledgment (e.g., screen credit) on all funded materials and products. The grant organization may also reserve a royalty-free, nonexclusive and irrevocable right to reproduce, publish or otherwise use a work produced with its funding. Some may even want the grant money to be repaid if the project makes a profit. It is important to know these requirements going in and to plan for them. The process of seeking grants gets even more complicated if an applicant is trying to obtain grant money from several sources. Then it is necessary to make sure the rights requirements of each organization are consistent with each other. 15


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Subsidies

Some grant-making organizations limit their grant funds to organizations or restrict the number of grants made to individuals. So it is important to note whether only individuals or only entities (or both) are eligible for the grant; and if an individual, whether that individual must be a U.S. citizen, must reside in a particular state or city and must have resided in any particular place for a period of time prior to the application being submitted. Application Process Some grant programs will allow a prospective grant applicant to send in a brief letter of inquiry before a request is made for a grant or programrelated investment. Through such a letter, the prospective grant applicant may be able to determine whether the foundation’s present interests and funds permit consideration of the request. Such a letter may include • the purpose of the project for which funds are being requested; • problems and issues the proposed project intends to address; • information about the production company proposing to produce the film; • the estimated overall budget for the project; • the period of time for which funds are requested; and • the qualifications of those who will be working on the film.

Then after receiving the letter, the grant organization’s staff members may ask the grant seeker to submit a formal proposal, or point out why there is not a good fit between the two. Usually, grant organizations will eventually require some form of more formal proposal or application. In other cases, there are no grant application forms. A grant application may have several components, including a cover sheet, narrative portion and budget. Each grant program will provide special instructions—program guidelines—on how to prepare an application for their grants. These should be reviewed carefully before beginning to prepare the application. Look for information about the focus of the program, the eligibility requirements and the types of funding offered. A film producer needs to make certain that he or she qualifies for the particular grant, since a considerable amount of time can be wasted if it is learned after the fact that the filmmaker or project are not eligible and therefore could not even be seriously considered for a particular grant. Although each prospective grant source will have its own specific requirements, grant proposals without application forms typically include

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• • • • • • •

the financial status of the production company; a description of the proposed film and how and where it will be produced; the names and biographical information for those attached to the film; a detailed film production budget; a description of the present means of support for the production company; the status of applications to other possible funding sources; and the legal and tax status of the film production company seeking the grant.

Unfortunately, there is no standard application form. So applications will have to be customized for each potential grant. One of the primary grant-writing skills is simply the ability to write effectively. If, as a filmmaker, writing is not one of your strong points, then clearly you will want the assistance of someone else who has those skills when applying for grants. There are professional grant-writing consultants who may be able to help in this process, but they also will either charge money up front, on a monthly basis or at least take a percentage of the money raised. Bringing someone with grant-writing expertise on board as a coproducer may be the dream of the producer seeking grants, but that situation is likely to be rare in the real world. Sometimes bringing on a more experienced film producer will enhance the strength of the grant application, regardless of whether the person has grant-writing skills, and so will putting together an experienced team of filmmakers to demonstrate that your group has the capability of producing a quality film. Others even suggest that a film producer should surround himself or herself with an experienced board of advisers to both gain their good advice and help strengthen the grant application. Often the application itself will ask whether the applicant has received other grants. Apparently many grant sources find the indication of commitment by other grantors reassuring, particularly in cases where they know that their own grant alone is not sufficient to complete the proposed project. Experienced grant writers advise that applications for grants need to be studied carefully. Any particular grant application may be one of hundreds or even thousands that are being submitted to a given grant source during a single grant season. Answers that write around a question or do not otherwise answer the question asked will reduce the chances of the application being well received. The same is true for incomplete applications. Grant consultants consider the following to be some of the more common characteristics of grant applications that are not very persuasive:

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• • • •

not really understanding the mission of the potential grant source; providing information that is not consistent with the grant’s guidelines; choosing to apply to a grant source that is not a good fit for the film; failing to answer all of the questions or failing to provide adequate information in response to one or more questions; and • significantly underestimating the cost of making the film, or grossly overstating the film’s budget.

Some grant providers are available to offer advice about preparing a proposal, to supply examples of grant applications and even to review preliminary drafts (for most programs, if they are submitted well before the deadline). Producers should pay close attention to each program’s instructions on how to submit the application, whether by mail or online. If the requirement is for mail, an online application is likely to be ignored. Note also that even if formal applications cannot be accepted by email or fax, a particular grantor may encourage the use of fax or email for other kinds of correspondence, including inquiries, preliminary drafts, recommendations or reports. To ensure that the application is processed in a timely fashion, the envelope or package used to send the application materials should prominently display the producer’s return address and should not be covered with tape. Each grant program will have its own deadline. If cutting it close, double-check whether the deadline is based on “receipt” of the application or its “postmark.” Some grant organizations consider applications throughout the year. In some instances, a grant applicant will have to wait seven to eight months after the deadline to get a decision. On the other hand, applicants to some grant organizations may at least receive within six weeks an indication of whether their proposals are within the grant organization’s program interests and budget limitations. Grant Monitoring Most grant organizations engage in some form of monitoring activities that may consist of regular financial and narrative reports submitted by the grantee. During the course of a grant, some grant programs send representatives out to actually visit with the grantee onsite. They review the grantee’s periodic financial and narrative reports and share them with a grants administrator and occasionally an attorney who also reviews them and provides comments. The grantee may be asked to attend meetings the organization convenes to discuss current and future program strategy. In other cases, the grant-making organization may hire 18


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consultants to help monitor groups of grants or a single grantee’s work. Monitoring is designed to ensure that the funds are used for approved and lawful purposes and to see whether those purposes are contributing to the grant-making organization’s larger goals. Latino Public Broadcasting Grants One example of a sponsored grant program for a specific type of film is that of the Latino Public Broadcasting (LPB) organization. The group holds an annual open call for independent producers throughout the United States in the first week of June to apply for funding for the development, production and distribution of television programming that represents Latinos and their culture. Made-for–television movies and documentaries are included. For four months before each year’s open call, LPB executives travel around the country, holding workshops to inform producers how to apply for funding. Independent producers, who apply for funding from LPB may expect to receive grants between $5,000 and $100,000 to help support their projects at any phase of production. While the LPB program focuses primarily on the promotion of Latino projects and subject matter, its target audience is not strictly Latino. The idea is for the projects to have a broad appeal. At the same time, the programming supported by LPB is noncommercial and conveys educational and cultural messages. The organization reports that it has seen a large increase in the number of proposals received at open calls in recent years. It may see as many as 135 proposals in a given year, from which only about 14 are selected for funding. Latino Public Broadcasting was created in 1998 by Edward James Olmos and Marlene Dernier and is part of the National Minority Consortia, a division of the Corporation for Public Broadcasting (CPB). The Minority Consortia includes five divisions, each of which receives funding from the CPB to finance programs representative of their respective minority communities. Advantages Only possible funding source. One or more grants may be the only available funding source for certain film projects that are highly specialized or targeted at small, specific groups and that are not expected to make a profit. No obligation to repay. Often, but not always, a filmmaker awarded a grant is not expected to repay the money. Combination financing. Small grants might be combined with other forms of film finance to bring a movie to the screen. 19


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Disadvantages Grants too small. Relative to the cost of producing a feature film or even a documentary, grants are rarely large enough to play a significant role in funding a feature-length movie. Lots of research involved. A considerable amount of research is generally required to identify potential grant sources and to determine more specifically whether an application relating to a specific film project is appropriate to any given grant source. Thorough grant research may require the review of hundreds, if not thousands, of possibilities, some from outside the subject area of filmmaking. Challenge of grant writing. Properly completing or drafting the grant application can be a tedious and time-consuming activity. Professional assistance. The expert assistance of a grant consultant may be required to reduce the time and effort involved in research and grant writing, and such assistance may cost money. Extremely competitive. Seeking grants for any purpose is generally a very competitive field and sometimes political—getting one or more grants is usually a long shot at best. Takes time. The passage of a considerable amount of time is usually involved in obtaining grants—research time, writing of the grant application, waiting for the decision and actually receiving the check. Monitoring required. The way in which the funds are being spent is likely to be monitored by the grant-making organization.

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2

Domestic Government Subsidies and Tax Incentives

It may not be quite accurate to consider tax incentives as a stand-alone form of film finance. In all fairness, tax incentives function more as a supplement to investor financing, in the sense that they provide additional motivation for investors to invest. Many investors are partly motivated by the opportunity to get tax deductions from their investments, whether in film production or otherwise. Recently in the United States, federal and state governments have begun passing various forms of tax incentives to encourage investment in U.S.-made films, while also discouraging “runaway” productions going to Canada and elsewhere. For the purposes of this book, domestic tax incentives are discussed separately from investor financing here. The Federal Approach When Congress passed the American Jobs Creation Act of 2004 (containing special rules for certain film and television productions—Section 244 of HR 4520) and the president signed the legislation into law in October of that year (later codified as IRC Section 181), many in the Hollywoodbased U.S. film industry cheered and predicted great things for the future of film production in the United States. At the time of this writing, it was still too early to tell how much of an impact the legislation would have on the financing of film production domestically, and more specifically, whether it would move significant amounts of investor funds into film production as intended. In addition, as of the early months of 2005, there were already reports of talk in Congress about the possible repeal of some elements of the new tax incentives for film. Such is the nature of government-provided tax incentives. To summarize, the “Special Rules for Certain Film and Television Productions” found at Section 244 of the American Jobs Creation Act of 2004 apply to films produced after October 22, 2004, and before January 1, 2009. The legislation would allow the investor members of an entity such 21

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as a limited partnership or limited liability company that has acquired the rights to produce a feature film to elect to deduct their pro rata share of 100 percent of the direct and indirect costs of producing the film as an expense for the taxable year in which the costs of production are first incurred, so long as the aggregate cost of the film does not exceed $15 million and 75 percent of the total compensation paid to actors, directors, producers and other relevant production personnel working on the film is paid for services performed in the United States. More specifically, the legislation provides that a taxpayer may elect to treat the cost of any qualified film (and in some instances, television productions) as an expense that is not chargeable to a capital account and to take such costs as allowable deductions. The deductions, however, are limited in that they do not apply to any qualified film or television production the aggregate cost of which exceeds $15 million. However, in the case of any qualified film production the aggregate cost of which is significantly incurred in an area eligible for designation as either a specified low-income community or a specified distressed county or isolated area of distress, the ceiling on the aggregate cost for which deductions may be allowed can go as high as $20 million. Taxpayers making such an election will not be allowed to use any other form of depreciation or amortization deduction relating to the same expenses in that tax year. The term qualified film as used in the legislation means certain productions, as further described in the law, in which 75 percent of the total compensation of the production is qualified compensation. The term qualified compensation means compensation for services performed in the United States by actors, directors, producers and other relevant production personnel. The term compensation does not include participations and residuals. However, IRS temporary regulations (Internal Revenue Bulletin: 2007–12, March 19, 2007, T. D. 9312) provide that these P and R costs are considered production costs for purposes of the production cost limit. The taxpayer’s election to take this deduction needs to be made by the due date (including extensions) for filing the tax return for the taxable year in which costs of the production are first incurred. In addition, such an election cannot be revoked without the government’s consent. Thus, in effect, this legislation moves the date of deductibility for film production expenses forward from the date the film is placed in commerce (the old rule), to the date in which the expense is incurred (the new rule). This might mean the deduction is available to a taxpayer-investor one or two years earlier in most instances. In addition, the legislation enlarges the percentage of deductibility for a film’s production expenses.

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However, Variety ran a headline as early as January 18, 2005, suggesting that Congress was likely to make some revisions to the new tax provisions (see “Congress Likely to Take Back Indie Pix Tax Break”). Be sure to review the latest developments in the tax law before relying on the provisions in existence as of this writing. Right or Wrong Solution The problem of so-called runaway production, referring to film production companies taking their operations out of the country to lower their costs, is the supposed reason for asking both federal and state governments to provide special tax incentives for the domestic production of feature films. But the problem is not necessarily caused solely by foreign government subsidies; rather there are other contributing factors that include the decisions made by U.S.-based film company executives who try to save money by seeking cheaper production costs, as opposed to reducing the salaries of major star talent or their own executive salaries. It is even possible that the practices of foreign governments offering film subsidies are not the real problem at all. Maybe the real culprits are the Hollywood major studio/distributors who, for nearly one hundred years, have used anticompetitive business practices to gain dominance over film distribution even in foreign countries (see “337 Reported Business Practices of the Major Studio/Distributors”; and Hollywood Wars: How Insiders Gained and Maintain Illegitimate Control over the Film Industry). When these other countries reacted to protect their own interests by providing film subsidies (i.e., when they hit us back), then the American film production community reacted to that by seeking government help. Maybe the U.S. government is being asked for the wrong service. Instead of trying to stop the foreign government subsidies or being drawn into a never-ending spiral of competing subsidies, maybe our governments, federal and state, should join with the governments of other countries to investigate the business practices of the Hollywood-based major studio/distributors. That is the genesis of the problem. Advantage Faster deductions. The new U.S. tax law (HR 4520 or IRC Section 181) allows production expenses to be deducted more quickly. Disadvantages Constantly changing. Just as other governments across the globe manipulate tax incentives for political reasons, the U.S. government is

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constantly changing the rules or even, in some instances, taking away or threatening to take away the incentives altogether. A fairness problem. Tax deductions provided to wealthy taxpayers to support a particular industry, such as the film industry, merely shift the burden to other taxpayers, who pay more taxes to make up the lost revenue. Many consider this sort of government activity to be inappropriate and even unconstitutional. State Tax Incentives Most of the fifty states offer some form of tax incentive to encourage film production in their state (some thirty or more states do this). These sorts of tax incentives, provided to a particular industry over other industries, are often hotly debated in the state legislatures, and for good reason. They provide examples of the quintessential special interest in conflict with the general public’s welfare. After all, what small industry wouldn’t want a special government subsidy or tax incentive to help it prosper? The specific incentives change from time to time. Thus, any listing of them will always be out of date in some respect. Some such listings do appear online at several film-related sites and can serve as a starting point for researching available tax incentives in states of interest. The better practice, however, is to contact the state film commission in each of the states being considered and obtain the most current information directly from such offices. In addition to state film commission offices, some regions and cities also fund and staff film commissions that can provide helpful information. There are approximately 350 film commission offices worldwide, representing countries, regions and cities. The information that follows provides some examples of the tax incentives offered by selected states that may be available to filmmakers. It also provides a collection and restatement of the arguments often used on both sides of this film industry debate, along with a listing of advantages and disadvantages of state-level tax incentives, as well as sources for additional information. Florida Film Finance Incentives Any company engaged in producing filmed entertainment in Florida may submit an application to the Florida Office of Film and Entertainment for the purpose of determining qualification for reimbursement on a percentage of qualified expenditures. Florida entertainment sales tax exemption. Qualified production companies engaged in Florida in the production of motion pictures, made24

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for-television motion pictures, television series, commercial advertising, music videos or sound recordings may be eligible for a sales-and-use tax exemption on the purchase or lease of certain items used exclusively as an integral part of the production activities in Florida. Sales tax exemption at point-of-sale. Florida does not require the payment of sales taxes on the sale or lease of motion picture, television or sound-recording equipment. This exemption takes place at the “point of sale.” In order to be exempt from Florida’s sales tax at the point of sale, the production company must apply for a certificate of exemption to be presented to a registered Florida sales-and-use tax dealer when making purchases and rentals of qualified production equipment. The form and instructions needed to apply for the Entertainment Industry Qualified Production Company Certificate of Exemption (form DR-230) can be viewed online and printed from http://www.filminflorida.com/ifi/incentives.asp. The certificate can be renewed for either a 12-month or 90-day period. Other Florida tax incentives. Florida does not require the payment of any tax on artistic or copyright material on master tapes, master films, master records and master videotapes. Transactions involving masters are taxed only on the value of the blank film, tape or other tangible personal property. The value of all the major cost components of making a master, such as artistic services, processing, copyrights and royalties, is excluded from taxation when the master is sold or leased. Florida does not impose a tax on the rent or lease of real property used as an integral part of a motion picture production. The renting of studios, soundstages, lots, buildings or any other real estate is exempt. This exemption applies to small, independent operations and to major studio facilities. In addition, Florida does not impose a tax on labor to produce a film, commercial or sound recording made for a company’s own use. Also, Florida is one of only seven states that have no personal income tax and no tax on inventory or goods in transit. Hawaiian Tax Incentives The State of Hawaii offers two tax incentives that may be applied to film production in that state. One is an investment tax credit based on Hawaii’s 2001 Session Laws (Act 221). This provision allows the state to grant 100 percent tax credits to local investors in movie productions that qualify. The second Hawaiian tax incentive is the Motion Picture and Film Production Income Tax Credit, which is a refundable tax credit for film productions that take place in Hawaii. 25

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Investment tax credit. In order to take advantage of the Hawaiian investment tax credit, the business must employ individuals, own capital or property or maintain an office in Hawaii and qualify under one of the “performing arts” provisions of the law. The credit is nonrefundable but is deductible from the Hawaiian investor’s net state income tax liability up to a maximum of $2 million a year, per investor. The tax credit is applied in percentages, over a five-year period. Production income tax credit. In order to take advantage of the refundable production tax credit, a film producer has to get the Hawaii Film Office to send a letter to the Hawaii Department of Taxation certifying that the film production actually occurred. An income tax return and the Motion Picture and Film Production Income Tax Credit Request (on state form N-316) must then be filed with the Hawaii Department of Taxation. Qualifying productions may receive, as a production income tax credit, 4 percent of the total production expenditures incurred during the film’s production in Hawaii, including purchases and payroll, as well as a credit amounting to 7.25 percent of hotel room taxes incurred during production in Hawaii. In order to receive 100 percent of these credits, • • • •

a Hawaiian name or word must be in the title; the film needs to depict Hawaiian scenery, culture or products; at least $2 million must be spent during production in Hawaii; and a distribution agreement covering a minimum of 66 percent of the U.S. market must be in place (evidence of domestic/foreign distribution may be substituted).

The Hawaiian film production income tax credit must be claimed on a state income tax return filed within one year after the close of the taxable year during which principal photography began in Hawaii. Illinois Film Production Services Tax Credit Act Illinois’s Film Production Services Tax Credit provides a 25 percent tax credit on Illinois income tax for wages paid by a production company to each employee that is an Illinois resident. Production companies must also be willing to promote diversity by hiring a certain percentage of minorities or by participating in a job-training, education or recruitment program. Tax credit eligibility. The Illinois Film Production Services Tax Credit is limited to the first $25,000 of wages paid to each employee of the production. To be eligible for the tax credit, a production of 30 minutes or less

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must pay at least $50,000 in wages, while productions of 30 minutes or more must pay at least $100,000 in wages. The salaries for the two highest paid employees of the production are excluded. The tax credit has to directly contribute to the production’s filming in Illinois. Application requirements. Written applications are required and must be submitted prior to filming activity on an application form provided by the Illinois Film Office. The applicant will be asked to provide the following information: • production title; • full script; • type of production: film, television series, movie-of-the-week (MOW), commercial, music video, documentary; • length of production; • number of planned shooting days in Illinois; • total budget of production; • estimated total salary and wages; • estimated number of Illinois residents to be hired to work on the production; • percentage of minority workers in Illinois that the applicant plans to employ to perform work on the production; • documentation on the applicant’s intention to participate in training, education and recruitment programs; and • documentation showing that the Illinois film production services tax credit is essential to the decision to film in Illinois.

Tax credit exclusions. The following types of programs cannot take advantage of the Illinois film production services tax credit: • news, current events or public programming, or a program that includes weather or market reports; • talk shows, games, questionnaires or contests; • sports events or activities; and • awards shows, galas or telethons.

Out-of-state applicants. If an applicant is not an Illinois taxpayer (i.e., has no Illinois income tax liability), the applicant may use one of the following structures in order to be eligible for the Illinois film production services tax credit: • establish a partnership or an LLC (limited liability company) in Illinois; • establish a subsidiary company registered to do business in Illinois; or • contract with an Illinois taxpayer to coproduce the production.

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For more information, contact the Illinois Film Office. Louisiana Motion Picture Incentive Act Louisiana’s Motion Picture Incentive Program was created by state legislation passed in July of 2002. It provides three separate sets of production initiatives: (1) a sales-and-use tax exclusion, (2) an employment tax credit and (3) an investment tax credit. The Louisiana Motion Picture Incentive Program was created in order to achieve three basic goals: • to encourage film and video production in Louisiana; • to advocate the hiring of Louisiana technical crew and talent; and • to support and encourage the use of Louisiana equipment and services related to film and video production.

A non-Louisiana producer or production company seeking to take advantage of the Louisiana tax incentives may have to coproduce with a Louisiana-based production company or establish a Louisiana LLC with Louisiana-based investors to whom the tax credits can be transferred. sa l e s-a n d -use ta x e xclusion The Louisiana Motion Picture Incentive Act grants an exclusion from the state sales-and-use tax (4 percent). A film production company will be granted the exclusion if it reports anticipated expenditures of $250,000 or more from a checking account in a financial institution in Louisiana in connection with filming or production of one or more nationally distributed motion pictures, videos, television series or commercials in the state of Louisiana within any consecutive 12-month period. Eligibility. Eligible applicants are motion picture production companies that report anticipated expenditures in the state that in the aggregate equal or exceed $250,000 in connection with the filming or production of one or more motion pictures in the state within a consecutive 12-month period. An eligible applicant’s expenditures must be made from a checking account at any financial institution in Louisiana. Application procedure. The Louisiana Office of Film and Television Development provides a standard form that applicants need to use in applying for the sales-and-use tax exclusion. The application asks for • • • • •

name of the production company; phone number of the production company; name of the producer; name and phone number of a company contact person; dates of first preproduction activity and production dates in Louisiana;

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• • • •

production office address and phone number in Louisiana; total budget of the project; total anticipated expenditures in Louisiana; and synopsis of the project.

Submission and review procedure. Applicants must submit their completed application to the director of the Louisiana Office of Film and Television Development. Submitted applications will be reviewed and evaluated by the director. Upon determination that an application meets the eligibility for this program, the director will then forward the application for approval to the Secretary of the Louisiana Department of Economic Development. Recapture provision. A motion picture production company that fails to expend the required $250,000 within a consecutive 12-month period will be liable for the sales-and-use taxes that would have been paid had the approval not been granted. In such cases, the sales-and-use taxes will be considered due as of the date that taxable expenditures were made. Reporting requirements. The production company applicant will be required to complete an expenditure questionnaire on a form provided by the Louisiana Film and Video Commission (“Commission”). e m pl oy m e n t ta x c r e di t Louisiana’s law provides that a motion picture production company is entitled to a tax credit for the employment of Louisiana residents in connection with the production of a nationally distributed motion picture, video, television series or commercial made in Louisiana. The credit is equal to 10 percent of the total aggregate payroll for Louisiana residents employed in connection with such a production when total production costs in Louisiana equal or exceed $300,000 but are less than $1 million during the taxable year, which increases to 20 percent when the total production costs in Louisiana equal or exceed $1 million during the taxable year. The term total aggregate payroll does not include the salary of any employee whose salary is equal to or greater than $1 million. The credit may be applied to any income tax or corporation franchise tax liability applicable to the motion picture production company. If the company is not subject to income or franchise tax (e.g., a limited partnership or limited liability company), the credit flows through its partners or members in the following manner: • corporate partners or members are to claim their share of the credit on their corporation income or corporation franchise tax returns;

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• individual partners or members are to claim their share on their individual income tax returns; and • partners or members that are estates or trusts are to claim their share of the credit on their fiduciary income tax returns.

Any unused credit may be carried forward no more than 10 years from the date the credit was earned. Eligibility. Motion picture production companies are eligible for the 10 percent Louisiana state tax credit if production costs spent in Louisiana on the qualifying film or other production equal or exceed $300,000, but are less than $1 million during the taxable year. Motion picture production companies are eligible for the 20 percent Louisiana state tax credit if production costs spent in Louisiana on the qualifying film or other production equal or exceed $1 million dollars during the taxable year. Amount of credit. The credit is based on the total aggregate payroll of the employment of Louisiana residents. Application procedure. The Commission provides a standard form that applicants need to use when applying for the tax credit. The application is similar to that used for the sales-and-use tax exclusion. Submission and review procedure. Applicants must submit their completed application to the Director of the Louisiana Film and Video Commission. Submitted applications will be reviewed and evaluated by the director. Upon determination that an application meets the eligibility for this program, the director will send a certification letter to the production company and the Louisiana Department of Revenue. Reporting requirements. The production company is required to complete and submit an expenditure questionnaire on a form provided by the Commission, along with a final cast and crew list for the project. i n v e st m e n t ta x cr edit The State of Louisiana also offers a tax credit against state income tax for taxpayers domiciled and headquartered in Louisiana. The stated objective of the Louisiana tax credit is to attract private investment for the production of nationally distributed feature-length films, videos, television programs or commercials made in Louisiana, in whole or in part, for theatrical or television viewing or as a television pilot. Further, the state hopes by means of the tax credit to encourage development in Louisiana of a strong capital base for motion pictures, in order to achieve a more independent and economically sustainable film and video industry. Amount of tax credit. Investors earn the tax credit at the time of their investment. If the total base investment is greater than $300,000 and

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less than or equal to $8 million dollars, each taxpayer will be allowed a tax credit of 10 percent of the actual investment made by that taxpayer. If the total base investment is greater than $8 million dollars, each taxpayer will be allowed a tax credit of 15 percent of the investment made by that taxpayer. Application for state certification. Again, the Commission provides a standard form for applicants to use in applying for state certification. Submission and review procedure. Applicants must submit their completed application to the director of the Office of Film and Television Development. Submitted applications will be reviewed and evaluated by the director of that office. Upon determination that an application meets the criteria for this program, the director will send a certification letter to the investors and the Louisiana Secretary of the Department of Revenue. Unused credit. In the event the entire credit cannot be used in the year earned, any remaining credit may be carried forward and applied against state income tax liabilities for the subsequent 10 years. Audits. A motion picture company applying for the investment tax credit will be required to reimburse the Louisiana Department of Revenue for any audits required in relation to granting it. Reporting requirements. The production company is required to submit a report evidencing the total base investment made in Louisiana, along with a completed expenditure questionnaire (on a form provided by the Commission) and a final cast and crew list for the project. Recapture of credits. If an investor received credit for funds not actually invested and expended in a state-certified production within 24 months of the date the credits were earned, then the investor’s state income tax for that taxable period will be increased by the amount necessary for the recapture of those previously granted credits. Procedure for recovery. The Louisiana Secretary of Revenue may recover investor credits previously granted to an applicant, but later disallowed, through any collection remedy authorized by state law. New York Tax Credit The State of New York offers a production tax credit program. Among the benefits is a 10 percent credit for below-the-line costs, provided that at least 75 percent of these costs are spent at a New York State soundstage. If below-the-line expenditures amount to less than $3 million, location shoots also are eligible for credit. The production scheme is capped at $25 million each year and credit is distributed on a first-come, first-served basis. New York City offers

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an additional 5 percent credit on production costs, as well as help with marketing, location scouting and sourcing. New Mexico Tax Incentives New Mexico offers a gross receipts tax deduction on certain production costs at the point of sale. In order to benefit from the deduction, production companies filming in New Mexico have to apply for an exemption certificate. In addition, New Mexico offers a film production tax credit. It is a fully refundable tax credit of 15 percent for eligible production costs that may be deducted from the income tax of a New Mexico–based production company or producer. Thus, producers not from New Mexico may want to coproduce a suitable film with a New Mexico production company. To qualify for either incentive, production companies must register with the New Mexico Film Office. Qualifying companies may choose one incentive per documented expenditure. Feature-length films must include an onscreen credit for the state of New Mexico. New Mexico also does not charge location fees for state-owned buildings. North Carolina Film Industry Development Accounts The State of North Carolina offers what it calls a “Film Industry Development Account.” The account is funded by taxpayers and pays up to $200,000 to any qualified production company making a film in North Carolina. The Film Industry Development Account subsidies require that a company spend at least $1 million in North Carolina to receive grants and prohibits a subsidy’s use for “political and issue advertising” or for “obscene” films. Unlike similar statutes in other states, the North Carolina statute creating the program does not, however, require that the film company be from North Carolina, create jobs for North Carolinians, contract with North Carolina businesses, purchase North Carolina products or pay North Carolina income taxes. North Carolina also offers fee-free use of state property and a 1 percent cap on the state sales-and-use tax. In addition, state sales taxes for hotel room occupancy in excess of 90 consecutive days may be refunded. Oklahoma Tax Programs The State of Oklahoma has created a rebate program to entice more long-term narrative film and television production to the state. It is referred to as the Oklahoma Film and Music Enhancement Rebate 32

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Program. The program rebates 15 percent of documented production expenditures made in Oklahoma. Costs incurred with state workers and businesses and directly attributable to the production, reproduction and postproduction of a long-form narrative film or television program will be rebated to producers. Producers choosing to use the Oklahoma rebate program may also take advantage of the Oklahoma Sales Tax Rebate. It offers eligible motion picture and television production companies a state and local tax rebate on all goods and services used or consumed on virtually any project shot in Oklahoma. The state’s current sales tax is 4.5 percent. Local taxes, which vary from city to city, range from 1 to 4 percent. The Texas Sales Tax Exemption The State of Texas offers production companies an exemption from sales tax on goods and services purchased, rented or leased for the production’s direct and exclusive use. This exemption applies to goods and services used in the production or postproduction of the film or video master. The Texas state sales tax rate is 6.25 percent, while local sales tax rates range from 0.25 to 2.0 percent. Productions eligible to qualify for this exemption include features, television projects, commercials, corporate films, infomercials or other projects for which the producer or production company will be compensated and that are intended for commercial distribution. South Carolina Film productions spending $1 million or more in the state of South Carolina may qualify for a 5 percent rebate on the withholding tax for labor and a rebate of up to 7 percent on goods and services purchased from state vendors. Puerto Rico The self-governing U.S. Commonwealth of Puerto Rico also offers tax breaks for local film productions. The Puerto Rican government has passed new legislation that allows local investors to write off a portion of their investment while the film is still in production and permits some 80 to 90 percent of the film’s revenues to remain tax exempt after the picture begins recouping its costs. Additional Information In addition to the Sources and Further Reading, the Association of Film Commissioners International (AFCI) website (http://www.afci.org) 33

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provides links to the details of the tax incentives and other financial incentives offered by each of the member jurisdictions. In addition, the Motion Picture Association of America (MPAA) publishes a state-by-state list of tax incentive programs for the film industry (see http://www.mpaa. org). Another good source of information is the Christopher Lytton article “Soft Money: The Weapon of Choice for Runaway Productions.” Advantages Another source of finance. Government subsidies or tax incentives at any level represent another opportunity to whittle down the size of a film’s budget. Tax incentives may reduce the net expenditure by 10 percent to 15 percent. Motivation for investors. Tax incentives may help to motivate investors to invest in a high-risk investment such as film. Disadvantages Thrust into debate. Accepting the benefits of tax incentives may thrust a producer into the vortex of a never-ending public debate regarding the propriety of government subsidy of the film industry. Philosophical conflict. Taking advantage of tax incentives or other government subsidies may be inconsistent with the producer’s personal philosophy regarding the proper role of government. Investor abuse. Historically and almost inevitably, there always seem to be some investors who interpret the tax laws so liberally as to engage in tax-shelter abuse, and a public outcry will follow and governments will reduce or eliminate the tax advantages. Ruinous competition. Many believe the studios here in the United States are pitting the different film commissions and legislative bodies from various jurisdictions against each other, as a way to get bigger and bigger subsidies, with the only sure result being larger profits for the studios and increased salaries for studio executives. The Great Debate over Government Tax Incentives for Film The appropriateness of and need for government tax incentives to encourage film production in any given locale has been and continues to be debated all across the country. Many of the arguments for and against such measures appear below: Arguments for State Subsidies Lost jobs. More than $13 billion in lost wages, production expenses, basic hotel and support industry budgets go across the border and overseas 34

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every year on films that could be produced in the United States, costing American jobs, American revenue. Helps the local economy. When a film shoots entirely in one area, as much as 40 percent of the budget may be injected into the local economy. Boon to tourism. Additionally, tourism (an important industry in many states) can be significantly impacted. There appears to be no stronger advertising medium available than the international release of a feature film that depicts potential vacation destinations in a favorable light (more confirmation that motion pictures influence behavior). Helps working people. Runaway production is a problem for the working people and small businessmen who depend on motion picture and television production for their livelihood. Millions lost. Runaway production can also be a problem for the economy of a given state, which could lose hundreds of millions of dollars directly, and more hundreds of millions indirectly, if the Canadians or others are allowed to hijack the U.S. film industry. Tax loss. Runaway production is a problem for California, which will lose a significant portion of tax revenues generated by motion picture and television production activities. Unfair competition. The U.S. film industry’s plight results from unfair, excessively generous tax breaks being offered by Canadian governments for production north of the border (as well as unfavorable currency exchange rates). Cheaper labor. With government assistance, film production companies are better able to afford shooting a film in locations away from Los Angeles, particularly in foreign locations, where they may also be able to take advantage of cheaper labor. Arguments against State Subsidies Unconstitutional. State subsidies of the film business violate some state constitutional requirements—those providing that tax revenues be collected and spent only for a “public purpose,” not for public aid to private businesses. Self-induced problems. When outsiders, such as the Wall Street Journal, examine the film industry’s problems, runaway production isn’t even mentioned. On the other hand, advocates of the tax breaks never mention the film industry’s self-induced problems. Cyclical business. The film industry is a cyclical business. It also has let its costs get out of hand. Just because the film industry may be going through a mild downturn does not mean that taxpayers ought to be asked to give film moguls multimillion-dollar subsidies. 35

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Misdirected. Most of these tax breaks do not necessarily do anything about runaway production. The tax benefits being offered could easily be obtained by producers who never had any intention of moving their film out of a particular state. Supports pornography and violence. In most instances, the tax breaks could also be claimed for pornographic films or those glorifying the kind of mindless (copycat) violence seen in high schools around the country. Taxpayer subsidies. In effect, taxpayers are being asked to subsidize the film industry’s irresponsible conduct, while adding millions of dollars more to the bank accounts of some of Hollywood’s richest residents. Social services squeeze. Tax subsidies for the film industry are difficult to justify when state-provided social services are being cut because of a fiscal squeeze. Independent films should get the support. If government-sponsored subsidies are to be made available, their application should be limited to low-budget, independently produced films. Hollywood does not deserve subsidies. The Hollywood major studio/ distributors have allowed their production and promotion costs to soar out of control, in large measure due to the ludicrously lucrative deals made with studio executives (e.g., a $90 million severance package for a studio executive only working at the studio for a little over a year), agents, managers, entertainment attorneys, advertising media, actors, directors, producers and screenwriters. Recent studies show that the average cost of making a motion picture released by the major studio/distributors reportedly doubled from $26 million to $52 million in less than a decade. Instead of subsidizing fiscal irresponsibility, it would make more sense to require the majors to tighten their belts. In effect, some legislators are simply asking whether Hollywood has enough money without a state legislature throwing taxpayer dollars its way. A bad idea. At a time of financial crisis in many states, the idea of handing over taxpayer funds to Hollywood filmmakers is seen as a waste of taxpayer dollars. It is an idea that should have ended up on the cutting-room floor. Making movies is not a necessary public activity, and the government has no business using taxpayer funds to enrich private film companies. If state government has to tax and spend, it should spend our tax dollars on projects that truly have a public purpose, like building roads, schools or hospitals for the citizens of the state. Ill-conceived schemes. These state subsidy schemes force state taxpayers to give their money to Hollywood film companies to pay directors, actors and actresses primarily coming from California or New York in

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the hope that some economic benefit will trickle back down to the state’s taxpayers generally. It is an inappropriate use of the government’s power to tax and an unconstitutional expenditure for a private purpose. Ensuring that some Hollywood starlet has a nicer trailer isn’t a public use of our taxpayers’ hard-earned money.

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PART TWO Investor Financing Investor financing of all or part of a film production or its distribution is distinctly different than the other common forms of film finance we will consider, such as gifts, grants or loans. With investments, the people or entities providing the money have an expectation of not only getting their money back but of making a profit, even if, as with independent films, the investment is a risky one. On the other hand, investors must accept that if the business venture does not go well, some or all of their investment could be lost, because as a general rule, the producer does not have to pay the money back unless the film is an economic success at a level that allows the investors to recoup their investment and/or make a profit. Investors may be actively involved in the management of the project they are invested in, or they may be passive (i.e., not involved in management). Certainly it is generally more desirable for the producers of a creative venture like a feature film to have the investors be passive, but sometimes, if the right active investors are brought together, it may make sense to finance a film project with funds provided by a small group of them. The distinction between active and passive investors is likely to be the most critical factor determining whether a film-financing scheme does or does not involve the sale or offer of securities. The sale or offer of a security triggers compliance obligations relating to the federal and state securities laws. Thus, filmmakers considering investor financing may first want to give some thought to the kind of investors who are available to them and who they would prefer to work with. In short, active investors are those who are regularly involved in helping the producer make important decisions with respect to the management of the project. Passive investors are those who do not materially participate in the management of the business.

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Investor Financing Strategies Within the context of film finance, investor financing offers a considerable amount of flexibility to filmmakers. Generally speaking, there is no legal limit to the amount of money that can be raised through investor financing, although specific securities laws relating to securities registration or exemption from registration may impose ceilings on the amount of money that can be raised pursuant to that particular type of securities offering. Spreading the Risk Investor financing can work with small groups of active investors (e.g., 1–3 investors) or with much larger groups of passive investors. One important point to remember about allowing a large number of investors to invest in a film project is that the risk of losing the invested funds is spread among more individuals, and therefore it is less likely that any single individual investors will suffer significant financial harm in the event that the film does not recoup their invested funds. In a highly risky venture such as the production of an independent film, that may be one of the more important risk-reducing mechanisms a producer has to offer. Alternative Uses for Investor Funds Investor financing can be utilized in a number of different ways. Note that there are three stages in the life of a feature or documentary film that can be financed separately: • development (including acquisition, script development, packaging and possibly even some preproduction activities, such as location scouting and budgeting); • production (including preproduction, principal photography and postproduction—along with marketing to distributors and delivery items); and • distribution.

Thus, investor financing can be used to provide some or all of the funds necessary to accomplish the following: Single-film development offering. To pay the costs associated with acquiring rights, developing a single film script and packaging a project; and when the project is fully developed and packaged, seeking production financing from other sources, or selling the project outright. Multiple-film development offering. To pay the costs associated with acquiring rights, developing several scripts and packaging multiple projects; 40


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and when the projects are fully developed and packaged, seeking production financing from other sources, or selling the projects outright. Single-film production offering. To pay the costs involved in producing a single film, including preproduction, principal photography and postproduction, along with expenses associated with marketing the completed film to distributors and delivering all required items to a distributor. Multiple-film production offering. To pay the costs involved in producing a slate of films. Coproduction offering. To pay for a portion of the production costs, with the express intention of seeking out a coproduction partner (i.e., joint venturer) to cover the balance of the film’s production costs. Finishing fund. To create a fund dedicated to the purpose of providing financial assistance to other filmmakers in finishing their films. Such funds may be used to aid in completing the production of a film, to pay for postproduction, to finance marketing the film to distributors and to pay the cost of distributor delivery items (also called completion funds). Distribution deal. To pay some or all of the costs of distributing one or more films, whether through a self-distribution or a rent-a-distributor arrangement. Thus, for example, investor financing may be used by a producer to resolve the classic “catch-22” of independent filmmaking; namely, the producer cannot raise production money without recognizable name actors attached to the project but can’t get such actors attached without money. Keeping in mind that the three stages in the life of a film can be and often are financed separately, it becomes apparent that by raising money through an investor offering as a development deal and using those early funds to, among other things, attach attractive elements to the project (create a package), a producer may be able to approach other sources of financing, whether studio or industry sources, lenders or other investor groups, with a completed and fully developed script along with a partly or fully packaged film project. On the other hand, this catch-22 may only exist in the minds of some filmmakers. After all, in the view of Paul T. Boghosian as set forth in his Imagine News article (see “The Beach: American Film Market 2002”), the world market for independent film appears now to be in the television and video markets, more specifically in DVD, and not in a theatrical release. Further, as Chris Anderson opines in his Wired Magazine article online (“The Long Tail”) filmmakers should “forget about squeezing millions from a few megahits at the top of the charts. The future of entertainment is in the millions of niche markets at the shallow end of the bitstream.” And that “shallow end of the bitstream” includes the Internet, which in 41


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the view of many will inevitably become a medium for the distribution of feature-length movies. Choice of Investment Vehicles and Entities Another decision that must be made by a filmmaker seeking financing, investor financing or otherwise, is to choose the entity through which to conduct the business of the production company and the investment or financing vehicle for the current project or projects. The investment vehicle may or may not be the same as the production company. This choice is commonly referred to as the “choice of entity” question, although sometimes the choice does not involve an entity (e.g., see “The Sole Proprietorship” below). Thus, the discussion is really about what form of doing business is considered best for the filmmaker at various stages in his or her career. At other times, the choice is not so much about which form or entity is most appropriate for the business, but which is most suitable for raising investor funds for one or more film projects. As noted above, there are two levels of choice relating to investment vehicles or entities: (1) which would be best for the ongoing operations (production and development) of the company; and (2) which would be best to serve as an investment vehicle for one or more film projects. These choices of entities and investment vehicles generally are made from the following types: • • • • • • •

sole proprietorship general partnership joint venture corporation (regular C corporation or S corp) member-managed LLC manager-managed LLC limited partnership

Note that business plan is not listed as an entity or an investment vehicle, for the simple fact that it is neither (see discussion below relating to the proper use of a business plan). Then there is even a third level of choice with respect to the entities and investment vehicles that can be used to serve the needs of the independent film producer: whether to choose an active investor (nonsecurities) vehicle or a passive investor (securities) vehicle. Each of these choices is discussed further in the following pages. It may prove helpful to independent film producers to provide an outline or brief overview of the likely choices to be made in seeking some form of investor financing: 42


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Operating/production company. How should the production and development or operating company be organized for the moment? Remember that some forms of operating or production companies offer an opportunity for a first level of (start-up) financing. Investment vehicle or entity. What form of doing business should be selected to raise money to develop or produce the current film or films? Does the independent producer really want to combine control and ownership of the operating and production entity with financing of the movie or movies, or should those be kept separate for now? Securities or nonsecurities. Should an active investor investment vehicle or entity (one not involving the sale of securities) or a passive investor investment vehicle or entity (one involving the sale of securities) be chosen to serve as the vehicle for raising money from investors? Type of offering. Assuming that the producer has chosen to raise money through some sort of securities (passive investor) vehicle, the next question relates to whether it should be a public (registered) offering or a private (exempt) offering? Private offering choices. Then, assuming (as is the case with investor financing of most independent film projects) the producer chooses to raise money from a large group of passive investors using one of the private (exempt) offering choices, a decision has to be made as to which provides the best combination of features for the current project. Public/private hybrid possibilities. Also because of the Internet, a producer may want to consider one of the so-called public/private “hybrid” exemptions that permit some limited advertising and do not restrict solicitation by requiring preexisting relationships (see chapter 13). There are no quick and easy answers to the above questions, certainly not for all producers of feature or documentary films. Often they are also very close questions and require some study. In each case, there are advantages and disadvantages for each proposed course of action. This book attempts to provide an objective presentation of those advantages and disadvantages so that producers can anticipate what the consequences of their choices might be. Caution If any of the industry professionals working in the field of film finance seem to be aggressively pushing one approach or another, suggesting that they know the “best way” to finance films, be cautious, because, in truth, the business models they promote may only be the ones that are most familiar to them and not necessarily the business model best suited to the current needs of independent producers. One of the independent 43


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producer’s responsibilities is to be familiar enough with the various available investment vehicles and entities (or other film finance options) to be able to make that decision on his or her own. That is not to suggest that the independent producer should not consult with as many film finance attorneys, consultants and advisers as possible, but that ultimately these decisions should be based on the special needs of the film production and the producer. The Sole Proprietorship Often the filmmaker will start out as a self-funded sole proprietorship. The sole proprietorship is neither an entity nor an investment vehicle. But, in the context of film finance, the sole proprietorship is the simplest and usually the first form of doing business for the producer’s production company. Such a sole proprietorship would be an unincorporated production company owned and managed by one person, for the purpose of making a profit. Out-of-pocket start-up expenses are often typically paid for by the sole owner, although it is possible for a sole proprietorship to make arrangements using the investor-financing agreement to bring additional capital into a sole proprietorship from an investor who is not an owner (for a sample of an investor-financing agreement, see Film Industry Contracts). Generally, it will be necessary for the owner of a film production company organized as a sole proprietorship to file a Fictitious Business Name Statement (in California) or to effect what in other states is called an assumed name filing, if the name under which the business is being conducted is different from the name of the individual owner. In some jurisdictions this form of doing business is referred to as a dba, that is, “doing business as” (name of company). As noted above, the film production company organized as a sole proprietorship will generally be self-funded by the individual owner; however, the sole proprietor may also seek gifts, grants, loans, use an investor-financing agreement, serve as the general partner of a limited partnership or serve as the manager of a manager-managed LLC in order to raise subsequent development and production funds. Advantages Creative control. The owner of a production company operating as a sole proprietorship has the authority to ultimately make all of the creative and other decisions regarding the operations of the company. In other words, there is only one boss and conflicts are thus minimized. Self-reliance. The sole proprietor is not subject to the incompetence, 44


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mismanagement or fraud of others who may have to be relied on in other forms of doing business. Cannot be fired. The sole proprietor of a film production company cannot be fired or otherwise removed from his or her office. Few legal formalities. There are few, if any, legal formalities that need be followed in creating the sole proprietorship except to make the aforementioned fictitious name filing, if one is required, with the county clerk in the county in which the firm is doing business (also called an assumed name filing in some states) and possibly with the secretary of state in other states. No formal maintenance requirements. There are also no formal maintenance requirements as in a corporation, such as the holding of annual shareholder meetings, the calling of regular meetings of a board of directors, the maintenance of minutes of such meetings or the approval of board resolutions for significant company actions. Inheritance. A film production company organized as a sole proprietorship can be left to the individual owner’s heirs with or without a will. Selling the business. The owner of a film production company organized as a sole proprietorship can sell the business or its assets (e.g., films produced or equipment) without the approval of or negotiations with partners or other owners. Taxation. The income of the sole proprietorship is taxed as the personal income of the individual owner at individual rates as opposed to corporate rates. Thus, depending on the current state of the tax laws and the individual’s level of income, the sole proprietorship may be taxed at a lower rate. Disadvantages Start-up costs. The owner of a film production company organized as a sole proprietorship may have to bear the burden of start-up costs. Only decision maker. In some instances, being the only decision maker can be a burden. Raising funds. It is generally more difficult to raise funds from investors using this form of doing business. Personal liability. The owner of the film production company organized as a sole proprietorship is personally liable for the obligations of the business and its debts. Tax deductions. The unincorporated sole proprietor cannot deduct losses from passive income, write off medical expenses or deduct the cost of pension plans, while under current tax provisions a corporation can do so. 45


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Difficult to sell. A film production company organized as a sole proprietorship may be more difficult to sell than a production company organized as a corporation since the most important asset of the sole proprietorship is often its owner. Doing business with others. Many businesses prefer to do business with corporations as opposed to sole proprietorships. Key employees. It is more difficult to entice key employees to work for a sole proprietorship and to create profit-sharing arrangements. The balance of this part two discussion relating to investor financing is divided into the two broad categories relating to active investor vehicles and passive investor vehicles. The passive investor vehicles (discussed in chapters 7, 8 and 9) all involve securities law compliance, and that material is further divided into an additional three sections relating to private (exempt) offerings (chapters 10, 11 and 12), private/public (hybrid) exemptions (chapter 13) and public (registered) offerings (chapters 14–18).

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Active Investor Vehicles There are at least four readily identifiable so-called active investor filmfinancing vehicles: • the investor-financing agreement; • the general partnership, or its more specialized form, the joint venture; • the initial incorporation; and • the member-managed limited liability company (LLC).

At least initially, active investor vehicles appear to be attractive because the money might be raised from one or two wealthy individuals. Occasionally, in fact, the Hollywood-based trade press will produce articles about film finance, but unfortunately such articles tend to focus on what are perceived to be current trends in film finance as opposed to providing a more balanced perspective that would be useful to a great majority of filmmakers. As an example, in February of 2003, Variety reporter Beth Pinsker wrote an article titled “Who Wants to Hook a Millionaire Film Patron?” implying that wealthy individuals are seemingly the sole source of capital (this latter statement was, in fact, the subtitle for the article). Pinsker went on to write that “most of the financing schemes concocted by independent producers over the years have stopped working in this difficult economy.” She then went on to add that “an old source of investment—private equity—is again bringing significant capital into the marketplace.” There are several problems with the article that tend to make it misleading. First, equity financing, or what is referred to in this book as investor financing, has always been available and has always played a part in film finance. The level of capital contributed by private investors may vary from year to year, but to suggest that it once played a role and then went away for awhile but once again is “significant” overlooks the many intervening years in which investor financing played an important role in either development or production financing. If, on the other hand, the article is concerned only with major studio financing or the financing of films intended to ultimately be released by the major studio/distributors, that bias would make the statement about equity financing a bit more accurate, but such bias ought to be disclosed. Investor financing has long been a source of capital for independently produced film projects. Furthermore, the article seems to suggest that the only area of investor financing that has made this remarkable comeback is financing by 47


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“wealthy individuals” (the individual investors more accurately categorized in this book as “active investors”). There is little to no discussion about the investment vehicles being used, or the much broader field of passive investor financing, or the advantages or disadvantages of choosing between active investors or passive investors or of the many options within each of those differing types of finance, and no hint about the need for securities law compliance should the investors want to be passive. The discussion merely cites several examples of this apparent “trend,” which is lot like reasoning from a “representative sampling” of one (i.e., the sampling is not representative at all). The point being made here is that the information about film finance in trade press articles generally is not very reliable, because such articles are merely exposing the tip of an iceberg and are therefore inherently misleading. To the extent that this particular article convinced anyone to seek out one or two wealthy (active) investors to finance some filmmaking ambitions, the article in all likelihood did a disservice to its readers. All persons investigating the world of film finance need to step back and take a broader view, recognizing that there are and have always been many ways to finance a feature film, that each form of film finance has its advantages and disadvantages and that each filmmaker’s situation is different, not only from other filmmakers, but on each film being considered. The choices made will depend more on what a given filmmaker brings to the table for a particular project than on what any industry reporter perceives to be the latest trend in film finance.

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3

The Investor-Financing Agreement

The investor-financing agreement is one of several active investor-financing (nonsecurities) transactions that may be used to raise a limited amount of funds from one, two or a few active investors. The other three discussed in this book are the general partnership/joint venture, the initial incorporation and the member-managed LLC. The investorfinancing agreement is merely a contractual arrangement between the film’s producer (or production company) and a single active investor. The single active investor makes whatever contributions to the project that are agreed upon and set forth in the contract in exchange for screen credit and a percentage participation at some specified level of the film’s revenue stream; for example, 50 percent of the producer’s share of net profits or 25 percent of the film’s net proceeds (percentages may vary). Use with Business Plan Just as with the initial incorporation, the joint venture and the member-managed LLC, the investor-financing agreement may be used in conjunction with a business plan to offer a single active investor an opportunity to review the business plan for a given film project or film production company and then to immediately invest by signing the accompanying investor-financing agreement and submitting his or her check to the producer. Active Investors Only The investor-financing agreement should specifically set out how the investor is going to be involved in the management of the project. In other words, in order to be considered active, the investor must materially participate in the activity; that is, the investor must be involved in the film’s operations on a sufficiently regular, continuous and substantial basis. Not only must the investor-financing agreement describe the level of investor involvement, but the investor’s actual conduct must reflect 49


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that active involvement, and it is important that the producer develop documentary evidence tending to show such involvement on the part of the investor. It is important that the investor be active in fact, so that if any securities regulator chooses to question the transaction after the fact (alleging that it might have involved the sale of a security to a passive investor), the producer will be able to demonstrate the active nature of the relationship. The investor-financing agreement typically runs to six or seven pages in length. (A sample of an investor-financing agreement appears in Film Industry Contracts.) Agreements like the investor-financing agreement may be called by another name. For example, if the agreement is actually being used to raise development money, it may be referred to as a “Development Money Investor Agreement,” or something similar. It is important to recognize, however, that even if the money being raised is to be used only for acquisition and development purposes, the critical distinction for securities law compliance purposes is whether the investor is passive or active. As a general rule, passive investors invest in securities; active investors invest in nonsecurities. Incidentally, from a legal perspective, this active/passive distinction, as described here, is an oversimplification of the law relating to the question of when a security is being offered or sold. But it is a much more easily applied concept for making nonlawyers aware of the possibility that they may be engaged in selling a security, and thus it is much more useful than the more cumbersome and more legalistic definitions of a security. Advantages Simplest form of investor financing. The investor-financing agreement may be the simplest form of investor financing and therefore the least expensive. Works with business plan. The investor-financing agreement can be provided to prospective investors along with the business plan so that if the prospective active investors are impressed with the business plan and want to invest, they may do so by signing the agreement. Disadvantages Single investor. It is extremely rare to find a single investor who has the wherewithal or willingness to fund the entire production budget for a motion picture, even a low-budget film. No limited liability. The investor-financing agreement is merely a contract. It is not an entity. Therefore, it offers no limited liability protection 50


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for either the investor or the producer. Thus, if any third party sues the production company, the personal assets of both the producer and the active investors may be placed in jeopardy. Multiple investors. To the extent that the producer may want to add a few active investors, he or she must realize that the more investors there are, the less likely that all of them will be truly active investors. Thus, the chances are increased that the producer has actually raised money from one or more passive investors, which probably means that the securities laws are involved and compliance with such laws would be required. Active investor. In order to comply with the federal and state securities laws, the producer must make certain that the investor is actively involved in the making of management decisions on a regular basis (i.e., the investor is materially involved in management). Producer difficulties. Use of an investor-financing agreement, or any of the active-investor financing options, for that matter, may not ultimately be to the advantage of the independent film producer since it places a heavy burden of financial risk on just one, two or a few individual investors, and if any one of them becomes the proverbial “disgruntled investor,” that could create some difficulties for the producer.

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4

General Partnerships and Joint Ventures

General Partnerships Another of the active investor vehicles that may be initially considered by a filmmaker for starting a film production business is the general partnership. Whenever two or more persons associate for the purpose of carrying on a business for profit, regardless of whether they intend to create a partnership or whether they call their association a partnership, a joint venture or any other name, the association may be considered a general partnership. A general partnership may be formed with or without a written agreement, although a written agreement is preferable. The laws relating to general partnerships are primarily based on state law. The discussion that follows is based on general principles that apply to general partnerships, but such principles may be modified by the specific provisions of a given state’s statutory or case-made law. There are several factors that typically indicate that a partnership has been formed: • expression of an intent to be partners; • contributing or agreeing to contribute money or property to the business; • participation or right to participate in control of the business; • receipt or right to receive a share of the profits; or • sharing or agreeing to share losses or liabilities.

Partnership management. General partners have a great deal of latitude for providing in the partnership agreement how the partnership will be managed. Unless the partnership agreement states otherwise, each partner has an equal right to participate in the management of the business. In some cases, however, partners will designate a partner or partners who will have management authority. Fiduciary duties. A partner owes duties of loyalty, care and candor to the partnership, the other partners and their heirs, legatees or personal 52

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representatives of a deceased partner, to the extent of their respective partnership interests. These duties are fiduciary in nature (i.e., acting primarily for the benefit of others). The duty of loyalty requires general partners to place the interests of the partnership ahead of their own interests. It requires them to account to the partnership for any partnership asset they receive or use and prohibits them from competing with the partnership or dealing with the partnership in an adverse manner. The duty of care requires a partner to act as an ordinarily prudent person would act under the same or similar circumstances. The duty of candor imposes a duty of disclosure of all material facts in dealings with the other partners. Partnership liability. As a general rule, all partners of a general partnership are jointly and severally liable for all debts and obligations of the partnership unless otherwise agreed by a claimant or otherwise provided by law. Typically, under common law, a general partnership as an entity is liable for loss or injury to a person, as well as for any fine or other penalty incurred as a result of the wrongful acts or omissions of any of its partners acting either in the ordinary course of the business of the partnership or with the authority of the partnership Provisions in a partnership agreement that serve to allocate liability among the partners are generally ineffective against third-party creditors. Under the applicable state’s law, however, any partner who is forced to pay more than his or her allocable share of a particular liability may have a right of contribution from the partnership or from the other partners who did not pay their allocable share. A person admitted as a new partner into an existing general partnership does not have personal liability for an obligation of the partnership that relates to an action taken or omission occurring prior to his admission or an obligation that arose before or after his admission under a contract or commitment entered into before his admission. A general partner who withdraws from the partnership in violation of the partnership agreement is liable to the partnership and the other partners for damages caused by the wrongful withdrawal. A withdrawing general partner may also be liable for actions committed by the partnership while he was a partner, even though the action was not adjudicated to be wrongful until after the partner withdrew from the partnership. General partnerships as financing vehicles. Some of the features of a general partnership, such as the lack of free transferability of interests, the unlimited liability of its partners and its decentralized management are all features that tend to make the general partnership ineffective as a vehicle for raising significant amounts of capital. On the other hand, 53

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persons associating together for the purpose of conducting a business may have inadvertently formed a general partnership before they take steps to organize their business in any other fashion, and for these initial organizational purposes, a general partnership may be a quick and easy way to bring in a limited amount of start-up capital. A general partnership may also serve as the general partner of a filmmaking limited partnership (LP) or as the manager of a manager-managed LLC, thus using the general partnership as the film production (operating) company and the LP or LLC as the investment vehicle. General partnership interests as securities. As a general rule, interests in a general partnership are not considered securities. However, a general partnership interest may be treated as a security when the venture, though a general partnership in name, functions as a limited partnership (i.e., certain partners do not actively participate in management and rely primarily on the efforts of others to produce partnership profits). Thus, a film producer who tries to avoid compliance with the federal and state securities laws by calling his or her investment vehicle a general partnership and seeking to raise money from a large group of investors, some of whom are passive, may well be guilty of selling an unregistered security without also complying with any of the available exemptions from the registration requirement, thus potentially triggering both civil and criminal liability. Self-employment tax. Partners of a general partnership generally will be subject to federal self-employment tax on their share of the net earnings of the trade or business income of the partnership and any guaranteed payments for personal services. Joint Venture Financing The following summary discussion of the joint-venture-financing vehicle seeks to distinguish the joint venture from similar forms of film finance and to highlight some of the more important issues that arise when using this vehicle. A joint venture as applied to a film project may also be referred to as a domestic coproduction deal. Joint venture versus general partnership. A joint venture is a specialized form of general partnership, created for a limited purpose (e.g., the production of a feature film). In other words, the business scope of the joint venture is limited. A general partnership, on the other hand, is used when the active investors intend to establish a continuing business relationship devoted to a broadly defined purpose or purposes. Joint venture versus investor-financing agreement. Generally, an investor-financing agreement may be used when a single active investor is 54

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providing all of the funds to finance the production costs of a motion picture (which may also be the case with a joint venture). However, the investor-financing agreement merely involves a contractual arrangement between the investor and the production company. No separate entity, as with the joint venture, is created. Joint venture versus limited partnership. Generally, the joint venture will be used when the investors are fewer in number and financially knowledgeable, but, even more important, they must all be active investors, that is, actively involved in the project. In contrast, the limited partnership investors must be passive investors. Thus, some aspects of the advantage to the producer of maintaining creative control, which the limited partnership offers, may be lost with the joint venture. Also, the limited partnership offers its investors limited liability, whereas the joint venture does not. The joint venture would be most appropriate when one entity provides the financing, the other entity brings the literary property and talent to the deal, and both are to be actively involved in the management of the project. Joint venture versus manager-managed LLC. The joint venture compares to the manager-managed LLC much as it does to a limited partnership. The limited partnership and manager-managed LLC are very similar in most respects, the main difference being in the limited liability for the manager or general partner. Whereas an individual or fictitious-name company serving as the general partner of a limited partnership does not enjoy limited liability protection, an individual or fictitious name company serving as the manager of a manager-managed LLC does. Filing costs and tax requirements may also differ between the LLC and LP (see discussions of both entities below). No limited liability. Under applicable law, general partnerships and joint ventures are treated the same. Both are general partnerships in that joint venturers have the same liability that general partners have under the law of partnerships; that is, joint and several. Joint venturer contributions. In the context of financing a feature film or films, the joint venture usually consists of two or more companies that contribute various elements to the project, some of which may be nonmonetary, such as unequal responsibilities, the script or underlying property, commitments from a director or actors, below-the-line facilities and the like. In other words, one joint venturer may contribute some or all of the money, and the other joint venturer may contribute the packaged literary property. The contributions of limited partners in a limited partnership (or of members in a manager-managed LLC), on the other hand, are generally monetary, even though some of the 55

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state laws regulating such contributions permit limited partners or LLC members to contribute money, property and past services (but not future services). Creative control issue. In negotiating and drafting a joint venture agreement, one of the most important issues is creative control. The joint venturer contributing the creative elements will typically want to maintain as much creative control as possible. The joint venturer contributing all or most of the financing for the project may want to have some important input relating to creative matters; thus, specific provisions need to be set out on this issue, such as approval rights. Duration of the joint venture. The term of the motion picture joint venture will generally be expressed in the alternative, for example, for a short specified term if production financing is not obtained, or for the longest term of any of the agreements relating to the literary property or for the duration of any and all copyrights owned by the joint venture. Title to the property. Usually, the literary property is transferred into the joint venture, and a provision is included that specifies that all rights to the literary property are held in the name of the joint venture. If, on the other hand, the joint venture does not hold title to the literary property, but merely acquires some more limited rights to it, the joint venturer contributing most or all of the money may want to create a security interest in the literary property to help assure performance by the other joint venturer of its obligations under the joint venture agreement. Allocation of profits and losses. Like the general and limited partnerships, the profits and losses of the joint venture pass through to the joint venturers; thus, the joint venture itself is not a taxable entity. The joint venturers are free to allocate profits, losses, tax credits and deductions in whatever manner suits them. Such decisions may be changed and modified at any time before the due date of the joint venture’s federal informational return for that taxable year. Books, records and bank account. Provision must be made for the creation and maintenance of books, records and a bank account for the joint venture, for naming the person responsible for such activities and for securing access to such by the other joint venturer. Resolving disputes. Since it is vital to keep a motion picture project moving forward without undue delay, it is extremely important to include a provision in the joint venture agreement relating to how disputes that arise between the joint venturers can be quickly resolved. For example, they can agree either that one of the joint venturers will have the final say on certain specified issues or that a third party or third parties will resolve such differences within a specified period of time. 56

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Tax consequences. Like limited partnerships and LLCs, a joint venture must normally file an informational tax return. Certain tax elections, for example, methods of depreciation, affecting the computation of a joint venturer’s taxable income must be made by the joint venture itself. A joint venture must adopt its own taxable year, but it may not adopt a taxable year different from that of any principal partner without the consent of the IRS. Tax issues may also arise when each of the joint venturers makes different contributions of money and property; for example, who will be credited with the depreciation on contributed property, and who receives any capital gain or loss allocations. These are issues for the joint venture’s accountant. Other issues and provisions. Additional provisions of the joint venture agreement may relate to management responsibilities of the parties, screen credit, distribution of available cash, joint venturer involvement in other similar projects at the same time, indemnification and warranty requirements, procedures in the event of the death or disability of a joint venturer, dissolution and termination of the joint venture, notices, arbitration and so forth. A sample joint venture agreement as used for a film venture appears in Film Industry Contracts. Advantages Not securities. Interests in a general partnership or in a joint venture are generally not considered securities; thus, it is not necessary to provide investors with a detailed securities disclosure document or otherwise comply with the burdensome federal and state securities laws. Less documentation. A general partnership does not require a written agreement, but it is preferable to set out the points of agreement between the general partners. A joint venture is a contractual arrangement, so it should be created with a joint venture agreement, but this contract is shorter and less complicated than the documentation associated with the offer and sale of interests in limited partnerships and manager-managed LLC’s or shares in a corporation (i.e., securities disclosure documents). No formation filing. There is no required filing of a general partnership or joint venture agreement with a secretary of state as is required for the limited partnership, LLC and corporate forms of doing business. Corporate joint venturers. If both general and joint venture partners are corporations, the risks relating to the lack of limited liability for such partnerships can be reduced, since the owners of the respective corporate partners already enjoy limited liability protection provided by the corporate entities. 57

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Disadvantages Limited term. The general partnership may exist for the life of the partners, but a joint venture is usually set up for a limited term and is thus not suitable for an ongoing long-term business. Active partners. Each of the general and joint venture partners needs to be actively involved in the project. Creative control. Since general and joint venture partners will be actively involved in the project, there may be disputes over creative issues. Limited liability. Neither the general partnership nor the joint venture offers its investors limited liability. Tax consequences. General partnerships and joint ventures are treated for federal income tax purposes the same in that neither pays such taxes, and instead their income or loss is allocated to the general partners or joint venturers.

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5

The Initial Incorporation

A third active investor vehicle possibility involves the creation of a new corporation. This transaction also provides an early opportunity to raise a limited amount of funds. As an example, if a producer brings together four or five close friends, family or business associates for the purpose of starting a new corporation and contributes the rights to a script as consideration for shares while the other founding shareholders contribute cash, property or past services as consideration for their shares, the new corporation will have some corporate funds with which to pursue its goals, including paying the costs associated with a subsequent round of financing needed to help reach those goals. An unincorporated production company that has been seeking funding for any number of purposes (e.g., development or production of a single film or a slate of pictures) and that has engaged in a properly conducted general solicitation through the use of a business plan but has failed to identify that single active investor capable of funding the entire project through the investor-financing agreement (see chapter 3) may instead opt for the formation of a corporate production company. Assuming that the initial active-investor general solicitation by means of the business plan resulted in interest from several prospective investors, none of whom are willing to fund the entire project, but who are willing to join with the producer as founding shareholders of a newly organized corporation (and whom the producer considers suitable as active investors), then the producer may be in a position to execute the initial incorporation scenario without actually conducting a securities offering. Although, technically speaking, corporate shares are securities, and corporate shareholders are passive investors, meaning that federal and state securities laws apply to the sale of corporate stock, a presumption arises during the formation of a corporation that all of the founding shareholders are adequately informed regarding the corporation and have adequate means to protect their interests in the creation and operation 59

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of such an entity. After all, they have an opportunity to get together in their first annual meeting and select the corporation’s initial board of directors, and some of them will likely be elected to the board, thus giving them considerable control over the activities of the corporation. This in turn means that the shareholder-directors will no longer be strictly passive investors and will not need the protection ordinarily provided by the securities laws that apply to the sale of corporate stock to outside shareholder prospects after a corporation has already been formed. That sort of secondary offering would surely require compliance with all of the federal and state securities laws covering any securities offering, including the provision of a complete disclosure document to each prospective investor. Forming a new corporation with a group of investors who are willing to be involved in the management of the corporation as shareholders, directors or officers allows the producer to avoid the time and expense involved in conducting a full-fledged securities offering (whether public or private). Again, such an offering would be required if the producer first incorporated and then sought to raise money from new shareholder investors. This two-stage investor solicitation strategy works best if the producer initially goes out into the marketplace to conduct a general solicitation by means of a generic business plan with the bona fide intent to find a single active investor or an active joint venture partner and only after failing to find one then shifts his or her attention to forming a corporation with several investors identified during the original general solicitation. In other words, the business plan must not precommit the producer to the initial incorporation strategy or the sale of any other security. If such language appears in the business plan, the general solicitation may be considered to have been conducted for the purpose of finding corporate shareholders, who are ordinarily passive investors. And a general solicitation conducted for such prospective investors can only be done legitimately after registering the securities with the Securities and Exchange Commission (SEC) at the federal level and with the state securities regulatory authorities in each state in which such sales or offers are contemplated; or, alternatively, by qualifying for available federal and state exemptions from such registration requirements (i.e., private placements). Bad Advice Some accountants advise producers that all that is necessary to do to incorporate is to file articles of organization with the secretary of state; what they fail to mention is that unless and until the first annual shareholder 60

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meeting is held and supported by minutes, the initial board of directors meeting is held and supported by minutes, officers are elected, corporate bylaws are approved, corporate shares are physically issued and noted of record, the corporate formation process is not complete and its limited liability protection may not be available. Angel Investor Financing This initial incorporation stage creates an opportunity to seek out socalled angels to provide “angel financing.” The term angel financing is typically associated with early-stage financing provided by individual wealthy investors, as opposed to that provided by the groups of individuals or companies organized as venture capital firms (see “Venture Capital Financing” in chapter 9). Furthermore, it is not necessary to form a corporation to bring in angel capital. The term may also apply to any of the active investor financing options discussed here. As a practical matter, however, the term is most often associated with early-stage corporate finance. Although no one can authoritatively say that it is incorrect to refer to an angel investor as a venture capitalist or to say that an angel investor is going to provide venture capital for a company, it would be more accurate to say that an angel investor provides start-up or early-stage financing, while venture capital firms usually provide funds for later stages in a company’s growth. The fact of the matter is that some wealthy individuals prefer to act as their own financiers rather than invest indirectly through an intermediary, such as a venture capital firm. The exact number of such individuals at any given time is not known, and the size and financial capabilities of these so-called angel financiers varies considerably. However, some commentators estimate that the amount of money invested in a given year by angel investors exceeds that invested by venture capital firms. The more important questions for filmmakers seeking financing are, what are the odds of finding an angel investor interested in risking money in a film venture; and to the extent there are such people, why would they be motivated to invest in one particular project when the film industry marketplace is crowded with films seeking production-money financing, and many of those projects have much more experienced producers attached? Without presuming what the answers are to such questions, part of the strategy of the film producer should be to pursue that sort of financing that is most likely to succeed for a given project. Secondly, the independent producer must carefully examine whether he or she is willing to work closely with such a wealthy individual and 61

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whether they both share a common vision for the film project. There may be nothing worse for a filmmaker than to have an active investor who has contributed most, if not all, of the money needed to produce a film get into a disagreement with the original independent producer over important issues like choice of talent or director and changes in the script (see the 1998 indie film 20 Dates for an example of an active investor placing burdensome demands on an independent producer). Angel Capital Electronic Network (ACE-Net) At one time in the mid to late 1990s, the federal government’s Small Business Administration (SBA), in partnership with a number of nonprofit organizations around the country, the SEC and the North American Securities Administrators Association (NASAA), sought to facilitate small companies’ access to such potential investors by establishing ACE-Net (Angel Capital Electronic Network), an Internet-based, secure listing service for companies seeking financing between $250,000 and $5 million in equity capital from angel investors. The potential investors were prescreened to ensure their status as qualified investors for private placements. The SBA actually sought to serve as an incubator for the program with the intention of allowing private entities to eventually assume stewardship of the program. The SBA-sponsored ACE-Net system was abandoned in 2004, and various private entities have created websites in an effort to continue the system. Advantages One-stop shopping. All of the money needed for a particular low-budget film project may be put up by a single active “angel” investor. Wealthy investor screening services. Even though the ACE-Net program is no longer in operation, there are some for-profit entities offering similar services (i.e., access to a prequalified group of wealthy investors online). Unfortunately, there also appear to be scam artists online who claim to offer access to prescreened wealthy investors, without performing what they promise. Avoids securities offering. If properly handled, this so-called initial incorporation technique can save the time, effort and money involved in preparing a complicated securities disclosure document and conducting a securities offering. General corporate finance. As shareholders of the corporation, the initial investors are in a position to benefit from all of the corporation’s activities to the extent that such activities are profitable and the board of directors chooses to declare dividends for the shareholders. The producer may also 62

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use this form of finance to fund a production company’s initial startup phase; that is, to raise a small amount of funds from a limited number of founding shareholders to cover film project acquisition, development, general corporate or subsequent securities offering expenses, while relying on other forms of finance for the film’s production costs. Disadvantages Angel interest. The vast majority of angel investors are not usually interested in providing the first-level financing for start-up companies. High-risk investments. There is no evidence that the angel investors previously on ACE-Net or now signed on to any of the other online prescreening services are interested in the very high-risk film production companies. Some uncertainty. The active investor (nonsecurities) strategy would probably not work with a large number of investors, and how many investors are too many cannot be predicted with certainty. Limited funds. The initial incorporation strategy is also only appropriate for raising a small amount of money for general corporate purposes from a limited number of founding shareholders, but again there are no official guides to how much is too much or how many investors are too many. Less control. In using this technique, the producer may have to give up some control of the company. Shareholders have the right to vote on board members. The board of directors must approve all of the corporation’s major decisions. Some of these same people may serve as officers of the corporation. The original producer may be fired.

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6

The Member-Managed LLC

A fourth active investor vehicle that may be considered by a film producer is the member-managed limited liability company. The LLC is a relatively new form of business entity available in most states. Its formation is based on state law and typically involves filing articles of organization with the secretary of state in the state selected as the base of operations and the drafting and signing of an LLC operating agreement. A producer choosing to form an LLC should be sure to check that state’s LLC statute for specific provisions that must be included in the operating agreement. Also, note that despite what many sources of information relating to film finance say, this entity is not properly referred to as a “limited liability corporation.” It is a “limited liability company.” Including the word corporation in the label may tend to confuse the LLC with the corporate form of doing business, but the two are quite distinct. The LLC combines aspects of the corporation, the limited partnership and the general partnership. The member-managed LLC has member-managers who function much like the general partners of a general partnership. The member-managers of an LLC, however, enjoy limited liability protection. It is important to note that there are actually two different kinds of LLCs. The company may be operated either in the fairly democratic tradition of a general partnership, with all of the member-owners involved in the management of the company (i.e., management by committee), in which case it is referred to as a member-managed LLC. Alternatively, the LLC may be operated in the more centralized manner of a corporation, with one or more managers, in which case it is referred as a manager-managed LLC. That distinction is usually made in completing the state form that is initially filed with the secretary of state (i.e., the articles of organization), but it is also made in the drafting of the provisions of the LLC operating agreement, since the two types of LLCs are operated differently. With the member-managed LLC, a limited number of investors are actively involved 64

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The Member-Managed LLC

in the management of the company. The LLC is managed by committee and majority vote. With the manager-managed LLC, the company is managed by one or more designated managers, and the members are passive (i.e., they are not actively involved in the management of the company). The former typically does not involve the sale or offer of securities (i.e., the LLC units or interests are not considered securities). But, with the latter, the LLC units or interests are considered securities, triggering the obligation to comply with the federal and state securities laws when offering and selling them (i.e., preparing a disclosure document, written disclosure of all material facts, notice filings, etc.). Either form of LLC may engage in any lawful business or purpose, including the production and distribution of a feature film. For federal income tax purposes, the LLC is treated much like an S corporation or a limited partnership; that is, the company is not taxed at the entity level (it is considered a “flow-through” entity for federal income tax purposes). However, unlike the limited partnership, which must have at least one general partner who does not have limited liability, all of the LLC’s managers and members can enjoy limited liability. Unlike an S corporation, the LLC can have subsidiaries and can allocate benefits differently among its various owners (the S corporation can only have one class of stock). It is important to discuss the advantages and disadvantages of an LLC with an experienced securities attorney before forming one. For example, it may not be necessary to create a member-managed LLC as the operating company (i.e., a production and development company) if a manager-managed LLC is subsequently to be used to raise money from a large group of passive investors. Furthermore, it may not be necessary to even create the manager-managed LLC until the minimum amount of the stated offering proceeds are actually raised and in the bank. Bad Advice Some accountants advise producers that to create an LLC, the filing with the secretary of state is all that is required. However, drafting and approving of the LLC operating agreement is also required; otherwise, the LLC would have no rules for operating (see further discussion under “Bad Advice” in chapter 7). Advantages Best of both worlds. The LLC combines the tax benefits of a partnership with the limited liability benefits provided by a corporation. Each of the member-managers enjoy limited liability protection. 65

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Flexibility. LLCs are generally more flexible with regard to their operations than are corporations, and they are easier to maintain. Informal and democratic operations. The member-managed LLC can be operated in a fairly democratic and informal manner like a general partnership without the burdens of the more formal corporate maintenance. Nonsecurities entity. The formation of a member-managed LLC does not generally involve the sale of a security. The member-managed LLC is considered an active investor entity. Suitable for operating company. The member-managed LLC may effectively serve as the operating company for a film development and production company, which in turn could serve as the manager for a manager-managed LLC used as the investment vehicle for financing the production of a film. First-level financing. The member-managed LLC may be used to bring in a limited amount of start-up financing for the company from its limited number of active investors. Disadvantages Not suitable for many owner-investors. The member-managed LLC is not very useful for business entities involving a large number of owners because of restrictions that may require the company’s dissolution upon the death, dissolution or bankruptcy of a member, and because the larger the number, the less likely that all of the investors will remain active. One or more passive investors could recharacterize the interests into securities. Not suitable for second-round financing. The member-managed LLC is generally not suitable as the investment vehicle for raising a significant amount of financing from large numbers of investors. Creative control issues. Just as with any of the active-investor entities or vehicles, creative control issues may arise within a member-managed LLC, and such conflicts can be devastating for a creative venture, such as a feature film. Franchise tax. In most states, the LLC is subject to an annual franchise tax, just like a corporation. Gross receipts tax. Some states also impose a gross receipts tax on the LLC’s revenues. The law regulating the formation and operation of an LLC in the selected state should be consulted.

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Passive Investor Vehicles Once the producer decides to raise money from a large group of passive investors (as opposed to one, two or a few active investors), he or she needs to recognize that the sale of a security is being proposed (regardless of the choice of investment vehicle). In other words, even if a producer calls the form of doing business a general partnership, which normally does not involve the sale of security interests, when enough general partnership interests are sold that it is either not possible for all of the purported general partners to be actively involved in the company’s management or one or more of these purported general partners are actually passive, then those interests are legally considered securities, no matter what the promoter thought or claimed they were, and that triggers an obligation to comply with the federal and state securities laws. As a general rule, compliance with the securities laws imposes an obligation to comply with both the federal securities laws and rules, as well as an obligation to comply with state laws and rules in every state in which sales or offers of the securities are planned. Often the state securities laws, as they are commonly known, are referred to as “Blue Sky laws.” There are some exceptions to the requirement to comply with the laws and rules at a dual jurisdictional level. As discussed in more detail below, the National Securities Market Improvement Act (NSMIA) provides a regulatory scheme for federal law to preempt certain aspects of state law in certain circumstances (see “National Securities Market Improvement Act” in chapter 12). Choice of Securities Offering Having made the choice of entity for operating as a production company and selected the investment vehicle through which investor financing may be sought, the producer who chooses to raise money from a group of passive investors is quite likely selling a security. In that case, the producer next has to decide whether to conduct a private (exempt) offering, or one of the newer public/private “hybrid” exempt offerings or a public (registered) offering of such securities. The more specific choices include the following: 1. Exempt (Private) Offerings Sec. 4(2) of 1933 Securities Act Sec. 4(6) of 1933 Securities Act—Accredited Investor Exemption Sec. 3(a)(11) of 1933 Securities Act—Intrastate Offering 67

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Regulation D Offerings Rule 504 Rule 505 Rule 506 National Securities Market Improvement Act (NSMIA) 2. Public/Private “Hybrid” Exemptions California Sec. 25102(n) SEC Rule 1001 Model Accredited Investor Exemption (MAIE) 3. Public (Registered) Offerings Small Corporate Offering Registration (SCOR) Regulation A Offerings Regulation S-B Public Offerings S-1 Public (Registered) Offerings Over-the-counter, NASDAQ and stock exchange companies

Each securities offering choice is associated with its own set of rules. There is some overlap in the rules, but each choice brings certain advantages and certain disadvantages. There is a great deal of risk in simply copying or modifying a securities disclosure document prepared by someone else (and assuming that is all that will be required) without knowing the rules with which the disclosure document was intended to comply. Without the preparer actually reading and understanding the applicable rules, it is highly likely that the offering will fail to comply. In addition, certain types of securities offerings require that an attorney’s securities opinion be included as an exhibit, that a tax discussion (either prepared by an attorney or accountant) be included in the body of the securities disclosure document and that a tax opinion (either prepared by an attorney or an accountant) be included as another exhibit to the securities disclosure document. Furthermore, the securities antifraud rule requires that all material facts relating to the proposed transaction be disclosed, that no material facts be omitted and that the facts set forth in the disclosure document be stated in a manner that is not misleading. Arguably, the judgments required to make the many decisions required to fulfill the antifraud requirements alone require the expertise of an experienced securities attorney. Considering these requirements, it is incredibly naive for independent film producers to assume that a securities disclosure document is so similar to a business plan that it can be prepared without the assistance of an experienced securities attorney and will actually comply with all of the rules for the specific type of offering selected. Contrary to the bad 68

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Passive Investor Vehicles

advice being passed out in the film industry by some writers and seminar presenters, in the area of film finance, particularly investor financing through securities offerings, there actually are rules, and particularly in the securities arena, noncompliance has consequences. Most independent film producers seeking investor financing from a group of passive investors tend to choose the private placement, since it takes less time to prepare and is less costly and less complex than public (registered) offerings. For that reason, the exempt (private) offerings are discussed here first. Exempt (Private) Offerings Once a film producer has decided to raise money from passive investors, whether through the sale of shares in an existing corporation, units in a limited partnership or units in a manager-managed LLC, all such interests become securities and therefore compliance with the federal and state securities laws is required if the producer wants to conduct business in a legitimate manner. As noted above, the producer seeking to raise money from a group of passive investors (i.e., sell securities) must decide whether to conduct • a public (registered) offering; • a public/private hybrid offering; or • a private (exempt) offering.

Pursuant to the securities laws, when someone chooses to sell or offer securities, they must first register those securities with the SEC at the federal level and with the state securities regulatory authorities in each state in which sales or offers are to be made. That registration is referred to as a registered, or public, offering. As discussed below, public (registered) offerings are more time-consuming, expensive and complex than private placements, so if a producer decides not to conduct a public offering, the only other alternatives are a private (exempt) offering or one of the more recently developed public/private hybrid offerings. The word exempt, as used here, does not mean exempt from all rules, but rather that the offering is exempt from the securities registration requirement. Exempt offerings simply have to comply with a different set of rules, those associated with the specific exemption chosen, and it is essential that an issuer of securities know which set of rules apply to a proposed offering. Bad Advice Some entertainment attorneys and other film finance pseudo-experts regularly advise filmmakers that selling securities only to accredited 69

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investors in some of the private placements (exempt offerings) discussed below eliminates the need to provide a securities disclosure document to the prospective investors. However, the entire federal regulatory scheme relating to the sale and offer of securities is based on the premise of an informed investor (i.e., one who has been advised in writing about everything that is important about the transaction offered). That is exactly what the antifraud provisions of the Securities Exchange Act of 1934 require—that all material aspects of the transaction be disclosed in writing, that nothing important be omitted and that everything be stated in a manner that is not misleading (see Sec. 10[b] of the Securities Exchange Act of 1934 and SEC Rule 10b-5). It would be absurd to assume that all accredited investors are knowledgeable about investing in the film industry. Thus, the irresponsible position that no securities disclosure document is required for making sales to accredited investors accomplishes only one thing—it places the film producer in a relatively weak position if disgruntled investors should come forward to ask for their money back, because they can argue that the producer did not fully advise them of certain risks associated with an investment in an independent film. The producer who failed to provide a properly drafted securities disclosure document has no convenient way to prove that such risks were fully disclosed, and the burden for proving otherwise in court will rest with the producer who sold the security. Producers concerned about their future careers who are seeking to sell securities would be well advised to comply with the more conventional interpretation of the securities laws and not put themselves at risk for both the civil and criminal liability that may apply. Those purveyors of bad advice are obviously not concerned about protecting the interests of producers who follow their advice. (For a more thorough discussion of issuer disclosure obligations in securities offerings, see “Issuers Raising Capital Directly from Investors: What Disclosure Does Rule 10b-5 Require?” by Harry S. Gerla).

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7

The Manager-Managed LLC

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 of organization need to be prepared and filed with the office of the secretary of state in the state in which it is being created. Generally, the form or articles used will provide a space for designating that the LLC is to be manager-managed 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 are significantly different, longer and more complex than the corresponding operating rules (agreement) for a member-managed LLC. The 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 “Choice of Securities Offering” below). Limited Liability Of particular importance to low-budget filmmakers, the manager-managed LLC offers limited liability protection to one or more individuals or a fictitious name company (dba) serving as the LLC’s manager, without having to take the time, trouble and expense of creating and maintaining another entity such as 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 an LLC, for example, without ever

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discussing whether it should be member-managed or manager-managed and that there are securities law implications for the latter. In addition, there are differing opinions about when to form a manager-managed LLC that will be 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 United States, 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-ofpocket expense is incurred by the manager or producer for the creation of the entity until the investor funds are in the bank and therefore available for prompt reimbursement, as soon as the LLC is formed and a second “production” bank account has been opened in the name of the newly formed LLC. The liabilities most commonly associated with the production of films—negligence on the set and defamation—do 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 misled by somebody or simply misunderstand what they are 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 one, and that it 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. To create 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. Otherwise there are no rules set out for operating the LLC, and it cannot function effectively. 2. When the articles of organization are filed and the operating agreement is drafted, the producer must be certain to properly designate in the 72

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articles which form of LLC is being created, a member-managed or manager-managed LLC, and to carry over this distinction into the operating agreement, because the provisions of the operating agreement for each form of LLC are significantly different. Before a producer can make that designation, he or she must understand the difference between the two LLC forms and to what purpose the one that is chosen 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. Advantages Number of investors. There is no limit on the number of investors imposed by the LLC statutes, but such a limitation may be imposed by the securities laws. Regulation D, for example, permits 35 unaccredited investors and an unlimited number of accredited investors (see chapter 12). No creative control issues. Since the manager-managed LLC is controlled and operated (pursuant to statutory law and the operating agreement) by the manager or managers, and the investor-members are passive, there are no conflicts between management and 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, it is not necessary 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, and the LLC’s operating agreement makes provision for doing so. Disadvantage Securities compliance required. Compliance with the applicable federal and state securities laws are required because manager-managed LLC interests are being offered and sold to passive investors (i.e., such interests are securities).

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8

Limited Partnerships

Another investment vehicle (a form of passive investor financing) that has been around much longer than the manager-managed LLC is the limited partnership (LP). The two entities are very similar so far as their tax treatment is concerned and in the way that they are formed and operated. However, an individual serving as the general partner of a limited partnership does not enjoy the limited liability protection that an individual manager of an LLC enjoys. That explains why most LPs have corporate general partners, or sometimes, member-managed LLCs. General Requirements Formation and filings. All limited partnerships must have at least one general partner and one or more limited partners. The partners (both general and limited) must enter into a limited partnership agreement that should be in writing. However, no government review or approval is required for the limited partnership agreement associated with a privately placed limited partnership offering. A certificate of limited partnership signed by all of the general partners has to be filed with the secretary of state of the state in which the limited partnership is being formed. As with the LLC, the filing of the certificate of limited partnership and thus the formation of the entity can wait until the offering is funded. Such an offering consists of an offering of units in a limited partnership to be formed upon funding. These units are still securities, and therefore compliance with the federal and state securities laws is required. Misinformation. Despite some of the misinformation floating around in film industry circles (some from prominent film industry organizations), a limited partnership, or LP, is not the same entity as a limited liability partnership, or LLP. The LLP is a specific and statutorily authorized entity used by attorneys, accountants and architects and is not a suitable entity for film finance; but the LP is.

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Naming the limited partnership. The name of a limited partnership cannot be the same or similar to other limited partnerships already organized in that same state. A particular name can be reserved with or cleared by the secretary of state in some states, and the name is protected in the state by the filing of the limited partnership certificate. Further steps, however, may need to be taken to protect the name of the limited partnership outside the state of its formation. The names of limited partnerships generally are required to include the words limited partnership or the abbreviations L.P. or Ltd. as part of their official name. Cost of formation. The drafting of the limited partnership agreement itself is usually, but not always, included in the cost of an attorney’s preparation of the associated securities disclosure document. Filing fees and other costs may range from $50 to $150. These are paid to the secretary of state and private filing services (if used to expedite the filing) upon the formation of the limited partnership. Keep in mind that there is much more involved in a feature film limited partnership offering than merely creating the limited partnership entity, and it is not necessary to form the limited partnership entity before starting the offering. Also note that just because some lawyers present themselves as entertainment attorneys does not mean they have bona fide expertise in the more specialized arena relating to compliance with the federal and state securities laws. Capital. Partners’ capital contributions and loans to the partnership from partners and outsiders are typically the main sources of capital for the limited partnership. Quite often, most, if not all, of the capital contributions in the form of cash come from the limited partner investors. Management and control. Management and control of the limited partnership is in the hands of the general partner or general partners. General partners may be individuals, fictitious name companies, general partnerships, member-managed LLCs, or corporations. Limited partners may lose their limited liability if they participate in the control or management of the limited partnership (except for specific acts listed in the applicable state statutes). Liability of owners. General partners have unlimited liability to thirdparty outsiders. Limited partners risk only the loss of their capital contribution unless they take part in management. Limited partners ordinarily are not required to guarantee partnership indebtedness. Operations. Important transactions effected by the general partners do not require advance approval if such activities are in compliance with the partnership agreement and applicable state statutes. In contrast, significant corporate actions require the support of board resolutions.

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Books and records. The limited partnership is required to maintain certain books and records at its principal office, but the requirements are less burdensome than those for the corporation. Sharing of profits. Limited partnerships provide considerably more flexibility (as opposed to a corporation) in the structuring of profit-sharing arrangements between the general partner group and the limited partner investors pursuant to the partnership agreement. This same flexibility is also an attribute of the manager-managed LLC. Continuity of business. The limited partnership exists for a limited and stated term. Thus, it may be more suitable for project financing (i.e., one or just a few films) as opposed to the long-term financing generally associated with corporate finance. Dissolution of the limited partnership may result from the loss of a general partner but not from the loss of limited partners. Such issues are dealt with pursuant to the terms of the partnership agreement and the applicable state statute. Transfer of interests. Restrictions on the transfer of limited partnership interests may be imposed by state statute, the limited partnership agreement or the securities and tax laws. The general partner’s right to receive distributions is typically assignable, but a transferee cannot be substituted as a general partner except by consent of the remaining partners (including the limited partners). Limited partners’ interests are also assignable, but an assignee cannot be substituted as a limited partner without the other partners’ consent, unless the partnership agreement provides otherwise. Substitution occurs when the limited partnership certificate is appropriately amended. Fringe benefits. Some, but not all, of the fringe benefits that corporations can offer employees are now available to limited partnerships as well. Taxation. Limited partnerships do not pay federal or state income tax at the entity level (unless qualified as a publicly trading partnership under federal tax laws), but limited partnerships must file information returns. Thus, a federal tax liability may be created for individual investors even though profit distributions have not actually been recorded. Both general and limited partners are taxed by the IRS on their share of the profits, whether distributed or not. The traditional double taxation of the corporate form is avoided through use of the limited partnership entity. Use of the limited partnership form may result in lower taxes generally, even without considering double taxation. If the partnership is the producing entity and it does not make enough money to return to the limited partners their total investment, the loss for income tax purposes is considered an ordinary loss, which may be offset (i.e., deducted) against ordinary income. Most investors need a loss that can be offset against income more 76

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than they need a capital loss, even though such passive activity losses can only be offset against passive activity gains. Limited partnerships doing business in a state may be subject to a franchise tax, but it is generally not prepaid as with corporations and LLCs. The applicable state’s law must be checked with reference to this question. Owner identity. Limited partners’ names often need not be disclosed to the public (depending on the state of formation); however, the name of the general partners are filed with the secretary of state as part of the LP’s articles of organization. Securities considerations. Interests in limited partnerships are securities and must be registered with federal and state authorities unless qualified for exemptions from registration (see discussion beginning with chapter 10). Offering costs. Attorney fees for the lawyer’s work involved in the preparation of a private placement feature film limited partnership offering disclosure document (offering memorandum) and related consultations regarding the proper way to conduct the offering vary widely in terms of (1) whether an hourly or a flat fee is charged, (2) how much is required up front, (3) whether there are fee deferrals, (4) whether the deferred portion is contingent on the success of the offering and (5) what specific tasks are undertaken by the attorney (e.g., creation of the entity, preparation of the securities disclosure document, federal and state notice filings, tax discussion, tax opinion, securities opinion, financial projections, etc.). The typical flat fees may range from $10,000 to $50,000, depending on the experience and ability of the attorney. The attorney fees associated with a public offering are generally significantly higher. Also, the costs associated with the printing and binding of the disclosure documents and artwork, if any, must be considered. (The printing and binding costs for publicly offered disclosure documents are considerably more expensive because of the smaller unit size typical of the public offering—thus, more investors and more disclosure documents are needed). Accounting fees may be incurred for preparation of financial statements and financial projections. If used, broker/dealers’ due diligence expenses and commissions are limited by the rules of the National Association of Securities Dealers (NASD) to 10.5 percent of the offering proceeds in public offerings, but such commissions and fees are more flexible in the context of a private placement, although ceilings on offering expenses, including broker/dealers’ commissions may be imposed by state law. Issuer marketing costs, which may be substantial, also might include phone, delivery service, fax, postage, envelopes, travel and the like. State notice filing fees may range from $50 to $800. 77

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Other states. If the limited partnership is actually doing business in a state other than the state of its formation, the laws of that other state regarding limited liability and foreign limited partnerships must be considered. Advantages More flexibility. The limited partnership offers more flexibility in structuring the deal between management and the investors as compared with corporations. Lower maintenance. The limited partnership is generally less cumbersome to maintain than a corporation. Fewer meetings and no minutes are required. Single-picture financing. The limited partnership may be more suitable for single-picture financing than a corporation because it is a limitedterm entity; however, it can also serve as a financing vehicle for a slate of pictures. Creative control. The limited partners are not permitted to participate in the management or control of the business; thus, creative control issues do not arise as with active investor vehicles. Flow-through tax vehicle. The limited partnership still has one significant tax benefit over the regular C corporation; that is, the limited partnership entity itself is not taxed at the entity level. Revenues to the partnership flow through to the partners and are only taxed at the individual level. Disadvantages Negative perception. The many thousands of investors who put money into the large, public, film limited partnerships of the 1980s and early 1990s experienced disappointing financial results and are not likely to be interested in any sort of similar offering unless it is clearly distinguished from the earlier offerings in a persuasive manner. Securities law compliance. Compliance with the dual system of securities law regulation (both federal and state) can be somewhat burdensome for small production companies, unless an experienced securities attorney is available to help. Fewer significant tax advantages. There are not as many significant tax advantages that favor the use of the limited partnership as an investment vehicle in the United States as there were before the 1986 Tax Reform Act, although the 2004 American Jobs Creation Act offers some help in this regard (see chapter 2).

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Securities attorney. Because of the complexity of the federal and state securities laws, it may be necessary to retain the services and pay the fees of an experienced securities attorney, specifically a securities attorney with feature-film offering experience.

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9

Corporate Finance

Another traditional passive investor vehicle is the existing corporation (as opposed to the newly formed “initial incorporation” scenario described in chapter 5). A corporation is a statutory entity created and regulated by state laws that has its own legal identity separate from any of the people who own, control, manage or operate it. It is a legal “person” capable of entering into contracts, incurring debts and paying taxes. Thus, the corporation is a separate taxable entity. C Corporations Forming the Corporation A regular C corporation is created by taking the following steps: • drafting and filing articles of incorporation with the secretary of state of the state in which the corporation is being created; • obtaining the secretary of state’s approval of the articles; • obtaining a certificate of incorporation from the secretary of state; • conducting an initial meeting of shareholders of the corporation, naming a board of directors and creating minutes to reflect the action taken; • conducting an initial meeting of the board of directors and naming officers, setting up a bank account, approving the corporate seal, approving corporate bylaws and issuing shares (all of which should be reflected in the board’s minutes); • physically issuing share certificates to shareholders; and • noting the issuance of such shares in the corporate stock transfer log.

In the event that the board of directors determines that it wants the corporation to be treated as an S corporation for tax purposes, in addition to the above steps to formation, special language should be included in the initial board of directors’ minutes authorizing the corporation’s characterization as an S corporation and directing the officers to file the necessary forms with the IRS (see “S Corporation” below). 80

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In some states, a corporation may be required to file something akin to a notice of sale regarding the issuance of the corporation’s initial shares with the state regulatory agency governing the formation of corporations, and a form disclosing the names of the officers of the newly formed corporation and its corporate address may be required to be filed at a later date (e.g., within 90 days). The corporation’s name cannot be the same or similar to other corporations in that state; thus, it must be reserved with or cleared by the secretary of state. The name is protected by filing the corporation’s articles but may need to be protected outside the state with trademark registration or “doing business” filings in each state. A nominal filing fee (something in the neighborhood of $100) is generally required when filing the articles of incorporation. Also, a minimum franchise tax prepaid deposit may be required. Corporate kits should also be purchased. The kits typically include sample bylaws, sample minutes, a corporate seal, share certificates and a stock transfer log, and they cost from $50 to $150. Attorney fees for a simple incorporation may be as little as $1,000 but vary widely depending on the state and whether the attorney is practicing in an urban environment or in a more rural area. Generally, but not always, the corporation is formed first (with one or more founding shareholders), and then if additional funding is needed, and the decision is made by the corporation’s board of directors to raise such financing by selling additional corporate shares (as opposed to so-called project financing options using limited partnerships or manager-managed LLC investment vehicles for so-called off-balance sheet financing), an offering of shares (i.e., securities) is conducted to those beyond the initial founding shareholders in public or private offerings (see chapters 10–17). However, the initial incorporation process offers an opportunity to bring a limited amount of start-up capital into the entity. A filmmaker, for example may contribute rights to a screenplay as consideration for his or her shares in the newly formed corporation, whereas the other founding shareholders may contribute other property, past services or cash as consideration for their shares. This start-up cash may be used to pay the costs associated with the acquisition of rights, script development, packaging, some preproduction expense and possibly even a subsequent securities offering. Capital. The sale of corporate shares (equity ownership interests) may be made in various forms, including common, preferred and convertible stocks. Also, corporate debt instruments can be issued in various forms, including bonds, debentures, notes and other evidences of indebtedness. 81

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Management and control. Corporate management and control is highly centralized in officers and directors. Many control devices are available to separate management from ownership, such as nonvoting stock, voting trusts, shareholder agreements and supermajority vote requirements for certain matters. Owner identity. Shareholder identities are not disclosed on public records in most states, but the names of the corporation’s officers and directors are filed and are thus available through inspection of the public records. Offering Corporate Shares After the corporation is initially formed, in the event that the corporation’s board of directors decides to offer additional shares to a broader group of investors (beyond the founding shareholders), such an offering would typically involve the sale of securities. Offering costs. Just as with a limited partnership offering, attorney’s fees for private offerings of corporate stock vary widely in terms of (a) whether an hourly or a flat fee is charged, (b) how much is required up front, (c) whether some of the fee may be deferred and (d) whether the deferred portion is contingent on the success of the offering. Attorney fees may range from $10,000 to $50,000, depending on the attorney or law firm and what services are included. An attorney or law firm will generally charge much more for a public offering of corporate stock. The costs for printing, artwork and binding for the disclosure document (prospectus for most public offerings and offering memorandum for private placements) also must be considered. The printing costs for the public offering prospectus is typically much greater than for a private offering because of the smaller unit size of the public offering and the need for a significantly larger number of disclosure documents. Private placements are generally not printed but copied from a computer-produced “camera ready” original. Accounting fees may be incurred in the preparation of financial statements and financial projections that may be included in the disclosure document or as exhibits. Also, if broker/dealers are used to raise funds, they may require up-front due diligence fees and the reimbursement of due diligence expenses. Broker/dealer commissions and expenses are limited in public offerings by the rules of the NASD (10.5 percent ceiling for public offerings, but more flexible for private offerings). Issuer marketing costs also may be substantial. State and federal filing fees for public offerings can also be significant. 82

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Advantages Long-term ventures. The corporate structure is most suitable for a longterm ongoing business as opposed to project financing of a single feature film or limited number of movies. Corporations generally are created to have perpetual existence but may be dissolved. Doing business with others. Many other businesses, for example, banks, prefer to do business with corporations in most circumstances. Liability of owners. Risks are primarily borne by the corporation. Shareholders risk only their investment, not their personal estates, unless there are defects in the organization or the corporation has been improperly maintained (e.g., failure to hold board meetings and prepare minutes). Officers and directors may incur liability for certain acts or omissions. Lenders may require personal guarantees of principal shareholders of closely held corporations. Transfer of ownership. Corporate shares may be more readily transferable than interests in partnerships or LLCs if there is a market for them. However, restrictions on sales to outsiders may be imposed by the corporation’s articles, bylaws or shareholder agreements or by federal and state securities laws. Tax considerations. Business income can be sheltered in the corporation and reported and taxed at the business (corporate) level. Tax-favored benefits. The corporation is eligible for tax deductible employee fringe benefits paid to its employees. Many tax-favored fringe benefits are available for corporate employees, such as profit-sharing, pension, health insurance and sick-pay plans. S corporation alternative. Use of an S corporation may reduce the federal tax burden on the corporation. Disadvantages Securities considerations. Debt and equity interests in corporations are securities and must be registered with federal and state authorities unless qualified for exemptions from registration (private placements). Taxation. Regular C corporations are taxed by the Internal Revenue Service on predividend profits, and shareholders are taxed on dividends, if any, which may result in the double taxation of the same revenue stream, once at the corporate level and again at the shareholder level. If the corporation is the producing entity of a feature film and it loses money, the loss is in the nature of a capital loss. Most investors need a loss that can offset income more than they need a capital loss (see chapters 6–8 for discussion of flow-through vehicles).

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Franchise tax. An annual state franchise tax is imposed on corporations in most states and is typically prepaid upon formation. Operations. Many corporate officer actions require resolutions approved by the corporation’s board of directors in addition to being in compliance with any applicable statutes, the corporation’s articles of incorporation and its bylaws. Foreign corporations. A corporation may have to register as a foreign corporation in any other state in which it conducts its business and pay taxes in that second state on the portion of its revenues derived from doing business there (see “The Out-of-State Corporation” below). Books and records. The corporation is required to follow specific formalities in the creation and maintenance of its initial organizational minutes, shareholder meeting minutes and minutes of board of directors’ meetings. The corporation must elect directors, adopt bylaws, issue shares, record transfers, conduct annual shareholder meetings, keep minutes of the board’s actions, prepare and publish annual financial statements, provide reports to shareholders and (if publicly held) submit periodic SEC filings. Sharing of profits. Corporate profits are paid to shareholders by means of corporate dividends in exact proportion to the ownership interests of the shareholders and at the discretion of the corporation’s board of directors. Corporations do not have the same flexibility as LPs and LLCs in the structure of revenue-sharing ratios between management and investors. Suspension of powers. A corporation’s powers may be suspended for failure to comply with certain of the corporate formalities described above. S Corporations Once the decision has been made to wholly or partly finance a film or films using investor financing generally, as opposed to the various studio, industry, lender or foreign financing alternatives, and the corporate vehicle is chosen, the producer must still decide whether to opt for an S corporation or a regular C corporation. A corporation that satisfies the requirements of subchapter S (often referred to as an “S corp”) is taxed differently than a regular C corporation (IRC Section 1362). Basic Characteristics of an S Corporation No federal entity level taxation. With the exception of certain capital gains, an S corporation bears no federal income tax consequences at the corporate level. However, some states may impose a small tax on the income of an S corporation. 84

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Shareholder taxation. The shareholders of an S corporation are taxed on all income of the corporation, with a few exceptions, regardless of whether or not the income is actually distributed to the shareholders; that is, a cash distribution to investors is not a taxable event, but the receipt of income for accounting purposes is (IRC section 1366). Requirements of an S Corporation The failure to meet any of the requirements listed below will cause the disqualification of the entity as an S corporation effective on the date of the failure. Timely election. To be taxed as an S corporation, a timely election must be made by the corporation under IRC section 1362. That election must be made for the current year on or before the fifteenth day of the third month of the taxable year (or prior to the first day of the year to come) in order to be effective for that year. Calendar year. An S corporation must use a calendar year for its fiscal year, unless it establishes a business purpose for a fiscal year. Unanimous consent. All shareholders of the corporation and persons who have an interest in the stock must consent to the S corporation election. Such consent should be reflected in the minutes. Domestic, unaffiliated operation. The S corporation must be a domestic U.S. corporation and cannot be a member of an affiliated group of corporations, nor a financial institution or an insurance company. An S corporation can only own up to 25 percent of the stock in another corporation. Limited number of shareholders. The maximum number of shareholders has to be fewer than seventy-five (a husband and wife are treated as one shareholder, as is the case with stock owned by a trust or other qualifying estate). Only individual shareholders. A shareholder must be an individual (U.S. citizen or resident), an estate or a qualified subchapter S trust. Thus, no corporations or partnerships may be shareholders of an S corporation. No foreign shareholders. A nonresident alien (those who reside in foreign countries) may not be a shareholder in an S corporation. Be especially careful with loans from nonresident aliens, particularly if those loans have equity features. Only one class of stock. Only one class of stock may be issued and outstanding, although there may be differences as to the voting rights among stockholders (e.g., it is currently permissible for S corporations to have voting and nonvoting common stock). Corporate debt may be allowed if it is not a disguised second class of stock. Proposed IRS regulations 85

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concerning the “one class of stock” requirement must be carefully considered when issuing stock other than ordinary common stock. Tax Features of Operating as an S Corporation Pass-through vehicle. Income, losses, deductions and credits are passed through to shareholders on a per-share, per-day basis. This is similar to the tax treatment of a limited partnership or LLC. (Pass-through vehicle is just another way of saying a flow-through vehicle.) Shareholder basis. The shareholder basis is increased by income, contributions and loans to the corporation but decreased by losses and distributions. Losses carried forward. Losses in excess of stock and debt basis are suspended and carried forward. Tax-free distributions. If the corporation has no earnings or profits, distributions not in excess of basis are tax-free. Distributions in excess of basis are capital gains. Taxation of dividends. Earnings and profits are taxable as dividends when distributed. Corporate level taxation. There is a tax applied at the corporate level on certain long-term capital gains or built-in gains. There is also a corporate-level tax on excess passive income of a former C corporation that has earnings and profits. Terminating the S Corporation The S corporation election will be terminated immediately if noneligible shareholders or too many shareholders acquire stock. The election will also be terminated immediately if the corporation ceases to be a small business S corporation. Following termination, no new election can be made for five years. Relief may be available for inadvertent termination. The election will be terminated on the first day of the fourth year if the corporation has earnings and profits and excessive passive income for three consecutive years. Advantages Flow-through vehicle. The S corporation (generally speaking) is considered a flow-through vehicle for federal income tax purposes (just like a limited partnership or a manager-managed LLC); that is, the entity itself is not subject to the payment of most federal income taxes. Ordinary losses. Corporate operating losses are deductible as ordinary losses by the shareholders, pro rata, up to their basis in the stock.

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Avoidance of double taxation. The double taxation normally associated with a regular corporation can be avoided by using the S corporation. Expected profits. The S corporation is a good idea if the corporation is expected to earn profits right away and there is no need to reinvest earnings in the corporation. Family income. The S corporation election allows corporate income to be spread among various family members to minimize the total income tax for the family as a whole. Disadvantages Shareholder limit. The number of shareholders is limited to seventyfive. Termination. The S corporation special status may be terminated if noneligible shareholders or too many shareholders acquire stock. Nonresident aliens. Nonresident aliens may not be shareholders in S corporations. Single class of stock. S corporations can only offer one class of stock. Individual shareholders. Generally speaking, shareholders must be individuals. Professional advice. The decision to choose this form of conducting business should almost certainly involve the professional advice of an accountant or tax attorney. Effect of legislation. One effect of the Revenue Reconciliation Act of 1993 is that S corporations that retain earnings to fund growth may be putting their shareholders in higher tax brackets than they would be if they terminated their S corporation election. Summary If earnings are not to be reinvested. An S corporation election is generally desirable when the business is expected to make a profit soon after incorporation and there will be little need to reinvest earnings in the business for expansion. In that case, the corporation will likely distribute most of its net income to shareholders, and so by making an S election, the double taxation of a regular C corporation would be avoided. If earnings are to be reinvested. On the other hand, if profits are going to be reinvested in the business for a few years, then an S corporation election is probably not desirable, because there would be no double taxation anyway since earnings are being reinvested rather than distributed to shareholders.

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Venture Capital Financing Venture capital financing is typically associated with corporate finance, although it does not have to be. As used in this discussion, the term venture capital refers to organized funds that serve as a source of financing for early-stage companies. This definition reflects the use of the term in the real-world marketplace. It is technically possible for wealthy individuals to function as venture capitalists; however, the term angel investor is the one more commonly associated with such individuals (see “Angel Investor Financing” in chapter 5). Venture capital companies are generally organized as privately held limited partnership or limited liability companies, and they receive most of their funds from institutional investors like pension plans, trust funds and insurance companies. Venture capital companies (or firms) provide a substantial amount of equity investment capital for small and developing companies, generally. Unfortunately for filmmakers, there is little evidence to suggest that venture capital sources are very interested in financing independently produced feature films. Typically, the venture capital funds act as a funding resource for companies that need considerable working capital but are not in a financial position to appeal to a broad public market of investors (i.e., not ready for significant securities sales to the public). On the other hand, venture capital firms are generally not interested in financing pure start-ups in any field. Venture capital companies may invest a substantial amount of capital and, in return, receive equity securities, often preferred stock, board of director positions and an ongoing role in management decisions. This description presumes that the company being invested in is organized as a corporation and that the venture capital firm is taking an active role in management, not necessarily a good thing for a creative venture like feature film production. Types of Businesses Each venture capital company tends to develop its own investment philosophy and portfolio of investments in client companies. Even though the investment interests of venture capital firms may change over time, they are typically more interested in computer hardware and software, telecommunications, electronics, biotechnology, healthcare, pharmaceuticals, environmental products and services, retailing, consumer products and services and sometimes environmentally and socially responsible projects. Even though there has been some interest in the related CD-ROM, multimedia, interactive television and Internet fields,

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there has been little venture capital interest in the feature film segment of the communications and entertainment industry. Investing Stage Although there are no universally agreed-upon definitions for the various stages in the life of a business, generally speaking in the business world, preformation or initial company financing, is referred to as “seed capital financing,” and that is different from the “early-stage financing” that generally comes in after the company is established. Seed capital financing and early-stage financing may be referred to in the context of film finance as “development money,” “development financing,” or “development funds” and even as “start-up funds.” Thus, a filmmaker must decide how to raise these early monies. He or she might consider gifts or grants (see chapter 1) or some of the active investor options discussed in this book (investor-financing agreement, coproduction or joint venture, initial incorporation or member-managed LLC). A filmmaker may also choose to cross that line between nonsecurities transactions and selling a security and to seek this development funding from a group of passive investors. As discussed under “Alternative Uses for Investor Funds” (see the introduction to part 2), this development-stage financing for one or more feature films may be used to cover the costs of acquiring the underlying literary rights, developing the screenplay or attaching elements to the script (packaging) to create a presentation that may then be taken to the industry for production financing. Another decision that is inextricably intertwined with these considerations is whether to approach prospective investors with a business plan or a securities disclosure document (see appendix B, Limited-Use Business Plans). Continuing the consideration of the traditional terminology associated with business generally, the terms second or third round, mid-stage or mezzanine financing refer to stages of funding for companies after the seed capital financing or early-stage financing, but before their eventual, more complete financial development through one or more public securities offerings. Again, this traditional terminology is generally associated with the creation and financing of corporations. Thus, another decision a filmmaker has to make is whether to form a corporation and seek this sort of traditional financing to pursue the goals of financing and producing feature films, or whether to (at least initially) finance one or more films on a project basis (the “choice of entity” or “choice of investment vehicle” question). The limited partnership or lim-

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ited liability company may be better suited for this latter form of project financing, regardless of whether it is intended to finance the production costs of a single motion picture or a limited number (slate) of films. Some venture capital companies in recent years have begun specializing in start-up and early development situations. These firms, commonly referred to as incubators, often impose a substantial degree of control over business development and marketing. Once again, however, most, if not all, of the so-called incubators specialize in the technology sector, not feature films. Studies of investing patterns by venture capital firms show that approximately 60 percent of such investments go to second- and later-stage companies. In fact, these same studies demonstrate that the average venture-backed company has been in existence for more than three years and has more than thirty employees when the venture capital financing comes in. Once again, these do not sound like film production company start-up situations. Venture capital firms are also looking for real depth of experience among the company’s management, so the venture capital route does not make much sense for the first- or second-time filmmaker. In addition, venture capital firms are generally looking for average returns at the time of their exit from the company of 20 to 50 percent per year. They will also want the company receiving their investment to be willing and able to sell the company or complete a successful public offering of the company’s stocks in three to seven years. In any case, a directory of venture capital firms is available through the National Venture Capital Association at http://www.nvca.org or 703524-2549. Also see Pratt’s Guide to Venture Capital Sources. Another list of venture capital companies is available from the National Association of Small Business Investment Companies, 202-833-8230. Advantages One-stop shopping. A film production company may be able to get all the money needed from one venture capital source. Significant money. Venture capital firms offer large amounts for equity financing. Specialized expertise provided. Sometimes, venture capital firms can provide expertise in marketing, human resources and business development. Helpful advice. Venture capital firms may be able to provide some helpful business advice in addition to capital. 90

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Disadvantages Not for start-ups. The vast majority of venture capital investments are made in second- or third-stage financing for companies; therefore, venture capital financing is simply not available for most film start-ups. A real long shot. The chances of getting an independent film funded this way are not good. The turn-down rate for venture capital applications may be higher than 99 percent, and that rate is based on other industries considered less risky than independent film. Corporate securities. Most venture capital companies prefer to invest in corporate securities, partly because they hope to gain substantial profits when the company goes public or is sold. Equity position. Most venture capital companies demand a substantial equity position in exchange for their investment, most typically through common or preferred stock or a combination of equity and debt. Management. Venture capital companies will typically demand a significant presence on the corporation’s board of directors and other controls on corporate or business management. Even if the venture capital company does not end up with a majority of equity ownership, it will generally require approval for all major business decisions. For a creative venture like film, this simply may not work. Not really long-term. Venture capital companies do not want to have their money tied up in a venture for more than several years. High growth. Venture capital companies look for high growth prospects. The most attractive start-up operations are considered to be those with nationwide markets and forecasted sales of $50 million to $100 million after five years. Different goals. The economic philosophy of a venture capital firm may not necessarily be consistent with the filmmaker’s plans for the company’s development and in fact may be in conflict with the company’s long-term growth goals. Not for high-risk ventures. Venture capital companies prefer not to take substantial risks with their investments. They have to be persuaded that there is even more than a reasonable chance of making a good return on their investment; thus, seeking venture capital as a form of film finance places a more than unreasonable burden on the filmmaker. Time and documentation. The process of seeking venture capital is generally time-consuming for both the venture capital company and those seeking venture capital investments. The venture capital company will demand a great deal of documentation from those seeking funding; thus, a great deal of time and effort has to be expended by those seeking

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venture capital funds. In addition, venture capitalists expend a considerable amount of time and effort examining and analyzing that documentation Highly competitive. Filmmakers seeking venture capital funding will be competing with thousands of other businesses seeking the same funding, and many of those are more suited for this type of financing. Some venture capital firms report receiving as many as two thousand applications a year, while choosing to invest in only one business per 166 applicants. Exit strategies. Venture capital firms are as concerned about getting out as getting in and are not often favorably inclined to invest except in companies that offer the likelihood of (1) being bought out fairly soon by larger companies, (2) being attractive to subsequent venture capital financing that will take over their initial positions or (3) being good prospects for significant public offering opportunities in the foreseeable future. Fast growth companies. Venture capital firms are under pressure to identify and exploit fast growth opportunities before more conventional financing alternatives become available. Tough terms. Venture capital firms have a reputation for negotiating tough financing terms and setting high demands on their target companies. Not for indie films. Venture capital financing is not generally available and not even a good choice of financing for independently produced feature or documentary films. Expensive money. The cost of financing through venture capital firms is high. Ownership demands for an equity interest in the company of 30 to 50 percent are not uncommon even for established businesses, and a start-up or higher risk venture could easily require transfer of a greater ownership interest to the venture capital firm. Loss of control. The demand of a high level of ownership may result in loss of control of the company. High returns expected. Venture capital firms might invest for periods of three to seven years, but they will expect at least a 20 to 50 percent annual return on their investment. That sort of return on investment is difficult, if not impossible, for start-up independent feature film production companies to offer. Existing businesses. Venture capital firms favor existing businesses that have a minimum operating history of several years. The financing of start-ups is limited to situations where the high risk is tempered by special circumstances, such as a company with extremely experienced management and a very marketable product or service. Preexisting capital investment. The target companies for venture capital firms will often already have revenues in excess of $2 million and a preexisting capital investment of at least $1 million. 92

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The Out-of-State Corporation The following points relate specifically to the question of whether to incorporate as an out-of-state corporation and do business in another state (the actual base of operations). Feature film producers are advised to consult with an attorney or accountant (or both) before making this decision and to look beyond the initial start-up costs and not rely on the formation expense as the sole deciding factor. Qualification Out-of-state corporations (also referred to as foreign corporations) that want to transact business in a state may have to first apply for registration with that state’s secretary of state. The application for registration typically has to be accompanied by a Certificate of Good Standing executed by an authorized public official of the state or place in which the corporation was organized. A qualification fee may also be required to accompany the application. Qualifying as an out-of-state corporation to do business in another state may therefore be just as expensive and troublesome as incorporating in the second state, especially if that is where the business is actually being conducted. Annual Report A foreign corporation that is qualified to do business in a state may be required to file an annual report with that state’s secretary of state, in addition to the reporting requirements of the state where the corporation was organized. A corporation can forfeit its powers or rights by failing to file its annual statement. Thus, it may have to file annual reports in two states. Franchise Tax An annual franchise tax based on the amount of net profits earned in a state where a corporation is doing business may have to be remitted in that state. Simply being incorporated in another state may not avoid such a tax. Application of Corporations Code Provisions A foreign corporation that does more than half of its business in a state other than its state of incorporation and has half of its shareholders in that second state may be subject to many of the same provisions of that state’s laws that apply to domestic corporations. Forfeiture If a foreign corporation fails to properly qualify itself, the exercise of its corporate powers, rights and privileges in that state in which it is doing 93

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business may be forfeited. If forfeited, all contracts made by a nonqualified foreign corporation are voidable at the option of the other party. The secretary of state may also forfeit the right of a foreign corporation to transact intrastate business. Other Penalties A foreign corporation’s failure to qualify or be in good standing to transact interstate business may make it impossible to maintain any cause of action in the courts of that state. A fine for pursuing such a suit may be imposed. A foreign corporation that transacts intrastate business without holding a valid Certificate of Registration may also be subject to a penalty for each day unauthorized business is transacted. Such a corporation may also be held guilty of a misdemeanor, punishable by a fine. Advantages Avoidance of state taxation. This is the single most popular reason put forth by film producers trying to decide whether to incorporate their production companies in a particular state. The better practice is to bring in some early investors who can provide the start-up funds needed for such expenses. Local production company. An independent producer who actually operates out of another state and seeks to raise a substantial amount of its funds from investors in that state for a local film production may find it advantageous to organize as a local corporation. Disadvantages Tax liabilities not entirely avoided. As discussed above, incorporating out of state does not always avoid the imposition of taxes on income generated by actually doing business in another state. Second level of bureaucracy. A production company that is organized as an out-of-state corporation but that is actually doing business in another state has merely superimposed a second level of rules, paperwork and expense on the corporation’s operations. The bottom line is that forming a corporation in a state other than the one in which the business is actually to be conducted, primarily to save some small up-front fees, is a short-sighted strategy. The supposed benefits are outweighed by the costs and burdens of qualifying to do business in another state as a foreign corporation.

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Securities Compliance A filmmaker selling corporate shares, units in a limited partnership or interests in a manager-managed LLC (i.e., any of the three passive investor vehicles just discussed) would be selling securities. Thus, the filmmaker would be obligated to comply with the federal and state securities laws in order to engage in legitimate film finance transactions. The balance of this part two discussion relating to investor financing is organized around the three levels of available securities law compliance: • private (exempt) offerings (chapters 10, 11, and 12) • public/private (hybrid) exemptions (chapter 13) • public (registered) offerings (chapters 14–18)

Although there are some similarities among each level of compliance (e.g., relating to disclosure) there are also significant differences (e.g., how the securities can be marketed).

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Securities Compliance: Private (Exempt) Offerings

10 Statutory Exemptions of the 1933 Securities Act, Section 4 Section 4(2): Nonpublic Offering One of the first nonpublic (private) exemptions a filmmaker may want to consider is Section 4(2) of the Securities Act of 1933. Federal legislation requires that all securities offered through the mail or other channels of interstate commerce be registered with the SEC. That requirement is found in Section 5. Once a film producer decides to sell any form of security in order to raise money for a film project, registration is the first obligation. Congress, however, provided certain exemptions from this registration requirement where there appeared little need for protecting the investing public. These exemptions are often referred to as unregistered offerings or exempt offerings (and sometimes private offerings, private placements or nonpublic offerings). They provide an alternative to the registration requirement (see “Public (Registered) Offerings” starting at chapter 14). Section 4(2) is the most basic of those private exemptions. It merely provides that “transactions by an issuer not involving any public offering” are exempt from the securities registration requirement. Unfortunately, it provides no further guidance with respect to the details of compliance, and anyone trying to rely on it for an exemption from the registration requirement has to look to years of conflicting and confusing case law (along with a few intermittent SEC rules) to determine how many people can be approached with a private offering, how many investors can be accepted, whether a disclosure document is required, what has to be disclosed in the offering memorandum and so forth. The actual intent and design of this statutory provision is to protect investors by encouraging full disclosure of information thought necessary for prospective investors to make informed investment decisions. Some practitioners make the mistake of assuming that since no specific 96

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disclosure is required (or that only access to such information is mandated), no offering memorandum need be given to prospective offerees. There are two problems with that interpretation: • the antifraud rule still applies across the board to all securities offerings, and the antifraud rule requires that all material aspects of the transaction be disclosed, that nothing important be omitted and that the information disclosed must be stated in a way that is not misleading to prospective investors; and • providing no written disclosure document gives no protection to the issuer in a dispute over what was stated orally to the prospective investors when they were considering the investment.

Thus, it would appear that some form of disclosure document is not only required to protect the best interests of potential investors, but that it is the safer choice for the film producer or other issuer. Unfortunately, none of this is actually stated in the statutory language, and not much else is provided for. Courts have held that the application of Section 4(2) should be based primarily on whether the particular class of persons affected needs the protection afforded by the law. This question, in turn, may be based on the level of knowledge the offerees have concerning the issuing entity and on the need of the offerees for the protection that would have been afforded by a registration statement. In other words, access to the kind of information that a registration statement would disclose is considered an important factor. An offering to those who are shown to be able to fend for themselves would likely be considered a transaction not involving any public offering. Pursuant to this provision, it is also important to know what steps the issuer has taken to prevent a redistribution of the securities from occurring. Thus, the courts and the SEC have interpreted the Section 4(2) exemption to be available for offerings to persons who have access to the same kind of information that a registration of the same securities would provide and who are able to fend for themselves. That being the case, a securities disclosure document (the private offering memorandum) for such an offering should look something like the prospectus for a registered offering for approximately the same or a similar amount of securities. In addition, the statutory language “transactions . . . not involving any public offering” has been interpreted in many judicial and administrative decisions to indicate that both the purchasers and nonpurchasing offerees must satisfy the requirements of the exemption in a private offering based on Section 4(2). Compliance is made even more complicated by the 1933 97

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Act’s very broad definition of the term offer, which creates offerees out of almost any modest solicitation effort. In all of its administrative rulings, opinions and responses relating to the prohibition against a general solicitation for nonpublic offerings, the SEC has taken the consistent position that the issuer and the offeree must have a preexisting business relationship (i.e., the SEC has never rendered a favorable opinion regarding the question of whether a general solicitation has occurred without the existence of a preexisting relationship). A preexisting 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. The preexisting relationship requirement has been applied even in mailings to individuals considered sophisticated in investment matters and to wealthy persons. On the other hand, this preexisting relationship need not be of a formal or contractual nature. It is enough if the relationship is sufficient to allow the issuer or someone acting on the issuer’s behalf to know about the offeree’s financial circumstances or level of sophistication. The initial burden of proof for an alleged securities registration requirement violation is on the plaintiff, or purchaser of the security, to show that the defendant, or issuer, offered or sold the security, that no registration statement was used and that interstate transportation or communication or the mail was used to sell the security. The burden then shifts to the defendant, or issuer, to demonstrate that all of the conditions and limitations imposed on the available and specific exemption relied on were complied with. When those conditions and limitations are so uncertain as they are with a Section 4(2) offering, that places a heavy burden on that defendant (i.e., for purposes of this discussion, the film’s producer). The chance of an investor becoming disgruntled in a high-risk investment like independent film is multiplied if the risk is not spread widely and the risks have not been adequately disclosed. Advantages Faster than a public offering. A private offering can be handled more quickly than a public offering and with less expense. No ceiling on amount. There is no ceiling on the amount of money that can be raised through the Section 4(2) nonpublic offering exemption. Issuer compliance. Compliance for such an offering initially and primarily rests with the issuer. Generally, securities regulators will not 98

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become involved in reviewing how the offering was conducted unless an investor complains. Disadvantages State compliance. State blue-sky laws regarding filing requirements, number of offerees or investors and notice filing fees may still apply. Some states may even require review of the disclosure document. Restricted securities. Privately offered securities are unregistered and thus their transfer is restricted. Minimal guidance. Little guidance is provided for what information ought to be disclosed in a private placement offering memorandum prepared pursuant to Section 4(2). Offeree limit. Offers pursuant to Section 4(2) need to be limited to 25 offerees (as opposed to the 35 unaccredited and the unlimited number of accredited investors under the SEC’s Regulation D, Rules 505 and 506; see chapter 12). No advertising. No advertising or general solicitation is permitted. Primarily for corporate insiders. The offerees should be limited to company insiders (i.e., directors, executive officers or control persons generally). Sophisticated investors may be required. Some courts require that each offeree have a certain level of sophistication (i.e., have sufficient knowledge and experience to understand the risks of the offering). Limited transfer. The exemption may be lost if qualified purchasers become mere conduits in the transfer of the securities to unqualified purchasers; thus, according to this interpretation of the statutory language, the securities must come to rest in the hands of only qualified purchasers. No compliance certainty. The statutory provision, SEC rules and case law provide little certainty as to how to comply, thus putting issuers at risk of inadvertently being guilty of selling unregistered securities. Section 4(6): Accredited Investor Exemption Another one of the possible private placement (nonpublic offering) exemptions available to choose from is Section 4(6) of the 1933 Securities Act. This provision exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million. The definition of accredited investor is the same as that used in the SEC’s Regulation D (see chapter 12). Just as with the private placement exemptions under Regulation D, Rules 505 and 506, this Section 4(6) exemption does not permit any form of advertising or public solicitation. Also, there are no specific document 99

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delivery requirements, but again, all transactions are subject to the antifraud provisions of the securities laws. In one sense, this just means that instead of providing any specific guidelines regarding what information must be included in a disclosure document, the more general provisions of the antifraud rule apply. The language of Section 4(6) exempts from registration transactions involving offers or sales by an issuer solely to one or more accredited investors, if the aggregate offering price of an issue of securities offered in reliance on this paragraph does not exceed the amount allowed under section 3(b), if there is no advertising or public solicitation in connection with the transaction by the issuer or anyone acting on the issuer’s behalf, and if the issuer files such notice with the Commission as the Commission shall prescribe.

The referenced Section 3(b) provides that The Commission may from time to time by its rules and regulations, and subject to such terms and conditions as may be prescribed therein, add any class of securities to the securities exempted as provided in this section, if it finds that the enforcement of this title with respect to such securities is not necessary in the public interest and for the protection of investors by reason of the small amount involved or the limited character of the public offering; but no issue of securities shall be exempted under this subsection where the aggregate amount at which such issue is offered to the public exceeds $5,000,000.

Disclosure Issues With respect to the Section 4(2) and Section 4(6) nonpublic offering exemptions, such offerings will still need to be in compliance with the provisions of the antifraud rules (specifically, the SEC’s antifraud rules, including Section 10b-5 of the 1934 Act). Unfortunately, most low-budget filmmakers seeking to raise small amounts of money from private investors will not be able to raise all of the money needed exclusively from wealthy accredited investors. By their very nature, there are fewer accredited investors in the marketplace than there are nonaccredited investors, and filmmakers may or may not have the required preexisting relationships with a sufficiently large enough number of accredited investors to rely solely on that source for the funds needed. Thus, reliance on Section 4(6) may be out of the question for these reasons.

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There also seems to be a difference of opinion among attorneys as to which rule ought to be relied on by filmmakers when seeking to raise money from private investors. Some attorneys rather recklessly advise filmmakers to take the most risky route and seek to comply with Section 4(2) or Section 4(6), sell only to accredited investors and provide minimal or no disclosure of information to prospective investors. In such situations, however, if an investor is disappointed with the results, or for any other reason decides to challenge the legality of the filmmaker’s offering of securities, the filmmaker will likely have a more difficult time in demonstrating compliance with the law since the standards to be applied for the Section 4(2) and Section 4(6) offerings are so vague. The question of what information needs to be disclosed to prospective investors (i.e., what must an issuer who raises capital through the sale of securities to investors disclose to those investors in order to comply with the antifraud provisions of the federal securities laws?) is discussed in Harry S. Gerla’s article “Issuers Raising Capital Directly from Investors: What Disclosure Does Rule 10b-5 Require?” While Gerla concludes that “current law on what disclosure Rule 10b-5 requires of issuers who sell securities directly to investors is unclear,” he also points out, Congress indicated its belief that the market for securities should be different than the market for other goods, services or commodities. Congress believed that the market for securities should be populated by informed purchasers rather than the cadre of potentially ignorant investors allowed by the doctrine of caveat emptor. These facts support a finding that an issuer does stand in some form of relationship of trust and confidence with the investors who purchase securities from it. . . . [and] that [t]he purpose of the federal securities laws has always been the protection of investors.

Thus, filmmakers and other issuers of securities are left with a choice: either take the risky road and provide minimal disclosure to investors, which is clearly contrary to the intention of Congress and the law, or comply with the specific requirements of Regulation D, Rule 506 (and the antifraud rules), by disclosing all material aspects of the transaction, not omitting anything that would be considered material (i.e., important to investors) and stating what is disclosed in a manner that is not misleading. This is an issuer’s basic obligation for disclosure pursuant to the antifraud rules. That means for filmmakers as issuers of securities to be safe, they should provide written disclosure documents, prepared in accordance with the combined standards of Regulation D and the antifraud rules,

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and these documents should be provided to all prospective investors prior to their purchase of the security. As a suggestion, when an attorney or other film finance consultant encourages a filmmaker to take that more risky route, that filmmaker should probably ask that attorney or consultant to either provide an opinion letter on his or her letterhead stating that in the attorney’s or consultant’s judgment the filmmaker is not offering a security and therefore does not have to comply with the securities laws; or alternatively, the filmmaker could ask the attorney or consultant to provide a securities opinion stating that when the securities are offered, they are “being offered and sold pursuant to the exemption from registration with the SEC and will when sold, be legally issued, fully paid and non-assessable.” If the attorney or consultant is not willing to do either, maybe the filmmaker ought to get a second opinion regarding the issue of what disclosure needs to be provided to prospective investors. After all, a mistake on this question could lead to both civil and criminal liability for the sale of an unregistered security, so it is not an issue that should be taken lightly or approached in a reckless manner. Clearly, the safer approach is to comply with the more specific disclosure guidelines of Regulation D and the antifraud rule, not to cut corners. The concept of “guerrilla filmmaking” does not apply here. Advantages No registration. Since Section 4(6) is an exempt offering, no registration is required. No specific disclosure. No specific disclosure requirements are mandated by the exemption itself. Disadvantages Disclosure risks. It is also possible to consider the fact of no specific disclosure requirements a disadvantage, in that the exemption provides no guidance for persons seeking to comply with its provisions. Antifraud compliance. Even without the requirement of specific disclosure obligations, the issuer must still comply with the disclosure obligations imposed by the antifraud statute. Reduced investor pool. Limiting the prospective purchasers to accredited investors significantly reduces the pool of prospective investors.

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11 Intrastate Offering Exemption Occasionally, filmmakers want to conduct a so-called intrastate offering to raise money to produce a feature film, believing they can raise the money that is needed in just one state. There are actually two intrastate exemptions from the securities registration requirement. One is based on the statutory language of Section 3(a)(11) of the 1933 Securities Act. The other is Rule 147 promulgated by the SEC. An issuer of securities can seek to comply with one or both, and the failure to comply with one does not prevent compliance with the other. The statutory intrastate exemption requires that the issuer of securities be organized and doing business in the state in which the securities are being offered and sold, that the securities be offered and sold only to persons who reside within that state (i.e., both the issuer and investors must be from the same state), that offering proceeds be primarily used within that state and that the securities come to rest within that state (i.e., no short-term resales to nonresidents of the state). The intrastate exemption has no offeree or purchaser qualifications other than residence in the subject state. There are no limitations on the manner of the offering, except that offers have to be limited to state residents. There is no prescribed disclosure format (but don’t forget the antifraud rule), no ceiling on the amount of securities that can be offered pursuant to the exemption, no filing or reporting requirements and no resale limitations except to nonresidents. Unfortunately, a single offer to a nonresident can void the exemption, even if all purchasers are residents of the state. For this purpose, it is not valid to claim that the offer to a nonresident was made by mistake or in good faith. Also, over the years, courts and the SEC have interpreted the exemption in ways that make it more complicated and its standards somewhat indefinite, thereby making compliance more difficult. For example, if a purchaser of an exempt security (i.e., exempt under the statute) resells the security to a nonresident, that resale although not 103

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under the control of the issuer, can void the exemption. In effect, state residency requirements must be met for the issuer, every offeree, every purchaser and every subsequent transferee of the security. Also, even though the statute does not refer to the use of offering proceeds, the courts and the SEC have consistently required that a substantial portion of the offering proceeds be used within the state. In addition, some courts have ruled that income-producing activities cannot be out of state. In short, the cases and administrative decisions are somewhat inconsistent. The safest practice is to only use the statutory intrastate offering exemption to raise money for a local company doing business locally (e.g., a restaurant). Since movies are intended to be exhibited throughout the world and will hopefully generate revenues from all across the globe, they hardly seem appropriate for the intrastate exemption. The same problem exists with the SEC’s Rule 147 intrastate exemption, which specifically requires that 80 percent of the revenues of the business be derived from operation of the business within the state of the offering. Again, films are usually intended to derive a significant portion of their revenues from outside a single state, and thus both the statutory and Rule 147 intrastate exemptions are inappropriate for most film finance situations. Advantages Investor qualifications. The intrastate exemptions do not impose offeree or purchaser qualifications other than residence in the subject state. Manner of offering. There are no limitations on the manner of the offering except that offers have to be limited to state residents. Disclosure. The exemption imposes no prescribed disclosure format. No ceiling on amount. There is no ceiling on the amount of securities that can be offered. Filings. There are no filing or reporting requirements. Resales. There are no resale limitations except to nonresidents. Disadvantages Easily voided. This exemption requires strict compliance and can easily be voided by an inadvertent failure to comply with one or more of its provisions. Limit on source of revenue. Most of the revenues generated by the business must also come from that one state. Not suited for international business like film. The intrastate exemption might be suitable for a truly local business venture, such as a restaurant or nightclub, but not for the selling of a product like a movie that is intended for international consumption. 104

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12 Regulation D For many years, the most commonly used private placement exemption at the federal level has been the SEC’s Regulation D. It is an exemption from the securities registration requirement, but it is an SEC rule, not a statute passed by Congress. Congress did, however, provide the statutory authorization for such a rule. As noted earlier, if a feature film producer raises money from passive investors, the interests in whatever vehicle or entity is created for that purpose are most likely going to be securities (corporate stocks, limited partnership interests, units in a manager-managed LLC); thus, the producer must comply with both the federal and state securities laws. One of the foremost requirements of those laws is that the issuer register those securities with the SEC at the federal level and with the appropriate state regulatory authorities in each state in which the securities are going to be offered or sold (these registered offerings are also referred to as public offerings). Alternatively, the issuer may wish to comply with available exemptions from the securities registration requirement, and the exemptions (more specifically, the transactional exemptions) are commonly referred to as private placements, private placement exemptions, exempt offerings, nonpublic offering exemptions or (at the state level) limited offering exemptions and small offering exemptions. As already noted, Regulation D is simply one of several exemptions available at the federal level. Sections 3(a)(11), 4(2) and 4(6) of the 1933 Securities Act are also considered private placement exemptions, although Regulation D is by far the most commonly relied-upon exemption, and it offers a so-called safe harbor for issuers who are not sure about how to comply with the statutory exemptions (and not many are). General Requirements of Regulation D In order for a film production company (or other securities issuer) to qualify for the transactional exemption for one of its securities offerings 105

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pursuant to Rule 504 (or Rules 505 and 506), the offers and sales must satisfy the general terms and conditions of Regulation D relating to • treating a series of offerings as a single offering to avoid application of the rules (securities integration); • disclosing prescribed information to prospective investors (information or disclosure requirements); • complying with the general prohibition against advertising and general solicitation (limitations on the manner of offering—limitations that as a practical matter mean sales can only be made to persons with whom upper-level management of the issuing entity had a preexisting relationship, that is, prior to the start of the offering); • complying with provisions that limit the resale of such securities by the original investors (limitations on resale); and • filing the required Form D in a timely manner (filing of notice of sales; although the exemption is no longer voided by a failure to do so).

Rule 504 Offerings Rule 504 is just one of three different specific sets of rules within Regulation D that permit issuers to sell securities in a nonpublic offering; that is, in a private placement. Ceiling on Amount of Money Rule 504 imposes a limit on the aggregate offering price (or amount of money that can be raised) in reliance on this specific rule; that is, no more than $1 million can be raised pursuant to Rule 504 within a twelvemonth period. Number of Investors There is no limit on the number of investors who can invest in a Rule 504 offering. However, since the securities issuer must comply with both the federal and state securities laws and since most compatible state private placement (or limited offering) exemptions do impose limits on the number of investors, this provision of Rule 504 is generally of little value. The ceiling on the number of investors that is imposed by the state law controls in such situations (i.e., the more burdensome provision prevails). No Specific Disclosure Requirements Rule 504 also provides that “The issuer is not required to furnish the specified information to purchasers when it sells securities under Rule 106

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504.” However, as already noted, this provision is often misinterpreted to mean that a Rule 504 offering does not require the preparation and presentation of a disclosure document (offering memorandum) to each prospective investor. Nothing could be further from the truth, since the Preliminary Notes to Regulation D clearly state that transactions conducted in accordance with Regulation D “ are not exempt from the antifraud . . . provisions of the Federal securities laws,” and the antifraud provisions require, as has been noted, that issuers of securities must disclose in writing to all prospective investors all material aspects of the transaction and in a manner that is not misleading. A violation of the antifraud rule could constitute securities fraud; thus, a complete disclosure document is still required for a Rule 504 offering. The safer practice, in the view of most experienced securities attorneys, is to rely on the specific disclosure guidelines provided for the next highest level of exempt offering (e.g., the Regulation D, Rule 505 exemption). Issuer Disqualifiers Unlike Rule 505, Rule 504 does not impose the set of so-called issuer disqualifiers (“bad boy” provisions) on those persons who would seek to sell securities under Rule 504. The disqualifiers basically state that the exemption is not available to persons who have been guilty of certain securities law or other violations within the most recent five years. Again, however, most of the state exemptions that would need to be complied with by an issuer relying on Rule 504 do impose similar issuer disqualifiers; therefore, the producer must carefully review those disqualifying provisions and be familiar with the backgrounds of persons involved in the selling of the offering. Advantages Disclosure less burdensome. The antifraud rule presumably allows a bit more leeway with respect to disclosure than the more specific disclosure guidelines of a Rule 505 offering. Faster than public offerings. A private placement generally allows the producer to put together a disclosure document and be “on the street” raising money more quickly than a public (registered) offering. No advance regulatory approval required. The private placement disclosure document does not have to be submitted to the SEC or state regulatory authorities for approval prior to its use with prospective investors as in public (registered) offerings. Less expensive. Private placements are generally less expensive to conduct than public offerings. 107

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Use with MAIE. Rule 504 can now be used in conjunction with the NASAA’s Model Accredited Investor Exemption (see chapter 13) to raise up to $1 million from accredited investors only, with some advertising, including on the Internet (see “Selling Securities over the Internet” at appendix D). Disadvantages Disclosure mistakes could be costly. A mistake in judgment with respect to disclosure when merely trying to comply with the very general antifraud rule as opposed to the more specific Rule 505 disclosure guidelines could constitute securities fraud. Funding limit. A Rule 504 offering only permits the producer to raise $1 million. Preexisting relationship. In contrast to a public (registered) offering, securities being offered pursuant to any Regulation D (private placement) exemption can only be offered, as a general rule, to persons with whom upper level management of the issuing entity has a preexisting relationship (i.e., before the start of the offering)—an MAIE offering is an exception to this rule. Complex securities laws. The complexity of the securities laws makes it almost imperative that an experienced securities attorney be engaged, preferably with specific and successful experience with film or film company offerings, and attorney fees can be relatively expensive for start-up production companies. State law compliance required. In addition to complying with the federal securities laws and regulations, issuers of securities must also comply with the applicable state securities laws and regulations (blue-sky laws) in each state in which those securities are to be offered or sold. Rule 505 Offerings Rule 505 is the second of the three specific sets of rules within the SEC’s Regulation D that permit issuers to sell securities in a nonpublic offering, that is, in private placements, and that set out the specific conditions and limitations upon which the issuer can rely. Just as with Rule 504, a feature film production company (or other issuer) seeking to qualify for the transactional exemption for one of its securities offerings pursuant to Rule 505 must satisfy the general terms and conditions of Regulation D listed above (see “General Requirements of Regulation D”). Ceiling on Amount of Money Rule 505, however, relaxes the ceiling on the amount of money that 108

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can be raised, to some extent. The Rule 505 limitation on the aggregate offering price is $5 million; again, that amount must be raised in a twelve-month period. Number of Investors Rule 505 utilizes a different approach than Rule 504 with respect to the number of investors that may be permitted to invest in such an offering. No more than 35 nonaccredited investors are allowed pursuant to Rule 505, but an unlimited number of accredited (i.e., wealthy) investors are permitted. There are eight kinds of accredited investors defined in Regulation D. However, film producers are most likely to be making offers to persons in only two categories: (1) natural persons whose individual net worth or joint net worth with that person’s spouse at the time of purchase exceeds $1 million; or (2) natural persons 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 who have a reasonable expectation of reaching the same income level in the current year. Specific Disclosure Requirements Unlike Rule 504, Rule 505 provides specific disclosure guidelines. Those disclosure guidelines are tied to the specific guidelines of the public offerings pursuant to Regulation A or Regulation S-B, depending on the amount of money being raised (see chapters 15 and 16). Once again, copying and modifying someone else’s offering memorandum provides no assurances that these disclosure guidelines have been met. The Rule 505 exemption does not require specific disclosure for sales to “accredited investors,” except as required by the antifraud provisions of the federal securities laws. Any offerings under these rules to nonaccredited investors require delivery of the specified information to those investors. Bad Advice Some practitioners and independent producers mistakenly believe that “no specific disclosure” means no disclosure and that no disclosure document is required to be given to each prospective investor before they invest. That is not what it means. It simply means that the disclosure requirements have not been set out with specificity. All securities offerings still must comply with the antifraud rule. One of the main purposes of Regulation D was to provide more specific disclosure guidelines so that issuers of securities would be more comfortable knowing that they have complied with their disclosure obligations. 109

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That is why Regulation D is referred to as a “safe harbor.” Instead of all of the confusion regarding disclosure obligations associated with the very general antifraud rule, issuers may rely on the more specific disclosure guidelines of Regulation D and be more confident of their compliance with the law. Issuer Disqualifiers As noted earlier, Rule 505 imposes a set of so-called issuer disqualifiers on those persons who would seek to sell securities under the rule. The disqualifiers basically state that the exemption is not available to persons who have been guilty of certain securities law or other violations within the most recent 5 years. Thus, if a producer allows persons who are disqualified to sell the production company’s securities, the exemption from registration may be voided, leaving the producer in the awkward position of having sold an unregistered security, an activity that might involve both civil and criminal penalties. Advantages Disclosure less burdensome. The disclosures required (i.e., the kind of information that must be put in writing in an offering memorandum and provided to each prospective investor prior to sale) for a Rule 505 offering are somewhat less burdensome than those required for a Rule 506 offering. Easier compliance. It is easier to comply with the more specific disclosure guidelines imposed by Rule 505 than the less specific antifraud rule type disclosure permitted under Rule 504 offerings. Higher level of funding allowed. As compared with a Rule 504 offering, the Rule 505 exemption permits the raising of five times the amount of money; $5 million as opposed to $1 million. Faster than public offerings. A private placement such as the Rule 505 offering generally allows the producer to put together a disclosure document and be “on the street” raising money more quickly than a public (registered) offering. Actually raising the money may take just as much time, depending on other factors. Less expensive. Private placements are generally less expensive to conduct than public offerings. Disadvantages Funding limit. A Rule 505 offering only permits the producer to raise $5 million, unlike the Rule 506 offering that imposes no ceiling on the aggregate offering price. 110

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Preexisting relationship. In contrast to a public (registered) offering, securities being offered pursuant to any Regulation D (private placement) exemption can only be offered to persons with whom upper-level management of the issuing entity has a preexisting relationship (i.e., knew before the start of the offering). Complex securities laws. The complexity of the securities laws makes it almost imperative that an experienced securities attorney be engaged, preferably with specific and successful experience in film or film company offerings, and again attorney fees can be relatively expensive for start-up production companies. State law compliance required. In addition to complying with the federal securities laws and regulations, issuers of securities pursuant to Rule 505 must also comply with the applicable state securities laws and regulations (blue sky laws) in each state in which the securities are to be offered or sold. Rule 506 Offerings Rule 506 is the last of the three specific sets of rules within the SEC’s Regulation D that permit issuers to sell securities in a nonpublic offering, that is, in private placements. As with Rules 504 and 505, a feature film production company (or other issuer) seeking to qualify for the transactional exemption for one of its securities offerings pursuant to Rule 506 must satisfy the general terms and conditions of Regulation D listed above (see “General Requirements of Regulation D”). No Ceiling on Amount of Money Unlike Rules 505 and 504, Rule 506 does not impose a ceiling on the amount of money that can be raised under the rule. Number of Investors Rule 506 utilizes the same approach as Rule 505 with respect to the number of investors that may be permitted to invest in the offering. No more than 35 nonaccredited investors but an unlimited number of accredited investors are permitted (see earlier discussion of accredited investors). Specific Disclosure Requirements Unlike Rule 504 (but as with Rule 505), Rule 506 provides specific disclosure guidelines that are matched with the disclosure guidelines for public (registered) offerings of the same or similar level. The Rule 506 disclosure guidelines are the same as those for the small business or public (registered) offerings conducted pursuant to Regulation S-B 111

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or Regulation S-1, depending on the amount of money being raised (see chapters 16 and 17). Issuer Disqualifiers Rule 506 does not impose the set of so-called issuer disqualifiers (i.e., “bad boy” provisions) on those persons who would seek to sell securities under the rule. Nature of Purchasers Rule 506 does impose investor suitability standards on investors who are not accredited. Thus, Rule 506 requires that each purchaser who is not an accredited investor, either alone or through a purchaser representative(s), have knowledge and experience in financial and business matters such that the purchaser is capable of evaluating the merits and risks of the prospective investment (sophisticated investor). Alternatively, the issuer must reasonably believe, immediately prior to making any sale, that the purchaser comes within that description. Producers and other securities issuers relying on Rule 506 must therefore inquire as to their nonaccredited investors’ financial knowledge and experience by means of the subscription application. Advantages No funding limit. A Rule 506 offering does not impose any ceiling on the amount of money that can be raised under the rule. Faster than public offerings. A private placement such as a Rule 506 offering generally allows the producer to put together a disclosure document and be “on the street” raising money more quickly than a public (registered) offering. Again, the actual time it takes to raise the money may be the same, depending on other factors. Less expensive. Private placements are generally less expensive to conduct than public offerings. Combine with NSMIA. The Rule 506 exemption can be combined with the National Securities Market Improvement Act (see below) to preempt state jurisdiction for all purposes except the notice filings. Disadvantages Highest level of disclosure. Rule 506 imposes the highest level of disclosure of the three Regulation D exemptions. Preexisting relationships. In contrast to a public (registered) offering, securities being offered pursuant to any Regulation D (private placement) exemption as a general rule can only be offered to persons with whom 112

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upper-level management of the issuing entity had a preexisting relationship (i.e., before the start of the offering). Complex securities laws. The complexity of the securities laws makes it almost imperative that an experienced securities attorney be engaged, preferably with specific and successful experience in film or film company offerings, and attorney fees can be relatively expensive for start-up production companies. State law compliance required. In addition to complying with the federal securities laws and regulations, issuers of securities must also comply with the applicable state securities laws and regulations (blue sky laws), except in specific instances were the state laws are preempted by federal law, as discussed next. National Securities Market Improvement Act One of the long-standing burdens relating to securities law compliance has been that of dual regulation. In other words, the sale of securities in the United States has been regulated by both the federal government and by each of the states. The National Securities Market Improvement Act of 1996 (NSMIA) was passed by Congress and signed into law in October 1996 to help relieve that burden. Added as Section 18 to the 1933 Securities Act, NSMIA basically provides that U.S. securities offerings that are national in character are to be regulated only at the federal level and specifically by the SEC, not by the states. Thus, some aspects of state regulation (blue-sky law) have been removed from certain offerings. NSMIA preempts state registration requirements with respect to certain transactions exempt under the Securities Act, including (among others) private placements pursuant to rules issued under Section 4(2) of the 1933 Securities Act, 15 U.S.C. § 77d (2)(1994), that is, those transactions exempt under Rule 506 of Regulation D, 17 C.F.R. § 230.506 (1996). In other words, NSMIA provides for the exemption from state regulation of certain offerings of “covered securities.” Included among the covered securities are offers to qualified purchasers (now considered synonymous with the accredited-investor concept as defined in Regulation D) and offerings made pursuant to the Rule 506 safe harbor. However, the states still retain the right to require notice filings and can bring enforcement actions with respect to fraud or deceit. Thus, the antifraud rule still applies to such offerings. A filmmaker wishing to conduct an interstate, nonpublic offering of securities may choose to rely on the provisions of Rule 506 and NSMIA, thus preempting state jurisdiction. Even so, state notice filings will still need to be effected. The remaining substantial benefit appears to be 113

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that such offerings are removed from state jurisdiction for most other purposes. NSMIA preserves the authority of the states to require notice filings and fees with respect to filings and to suspend the offer and sale of securities within a state as a result of the failure to submit a required filing or fee (see 15 U.S.C. 77r (c)(2)(1997). State Compliance Studies of state coordination with NSMIA have revealed that some 29 states require filing of the Form D in accordance with NSMIA (i.e., no later than 15 days after the first sale), but 3 states require presale or preoffer Form D filings; 3 states require Form D filings other than within the 15day period after the first sale; 2 states require notices other than Form D or in addition to Form D; 4 states require filing of disclosure documents as part of the notice filing; 5 states may require issuer registration; and 7 states may require agent registration in Rule 506 offerings. Such state requirements also continue to change. Thus, state blue-sky compliance continues to be burdensome in spite of the SEC’s efforts to coordinate and simplify it. In other words, the nonuniform state notice filing and fee requirements continue to be a problem for issuers relying on NSMIA. Advantages Preempts state jurisdiction. Complying with NSMIA allows a private placement offering to avoid state regulation for most purposes. Less expense. An offering that does not have to comply with state law could be less expensive, assuming the issuer is paying an attorney to handle state compliance, particularly on an hourly fee basis. Disadvantage Notice filings. State notice filings can still be required by the states in which securities are offered or sold.

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13 Public/Private (Hybrid) Exemptions In the event that a filmmaker (or other small business entrepreneur) is concerned about there not being a sufficiently large pool of prospective investors with whom the production company’s upper-level management has preexisting relationships at the time of the offering to be able to successfully raise the amount of money required, one of the so-called public/private hybrid exemptions may need to be considered. The following three public/private hybrid exemptions are grouped together as one form of film finance for the purposes of this chapter because they are very closely related and more often than not are used together for a single offering, or in lieu of one another. In fact, the California Section 25102(n) exemption described below, in all likelihood, has already been superseded by the Model Accredited Investor Exemption for most interstate offering purposes. California’s Section 25102(n) Exemption The State of California adopted a new sort of public/private hybrid exemption in September of 1994. It came into law as Section 25102 (n) of the California Corporations Code. It was designed to allow California entities (and foreign entities qualified to do business in California) to advertise, by use of a so-called Tombstone Ad (otherwise referred to as a “General Announcement”), that they were conducting a private offering of securities. Thus, the new California exemption permitted some elements of a public offering (the ability to advertise) to be combined with a private offering. The idea was to give issuers an opportunity to conduct a form of general solicitation within the context of a private offering up to a limited amount, and this was the first time such a concept had been tried by securities regulators. The California Public/Private Exemption The Section 25102(n) exemption provides that any offer or sale of 115

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any security in a transaction, other than an offer or sale of a security in a roll-up transaction (i.e., a move from one option position to another having a higher exercise price), that meets all of the following criteria is exempt from the state’s securities registration requirement and the state’s prohibition against advertising. Qualified Issuers The issuer has to be a California corporation or be doing business in California (see California Corporations Code 2115 for the tests to determine whether a foreign corporation is doing business in California and is therefore subject to regulation in the state), or in the alternative, the issuer may be any other form of business entity, including a partnership or trust organized under the laws of California, but not a blind pool or investment company. In other words, this exemption is not available to a limited partnership or other investment company that does not specify the properties intended to be acquired (a “blind pool” issuer), or to an investment company subject to the federal Investment Company Act of 1940. Qualified Purchasers Sales of securities must only be made to qualified purchasers or other persons the issuer reasonably believes, after reasonable inquiry, to be qualified purchasers. In effect, the California law provides an exemption from state registration for offerings made to specified classes of qualified purchasers that are similar, but not the same as, accredited investors under Regulation D. Not only does the California qualified purchaser definition differ from the federal accredited investor definition for individuals, the California law includes additional suitability standards. For a more complete and detailed listing of the people or entities that may fall within the category of qualified purchasers see Title 10, Section 260.102.13, of the California Code of Regulations. Note also that a corporation, partnership or other organization specifically formed for the purpose of acquiring the securities offered by the issuer in reliance upon this exemption may be a qualified purchaser if each of the equity owners of the corporation, partnership or other organization is a qualified purchaser. Purchaser Representation Each purchaser must represent that the purchase is being made for his, her or its own account (or trust account, if the purchaser is a trustee) and not with a view to, or for sale in connection with, a distribution of the security.

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Disclosure Document Each natural person purchaser, including a corporation, partnership or other organization specifically formed by natural persons for the purpose of acquiring the securities offered by the issuer, must receive (at least five business days before securities are sold to, or a commitment to purchase is accepted from, the purchaser) a written offering disclosure statement that meets the disclosure requirements of the SEC’s Regulation D and any other information as may be prescribed by rule of the commissioner. However, the issuer is not obligated to provide this disclosure statement to a natural person qualified under Title 10, Section 260.102.13, of the California Code of Regulations. Thus, this provision sets up a twotier disclosure system for the 25102(n) exemption, which may be useful if an issuer is only selling securities to persons who qualify and is foolish enough to want to sell securities to anybody without the protection of a properly drafted disclosure document. The better practice is to prepare and provide a disclosure document to all prospective investors regardless of whether they fit into this overly complicated scheme promulgated by California legislators and those who influence them. General Announcement The 25102(n) exemption provides that a general announcement of the proposed securities offering may be published by written document only, provided that the general announcement of proposed offering sets forth the following required information: 1. The name of the issuer of the securities. 2. The full title of the security to be issued. 3. The anticipated suitability standards for prospective purchasers. 4. A statement that a. no money or other consideration is being solicited or will be accepted, b. an indication of interest made by a prospective purchaser involves no obligation or commitment of any kind, and c. if the issuer is required to deliver a disclosure statement to prospective purchasers, no sales will be made or commitment to purchase will be accepted until five business days after delivery of a disclosure statement and subscription information to the prospective purchaser in accordance with the requirements of this subdivision. 5. Any other information required by rule of the commissioner.

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6. The following legend: “For more complete information about (Name of Issuer) and (Full Title of Security), send for additional information from (Name and Address) by sending this coupon or calling (Telephone Number).”

The above-referenced general announcement of proposed offering may also set forth the following information: • a brief description of the business of the issuer; • the geographic location of the issuer and its business; and • the price of the security to be issued, or, if the price is not known, the method of its determination or the probable price range as specified by the issuer and the aggregate offering price.

The general announcement can only contain the information set forth above. Dissemination to Others The Section 25102(n) exemption also provides that dissemination of the only general announcement of the proposed securities offering to persons who are not qualified purchasers, and nothing more, will not disqualify the issuer from claiming the exemption. Telephone Solicitation No telephone solicitation is permitted until the issuer has determined that the prospective purchaser to be solicited is a qualified purchaser. Notice Filings The issuer must file two notices of transaction for this exemption at the following times: • concurrent with the publication of the general announcement of proposed offering or at the time of the initial offer of the securities, whichever occurs first, accompanied by a filing fee, and • within 10 business days following the close or abandonment of the offering, but in no case more than 210 days from the date of filing the first notice.

The first notice of transaction must contain an undertaking, on the prescribed California form, to deliver a copy of the required disclosure statement, and any supplement thereto, to the California Department of Corporations (DOC) within 10 days of the DOC’s request for the information. 118

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This 25102(n) exemption from registration is not available if an issuer fails to file the first of the required notices described above, or fails to pay the required filing fee. The DOC has the authority to assess an administrative penalty of up to $1,000 against an issuer that fails to deliver the disclosure statement required by the DOC in a timely manner. Neither the filing of the disclosure statement nor the failure by the DOC to comment thereon precludes the agency from taking any action deemed necessary or appropriate with respect to the offer and sale of the securities. Advantages Limited advertising permitted. The California Section 25102(n) exemption allows a limited form of advertising for what is essentially still a private placement. No ceiling on amount. There is apparently no ceiling on the amount of money that can be raised (at least per state law). Disadvantages California companies only. Only California issuers and entities doing business in California can use this exemption. California sales only. All sales must be in California, and it is rare that film offerings can be completely financed with investors in one state. Federal compliance. At the federal level, the California Section 25102(n) exemption must be paired with the federal Section 3(a)(11) intrastate exemption (see chapter 11), thus making it even less useful for a film offering. Overly complex. The exemption creates an overly lengthy and complicated list of qualified purchasers. Not well coordinated. Since the NASAA took a different approach (see “NASAA’s Model Accredited Investor Exemption” below), the California Section 25102(n) exemption does not work well with other states. And it does not fit well within any current federal exemption, other than Rule 504, which imposes a ceiling of $1 million on the amount of money that can be raised, or potentially the intrastate offering exemption, Section 3(a)(11), which, as already discussed, has its own problems. Rules 505 and 506 of Regulation D prohibit general solicitations; moreover, California’s definition of qualified purchasers is broader than Regulation D’s definition of accredited investors. The intrastate offering exemption is available only for those offerings by issuers incorporated and doing business in a single state. Disclosure problems. The exemption creates a two-tier disclosure system that encourages issuers to avoid preparing and providing a disclosure 119

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document to certain designated prospective purchasers if, in their judgment, they think that they can raise the amount of funds needed from this limited group of investors and that all of their prospective investors fit into the permissible category. Rarely does an issuer know that sort of information in advance, and the absence of a properly drafted disclosure document always exposes the issuer to greater potential liability for fraud and material misrepresentation. The SEC’s Rule 1001 Exemption The SEC reacted positively toward California’s adoption of its Section 25102(n) exemption and subsequently adopted SEC Rule 1001, which, in effect, encouraged other states to follow California’s lead by adopting similar laws. This SEC exemption designed to coordinate with California’s Section 25102(n) was adopted on May 1, 1996 (SEC Release No. 33–7285). In summary, the SEC stated that in order to reduce regulatory burdens associated with certain offers and sales of securities, it would adopt a new exemption from its registration requirements for limited offerings of up to $5 million that are exempt from qualification under the 1994 California state securities law, Section 25102(n). The SEC adopted Rule 1001 under Section 3(b) of the Securities Act of 1933. The rule exempts from the registration requirements of the securities act offers and sales up to $5 million that are exempt from state qualification under paragraph (n) of Section 25102 of the California Corporations Code. The SEC exercised its exemptive authority pursuant to Section 3(b) to provide a parallel federal exemption for the California exemption by adopting the new Rule 1001. Rule 1001 provides that offers and sales of securities, in amounts of up to $5 million (less the aggregate offering price for all other securities sold in the same offering of securities, whether pursuant to this or another exemption), that are exempt from registration under paragraph (n) of California’s Section 25102 are also exempt from the federal registration provisions of Section 5 of the Securities Act of 1933 by virtue of Section 3(b) of that act and are exempt from the prohibition against general solicitation found in Rule 502(c) of Regulation D, the Securities Act Section 3(a)(11), and the SEC’s Rule 147. All issuers that qualify for the state exemption can rely on the Rule 1001 exemption. The SEC took the position that issuers should look to the state of California for interpretation of who qualifies for the exemption, since any person who lawfully relies on the state exemption also could rely on its federal counterpart.

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Rule 1001 does not require issuers to notify the SEC when they rely on the California exemption in view of the notification provisions of the California law. Antifraud Provisions Still Apply While the transactions would not be subject to registration under Section 5, the antifraud provisions of the federal securities laws would continue to be applicable to all exempt transactions. In other words, nothing in the Rule 1001 exemption is intended to be or should be construed as in any way relieving issuers or persons acting on behalf of issuers from providing the necessary disclosure to prospective investors to satisfy the antifraud provisions of the federal securities laws. This Rule 1001 only provides an exemption from the registration requirements of the Securities Act of 1933. Certain Companies Cannot Use As noted above, California law precludes reliance on the exemption in connection with investment company, blind pool or roll-up offerings; thus, the Rule 1001 exemption also would be unavailable in those cases. Where a transaction involves other-than-cash consideration, the amount of the offering would be calculated as provided under California law. Resale Limitations Securities issued pursuant to Rule 1001 are deemed to be “restricted securities” (as defined in Securities Act Rule 144). Resales of such securities must be made in compliance with the registration requirements of the 1933 Securities Act or an exemption therefrom. In other words, Rule 1001 provides an exemption only for the transactions in which the securities are offered or sold by the issuer; it is not an exemption for the securities themselves. Consequently, purchasers must either register subsequent resales of the securities or comply with all of the conditions and limitations imposed on the use of such an exemption for sales. Categorizing the securities offered and sold pursuant to Rule 1001 as “restricted” is consistent with the California exemption, since the latter requires an investment intent on the part of purchasers in the offering, and such shares could not be resold under California law without qualification or some other exemption under such law. In addition, the treatment is consistent with other federal exemptions, the availability of which depends on the sophistication, wealth or institutional character of the investor.

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State Compliance Still Required Nothing in the Rule 1001 exemption obviates the need to comply with any applicable state law relating to the offer and sales of securities. Thus, federal and state jurisdictions still apply. Not an Exclusive Election Attempted compliance with the Rule 1001 exemption does not act as an exclusive election, which means, the issuer also can claim the availability of any other applicable exemption. No Scheme to Evade The Rule 1001 exemption is not available to any issuer for any transaction that, while in technical compliance with the provisions of the rule, is part of a plan or scheme to evade the registration provisions of the 1933 Securities Act. In such cases, registration under the 1933 Securities Act is required. The SEC adopted Rule 1001 after California created its Section 25102(n) exemption, and it also provides that if other states adopt California’s law, then their sales would be considered exempt up to the 1933 Act’s Section 3(b) limit of $5 million. This, of course, differs from the California nolimit approach. This conflict has caused some confusion, since some issuers and film producers think California is limited to $5 million dollars, but that is not technically accurate. On the other hand, securities sales are subject to both federal and state jurisdictions, and in cases where exemption conditions or limitations imposed by various jurisdictions differ, the securities issuer is obligated to comply with the more burdensome provision. Thus, since the California Section 25102(n) exemption is to be used with the federal intrastate exemption, Section 3(a)(11), the federal $5 million limit would apply. NASAA’s Model Accredited Investor Exemption In January of 1997, the North American Securities Administrators Association (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 limiting sales to “accredited,” as opposed to the “qualified investors” 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) exemption by federal law. Thus, for interstate offerings, the California exemption is not all that useful. 122

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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 (MAIE) and Regulation D, Rule 504. Notice filings are still required in each state under the MAIE. Elements of the MAIE NASAA adopted the MAIE on April 27, 1997. It exempts from registration and from sales or advertising filing requirements those offers and sales of securities issued to accredited investors. As noted earlier, the term accredited investor is defined at Regulation D, Rule 501(a), with a listing of entities and individuals possessing substantial assets 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. 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 million 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. Again, 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 make sales without the requirement of a preexisting relationship. The specific requirements to be complied with include: Accredited investors only. Sales of securities must be made only to persons who are, or who the issuer reasonably believes are, accredited investors, as defined in Regulation D, Rule 501(a). 123

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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 has 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 must believe 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 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 that 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, preliminarily 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 securi124

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ties 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: • the name, address and telephone number of the issuer of the securities; • the name, a brief description and price (if known) of any security to be issued; • a brief description of the business of the issuer in 25 words or less; • the type, number and aggregate amount of securities being offered; • the name, address and telephone number of the person to contact for additional information; and • 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 prequalified 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 states 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. 125

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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 investor, whereas the other states require the less complicated accredited investor definition, as already set forth in Regulation D, and (2) California (combined with the federal Rule 1001) 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 chapter 11). On the other hand, if a film producer believes that it may be necessary 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’s MAIE and use that approach, combined with an Internet announcement. NASAA’s adoption of the MAIE was not actually in response to California’s Section 25102(n) but rather to the Small Business Administration’s ACE-Net program (now defunct or at least in private hands; see chapter 5). 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 Regulation D with its $1 million dollar limit. Even among those states that have not adopted the MAIE, almost all have some form of exemption pertaining to accredited investors. Practical Considerations Re: 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 are 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) exemption and the MAIE 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 of126

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ferings actually work, which to date has not been the case, certainly not for film offerings). 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 highrisk 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 face-to-face meetings with people known to the producer and the production company’s upper-level management than through some Internet scheme. Advantages Advertising and general solicitation. The MAIE allows a limited amount of advertising and general solicitation for nonregistered offerings of $1 million or less. Disadvantages 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’ offerings, 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.

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Securities Compliance: Public (Registered) Offerings

14 Small Corporate Offering Registration The Small Corporate Offering Registration (SCOR) form of corporate securities registration (public offering) is designed to reduce the costs and paperwork involved in public offerings, thus diminishing the burden on small businesses that seek to raise capital. The NASAA adopted the SCOR form (U-7) on April 29, 1989, and many state legislatures around the country have since adopted state legislation patterned after the NASAA model. The Form U-7 was developed pursuant to Congress’s Small Business Investment Incentive Act of 1980 (now contained in Section 19 of the federal Securities Act of 1933). Form U-7 is the general public-offering registration form for corporations registering under state securities (blue-sky) laws that provide exemptions from the registration requirements of the SEC compatible with the federal agency’s Regulation D, Rule 504. To be eligible to use Form U-7, a company (1) must be a corporation organized under the laws of the state in which the offering is to be filed and (2) must engage in a business other than petroleum exploration or production, mining or other extractive industries. Thus, feature film production companies qualify. Blind pool offerings and other offerings for businesses or properties that cannot be specified are ineligible to use Form U-7. In other words, film producers cannot raise a fund for use in producing unspecified film properties using the form. The company’s securities may be offered and sold only on behalf of the company, and Form U-7 may not be used by any present securities holders of the company to resell their securities. The offering price for common stock must be equal to or greater than $5 per share. Also, the company must agree not to split its common stock or declare a stock dividend for two years after the registration becomes effective without the permission of the state regulators involved. The SCOR process presumes that the investment vehicle is a corporation; thus, each state in which sales are anticipated will have to be checked to determine whether other invest128

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ment vehicles, like limited partnerships or manager-managed LLCs, are acceptable for such offerings. Companies using Form U-7 may engage selling agents to sell their securities. However, commissions, fees or other remuneration for soliciting any prospective purchaser may only be paid to persons who are registered as securities broker/dealers in the state in which sales occur. Thus, finders who by definition are not registered securities broker/dealers may not be paid so-called finder’s fees (see “Finder Sales” in appendix D). Advantages Disclosure document. Form U-7 itself, once filled out, filed and declared effective, constitutes the offering circular or prospectus (disclosure document) for the offering and may be reproduced by the company by copy machine or otherwise for dissemination to prospective investors. Attorney not necessarily needed. Some producers may be comfortable with their ability to complete the registration form and conduct the offering without the assistance of counsel so long as compliance with the applicable state securities laws is observed (but see “Attorney’s opinion requirement” below). Disadvantages No sales until effective. No offers or sales may be made until the registration has been declared effective by state regulators. Selling materials must be approved. Any and all supplemental sales literature or advertisements announcing the offering must be filed by the company and cleared with the state securities regulator of each state prior to publication or circulation within that state. Content of public announcements. The information contained in public announcements regarding the offering is specifically limited. Disclosure requirements. The disclosures required by Form U-7 are very similar to those required in other securities offerings. The information is just presented in a less readable Q&A format. Not a good selling document. Most experienced sellers of securities indicate that Form U-7 is not as effective a selling document as a welldrafted private placement offering memorandum. Ceiling on amount of money raised. The form can only be used if the total amount of money being raised does not exceed $1 million during a 12-month period. Form D required. A completed and signed SEC Form D must also be filed with the SEC, claiming exemption from the federal securities registration requirement (pursuant to Regulation D, Rule 504). 129

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Corporate form. The SCOR scheme may require that the corporate form of doing business be used, when there are other good reasons for using a limited partnership or LLC. Attorney’s opinion requirement. The opinion of an attorney licensed to practice in the state of registration must be submitted to the state regulator. In it, the attorney must state his or her opinion that the securities to be sold in the offering have been duly authorized and, when issued upon payment of the offering price, will be legally and validly issued, fully paid, nonassessable and binding on the company, and that this statement is true and accurate. Such opinions may be hard to come by unless the attorney is heavily involved in preparing the Form U-7 or another disclosure document.

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15 Regulation A Another of the small public offering opportunities is provided by the SEC’s Regulation A. Although the language of Regulation A describes the rule as an “exemption,” it is actually a small public (registered) offering that permits the feature film producer (or other issuer of securities) to conduct some limited advertising. In other words, even though the SEC’s language refers to Regulation A as an exemption from the securities registration requirement, that is misleading since the process of filing a Regulation A offering is more akin to a registration than to a private placement. For these reasons, the Regulation A exemption is often termed a “miniregistration” process, because it does require the filing of an offering statement, which includes the securities disclosure document (termed an offering circular) containing required disclosures, although these disclosures are not as burdensome as those for an S-1 public (registered) offering (see chapter 17). Elements of Regulation A Offerings Regulation A limits the amount of money that can be raised during any given one-year period to $5 million, certainly enough for most lowbudget feature film projects. Unlike Rules 505 and 506 or registered offerings, the financial statements in a Regulation A offering statement need not be independently audited. The offering statement is processed by the SEC’s Division of Corporation Finance in a manner similar to that applied to other registration statements. After completing its review of the disclosure, the Division “qualifies” the offering statement. Securities may be sold in the offering only after the offering statement is qualified. Prefiling requirement. The regulation specifically requires that at least 10 business days (Saturdays, Sundays and holidays excluded) prior to the date on which the initial offering or sale of the securities is to be made 131

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under the regulation, the producer must file with the SEC regional office 5 copies of the offering statement. That offering statement consists of “Part I—Notification,” “Part II—Offering Circular” and “Part III—Exhibits.” In lieu of the offering circular (the term used by Regulation A instead of offering memorandum or prospectus for the securities disclosure document), Regulation A also now permits the use of a fill-in-the-blank form similar to the SCOR Form U-7. Once again, however, note that such forms are generally considered to be less effective selling documents compared to the other forms of securities disclosure documents (i.e., prospectus, offering circular, offering memorandum). Disclosure document. No written offer of the securities can be made unless an offering circular (or completed form) containing the required disclosures (the information specified in Part II of the offering statement) is concurrently given or has previously been given to the person to whom the offer is made. Also, no securities of the issuer (production company) can be sold under Regulation A unless the offering circular or the completed fill-in-the-blank form is furnished to the prospective investor at least forty-eight hours prior to the mailing of the confirmation of sale by the production company (issuer) and the SEC has not disallowed the offering. Advertising limits. Written advertisements or other written communications and radio or television broadcasts can contain no more than the following information: • the name of the issuer of the security; • the title of the security (e.g., corporate stock, limited partnership interest or LLC units); • the amount being offered (the aggregate offering price or total amount of money being raised); • the per-unit offering price to the public; • the identity of the general type of business of the issuer (for example, development or production of feature films); • a brief statement about the general character of the film project or projects; and • from whom an offering circular can be obtained.

Sales materials. Four copies of all of the sales materials prepared in conjunction with the Regulation A offering must also be submitted to the SEC. Revised circular. If the offering is not completed within 9 months from the date of the offering circular, a revised offering circular must be prepared, filed and used in accordance with the Regulation A rules. 132

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Test-the-waters provision. Regulation A procedures allow the feature film producer (securities issuer) to engage in a so-called testing of the waters; that is, to publicly disseminate an executive summary of the proposed offering in order to gather expressions of interest from prospective investors. Regulation A thus allows producers to gauge investor interest before incurring the expense of printing and binding hundreds of offering circulars or other forms of disclosure documents. It is much less expensive to disseminate a four- or five-page summary of the offering than the entire offering circular. A similar testing of the waters can be accomplished through the proper drafting and circulation of a generic business plan, not specifically associated with a possible subsequent securities offering, but instead tied to active investor vehicles like the investor-financing agreement, joint venture, initial incorporation or member-managed LLC vehicles described earlier (see chapters 3–6). State coordination. Unfortunately, many states have not yet adopted provisions compatible with the SEC’s Regulation A test-the-waters provision, and since the securities laws require compliance with both federal and state laws, that provision may not be useful in those nonadopting states. Thus, the status of the applicable provisions in each state in which offers or sales are anticipated must be determined and complied with. Reports of sales. Within 30 days after the end of each 6-month period following the date of the original offering circular (or form), the producer or issuer must file with the SEC’s regional office a completed SEC Form 2-A, and a final report must be submitted upon completion or termination of the offering, but no later than 6 months from the last sale. Advantages Public offering. Regulation A claims to be an exemption but is actually a form of small public offering; thus, the producer can conduct a general solicitation (including the use of “cold calls,” mass mailings and the Internet) and engage in some advertising to raise money. SEC filing. The required SEC filing may be effected through the nearest regional office of the SEC (although this concession can be changed by the SEC). Disadvantages Prefiling. A proper filing must be effected prior to any sales. State laws may differ. Regulation A is not fully coordinated with the various state laws. Dual regulation. Compliance with both federal and state rules is required. 133

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Offering price ceiling. Although $5 million is enough to allow for the production of most low-budget feature films, this ceiling on the amount of money that can be raised pursuant to Regulation A does prevent higher-budget pictures from relying on it, except for those utilizing other sources of financing in conjunction with the funds provided by an investor-financed Regulation A offering.

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16 Regulation S-B The SEC’s Regulation S-B is another form of public (registered) securities offering for small business issuers, including corporations, limited partnerships and manager-managed LLCs. For purposes of the regulation, the small business issuer is defined as a U.S. or Canadian company with revenues of less than $25 million; if the company is a majority-owned subsidiary, the parent corporation must also be a small business issuer. Regulation S-B Requirements Regulation S-B does require that the producer (issuer) provide an SECapproved disclosure document (prospectus) to each prospective investor prior to the investment. Currently, such approval is sought through an electronic filing. The regulation sets out in fairly rigorous detail the kinds of information that must be included in the disclosure document. For example, the following information must be provided (but this is not a complete list of the disclosure requirements): • a description of the business of the issuer (including form and year of organization); • a statement declaring whether the issuer is a party to any pending legal proceedings; • certain financial statements; • the names of the issuer’s directors, executive officers or upper-level management; • management compensation in all forms; • specific information that must appear on the outside front cover of the prospectus; • a summary of the prospectus (under some circumstances); • a discussion of any factors that make the offering speculative or risky (risk factors);

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• a statement regarding how the net proceeds of the offering will be used (use of proceeds); • the issuer’s plan for selling the securities (plan of distribution of the securities); • certain exhibits, such as existing material contracts and attorney’s opinions (under some circumstances); and • other special disclosures relating specifically to the nature of the issuing entity, that is, whether corporation, limited partnership or managermanaged LLC.

Financial projections. Unlike earlier years, the SEC now encourages the use of management’s projections of future economic performance in conjunction with public offerings like the Regulation S-B provisions. However, the SEC does require that such financial projections have a reasonable basis and that they be presented in an appropriate format (see appendix C, “Financial Projections”). For additional information regarding the S-B forms, see Corporate Forms I—Under the Securities Act of 1933, at http://www.aspenpublishers. com/SECRUYLES/crpfmttI.pdf. Advantages Advertising permitted. A public (registered) offering such as that under Regulation S-B permits advertising to the general public and marketing techniques that fall under the label general solicitation (see “Selling Securities over the Internet” in appendix D). Compared to form S-1 offerings. A Regulation S-B offering is somewhat less burdensome than a Form S-1 securities offering (see chapter 17). Key employees. A publicly held corporation may have an advantage over certain other forms of doing business when it comes to attracting and retaining key employees. Future options. The management of a publicly held corporation generally has more options with regard to future financing of company activities once past the initial public offering (IPO) stage. Less review time. In theory at least, the SEC review of an S-B offering does not take as long as its review of an S-1 offering. Disadvantages Securities attorney. The assistance of (and expense associated with the services of) an experienced securities attorney will undoubtedly be required to conduct this level of securities offering. More expensive overall. In addition to the attorney fees, the other expenses associated with a public securities offering are (1) printing and 136

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binding of disclosure documents, (2) accounting fees, (3) broker/dealer due diligence expenses and commissions and (4) other marketing costs that are generally higher than SCOR, Regulation A or private placement securities offerings. More time-consuming. It will generally take more time to “get on the street” with a Regulation S-B offering as opposed to a SCOR or Regulation A offering, but that partly depends on the experience of the securities attorney. Certainly an S-B offering will take more time to prepare than a private placement offering. Management flexibility. Publicly held companies have less flexibility in management. Loss of control. In the instance of a corporation, corporate insiders (including the film’s producer) may lose control of the company if enough of the corporation’s shares are sold to the public. Film company IPOs. Few, if any, feature film production companies have successfully conducted an initial public offering of stock in recent years, a situation that results more from the inability of the securities issuers to provide any assurances that they can resolve existing problems with the business practices of feature film distributors than from the actual form of doing business or the form of the securities offering (see The Feature Film Distribution Deal and Hollywood Wars: How Insiders Gained and Maintain Illegitimate Control over the Film Industry).

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17 S-1 Public Offerings The SEC’s Form S-1 is a form of public (registered) securities offering that can be used by feature film producers (and other securities issuers) when a public offering is preferred, as opposed to a private placement, and the issuing organization does not wish to use or does not qualify for the SCOR, Regulation A or Regulation S-B offerings discussed previously. Elements of an S-1 Offering There is no ceiling on the amount of money that can be raised through S-1 offering, but since the S-B form of securities registration permits the issuing entity to have revenues up to $25 million and imposes no specific limit on the amount of money that can be raised, it is unlikely that a feature film producer seeking to raise funds for a single motion picture would have to resort to an S-1 offering. On the other hand, if the producer is seeking to fund the production budgets for a slate of motion pictures or to finance the activities of a corporate production company, the S-1 may prove to be the most useful form of securities registration available. The S-1 requires the highest level of disclosure; thus, the prospectus used as the disclosure document in conjunction with an S-1 offering will contain more information or more detailed information, generally speaking, than the other forms of securities offerings. This in turn means that the level of expertise required of the securities attorney is a bit higher than that required for the S-B or other public offerings, and the cost of that expertise may also be reflected in higher attorney’s fees. Like the Regulation S-B offering, the S-1 requires that the producer (issuer) provide an SEC-approved disclosure document (prospectus) to each prospective investor prior to the investment. And like Regulation S-B, the S-1 registration statement and prospectus are submitted to the SEC electronically through the SEC’s EDGAR (Electronic Data Gathering, Analysis and Retrieval) system. The regulation sets out in fairly rigorous

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detail the kinds of information that must be included in the disclosure document. For example, the following information must be provided (but this is not a complete list of the S-1 disclosure requirements): • a description of the business of the issuer (including form and year of organization); • a statement declaring whether the issuer is a party to any pending legal proceedings; • certain financial statements of existing companies; • names of the issuer’s directors, executive officers or upper-level management; • management compensation in all forms; • specific information that must appear on the outside front cover of the prospectus; • a summary of the prospectus (under some circumstances); • a discussion of any factors that make the offering speculative or risky (risk factors); • a statement regarding how the net proceeds of the offering will be used (use of proceeds); • the issuer’s plan for selling the securities (plan of distribution of the securities); • certain exhibits, such as existing material contracts and attorney’s opinions (under some circumstances); and • other special disclosures relating specifically to the nature of the issuing entity; that is, whether corporation, limited partnership or managermanaged LLC.

The primary difference between the S-1 and S-B offerings lies in the area of financial reporting. The S-1 will generally require more financial information relating to the issuing company and covering a longer period of time than the form S-B. It is also generally true that the SEC review of the S-1 takes longer to complete than the other types of offerings. Financial projections. As with the S-B offerings, the SEC now encourages the use of management’s projections of future economic performance in conjunction with public offerings like the Regulation S-1 provisions. However, the SEC also requires that such financial projections have a reasonable basis and that they be presented in an appropriate format (see appendix C, “Financial Projections”). For additional information regarding the S-1 form see Corporate Forms I—Under the Securities Act of 1933, http://www.aspenpublishers. com/SECRUYLES/crpfmttI.pdf.

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Advantages Advertising permitted. A public (registered) offering such as that under Regulation S-1 permits advertising to the general public and marketing techniques that fall under the label general solicitation (see “Selling Securities over the Internet” in appendix D). No ceiling. There is no ceiling on the amount of money that can be raised through an S-1 public (registered) offering. Key employees. A publicly held corporation may have an advantage in attracting and retaining key employees. Future options. In the case of a publicly held corporation, its management generally has more options with regard to future financing of company activities once past the initial public offering (IPO) stage. Disadvantages Securities attorney. The assistance of (and expense associated with the services of) an experienced securities attorney will undoubtedly be required to conduct this level of securities offering. Compared to S-B offerings. A Regulation S-1 offering is somewhat more burdensome than a form S-B securities offering (see chapter 16). More expensive overall. In addition to the attorney fees, the other expenses associated with a public securities offering—(1) printing and binding of disclosure documents, (2) accounting fees, (3) broker/dealer commissions and fees and (4) other marketing costs—are generally higher than SCOR, Regulation A or private placement securities offerings. More time-consuming. It will generally take more time to “get on the street” with a Regulation S-1 offering than a SCOR, Regulation A or S-B offering, and certainly more time than a private placement. Management flexibility. Publicly held companies have less flexibility in management than private companies. Loss of control. In the instance of a corporation, corporate insiders (including a film’s producer) may lose control of the company if enough of the corporation’s shares are sold to the public. This control issue has been an ongoing battleground in the film industry ever since the early major studio/distributors began going public.

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18 Over-the-Counter, NASDAQ and Stock Exchanges At some point, a well-established, publicly held film production company may arrange to trade its securities (i.e., arrange to have its securities bought and sold) on any one of the several existing markets, such as over-the-counter, NASDAQ or a stock exchange. The Over-the-Counter Market The securities of an over-the-counter (OTC) company are not listed and traded on an organized exchange. The OTC market was created by dealers who primarily handle trading in securities that are not listed stocks on an organized exchange. OTC trading differs from exchange trading in that transactions are carried out through a telephone and computer network and negotiations with a number of dealers, called market makers, as compared to the single-specialist, single-location auction market mechanism used for listed securities trading. In addition, the market maker acts as principal in the transaction, which involves the dealer as buyer and seller from his or her own inventory. Some financial observers would suggest that trading a company’s securities in the over-the-counter market implies that there is not much interest in the securities; however, OTC trading can also reasonably be interpreted to mean that the company has simply chosen not to be listed on an exchange and thus seeks to exercise more control over the market for its securities. A number of broker/dealers in the OTC market may express interest in a particular company’s securities, with the result that they compete more vigorously to get the best possible price for their customers (or themselves), and this competition in turn benefits the company whose securities are being bought and sold. From a governmental regulatory standpoint, the OTC market is primarily regulated by the SEC and to some extent by the securities 141

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regulatory authority in each state. However, the OTC market is also regulated in a certain sense by the broker/dealers’ interest in the security (governed by the supply of the security and the demand of customers for it). Erratic price movements may become the subject of SEC inquiry for facts to justify the activity. Active markets in the OTC sector generally result from the public (registered) offerings that have been the subject of SEC filings. Advantages Fewer regulations. OTC trading imposes fewer regulations on a public company than the NASDAQ market or the stock exchanges. More control. A company may be able to exercise more control over the market for its securities through the OTC market than through the stock exchanges. Disadvantages Less visibility. The OTC market does not provide a company’s stock or other securities with as much visibility as listings on the NASDAQ system or the stock exchanges. Not much interest. Relative to being listed on NASDAQ or one of the stock exchanges, OTC trading may suggest that there is less interest in the securities of the company. NASDAQ NASDAQ is the acronym for the National Association of Securities Dealers Automated Quotations, a national automated quotation service for over-the-counter securities. Operation of the NASDAQ system is supervised by the National Association of Securities Dealers (NASD) and informational input is provided by hundreds of over-the-counter market makers. Market makers are securities broker/dealers who make a market for a given security; that is, such firms maintain a firm bid and offer price on a given security by standing ready to buy or sell round lots at publicly quoted prices. A managing underwriter typically makes a market for its client’s stock. In order to qualify for inclusion in the NASDAQ system, a security must satisfy numerous requirements. For example, initially it requires that • • • •

the issuer must have two registered and active market makers; the issuer must have total assets of at least $2 million; the issuer must have capital and surplus of at least $1 million; in the case of a convertible debt security, there must be a principal amount outstanding of at least $10 million; 142

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• in the case of common stock, there must be at least 300 holders of the security and at least 100,000 publicly held shares; • in the case of rights and warrants, there must be at least 100,000 issued; • the security must not be under a current SEC trading suspension; • the issuer has to pay a NASDAQ Issuer Quotation fee; • the issuer has to file with the NASD three copies of all reports and other documents filed or required to be filed with the SEC; and • the company’s annual reports filed with the NASD must contain audited financial statements.

Many persons in the securities industry feel the NASDAQ system has resulted in significant improvements in the over-the-counter securities market. NASDAQ has made available electronic price quotations and trading-volume information for a significant number of over-the-counter securities. Many newspapers currently carry the NASDAQ National List of securities, which has similar financial criteria to that of the American Stock Exchange. Some newspapers also publish the Additional List of NASDAQ securities, which is based on the dollar value of share volume. The total number of shares traded on the NASDAQ market now exceeds that of the American Stock Exchange. An actively traded NASDAQ security supported by several market makers may (1) command more broker/dealer interest, (2) have a larger trading volume and (3) develop more market depth than many stocks listed on the exchanges. As a result, many NASDAQ-traded companies no longer seek exchange listing when they become eligible for such listing, preferring to remain in the NASDAQ market. Advantages Instant availability. The NASDAQ market makes the securities of qualifying companies instantly available for trading by broker/dealers all across the country, which may facilitate rapid capitalization. Eligibility requirements. The NASDAQ eligibility requirements are generally less burdensome than the requirements of the major stock exchanges. Disadvantages More mature companies. The NASDAQ market is generally only suitable for more mature companies with sophisticated management and the capability of paying significant professional fees to accountants and attorneys qualified to supervise such transactions. Eligibility requirements. The NASDAQ eligibility requirements are generally more burdensome than general OTC requirements. 143

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Stock Exchanges The national securities exchanges provide a convenient marketplace for their member broker/dealer firms to execute buy and sell orders for customers. However, a film production (or other) company’s securities can be traded on a specific exchange only after meeting the exchange’s listing requirements. After those requirements are met, a broker/dealer (a so-called specialist) is assigned to make an orderly market in the security. In other words, it is the responsibility of the specialist to match buy and sell orders for the production company’s securities and generally maintain some degree of liquidity in the company’s securities. The two major stock exchanges (the New York Stock Exchange and the American Stock Exchange) maintain certain policies that have to be considered by any company before making the decision to list on either exchange. Those policies are set forth in the respective New York and American Stock Exchange guides, which may be obtained from those exchanges. Such policies relate to conflicts of interest, voting rights, the requiring of shareholder votes in certain situations, outside directors, audit committees, controls relating to the future issuance of a company’s stock and the timely public release of important corporation developments. Most of the policies are articulated as general guides for the conduct of their respective listed companies, and the guides are applied on a case-bycase basis, depending on the individual facts. Even if a film production or other company decides not to apply for listing on an exchange, those well-established exchange policies may serve as useful guides to good corporate practice—even for OTC companies. The exchanges regulate themselves and their specialists with rules approved by the SEC. Price movement greater than a specified amount (e.g., over ¼ of a point) or other unusual price movements may require approval of a floor governor or the exchange, as well as general publicity intended to offer an explanation. Listing on some of the stock exchanges may provide for automatic securities registration in certain states. The securities laws of each state (blue-sky laws) in which the security is intended to be offered or sold should be reviewed to determine whether exchange listing brings automatic state registration. If a film production company can meet the listing requirements of the New York Stock Exchange, it is generally regarded as highly desirable to do so. However, only a few companies can typically meet those requirements after a single public offering of their securities. If a film production company can meet the somewhat lower listing requirements 144

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of the American Stock Exchange, it may choose to do so. Some issuers, however, prefer to season (mature in the marketplace) their securities with a brief period of over-the-counter trading before the listing on an exchange is completed. Small public issues of corporate film production company securities may be listed on regional stock exchanges. The principal regional exchanges are located in Boston, Detroit, Chicago (the Midwest Stock Exchange), Philadelphia and Los Angeles (the Pacific Stock Exchange, which actually maintains facilities in both Los Angeles and San Francisco). The exchanges generally do not have regulations concerning the underwriting of OTC securities by member firms. Advantages Prestige. Listing on a stock exchange may create more prestige for a film production company in the eyes of investors, customers and suppliers. Employee considerations. A film production company whose stock is listed on an exchange may appear to be more attractive to new employees. Acquisitions. Stock exchange listing of a company’s securities may facilitate the acquisition of the company by another firm. Collateral value. Securities listed on a stock exchange will generally have higher and more readily ascertainable collateral values in the event that the investor wishes to borrow funds using the security as collateral. Press releases. Stock exchange listing generally increases a company’s ability to get its press releases and quotations more widely disseminated by the news media. Value of specialist. The stock exchange listing typically obligates the specialist to make a fair and orderly market for the security by purchasing it and selling it for the specialist’s own account if necessary. State preferential treatment. Generally speaking, listing on a stock exchange will qualify a company’s securities for preferential treatment by the state securities regulators. More stable prices. There is generally less volatility in the price of a company’s securities when those securities are listed on a stock exchange rather than being traded in the OTC market. Closer spreads. The spread (difference between the bid and offered quotations on a security) is typically not as great on listed securities as on securities traded in the OTC market. Disadvantages Listing requirements. Many companies cannot meet the listing requirements to become an exchange company. 145

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OTC trading. Over-the-counter trading of a company’s securities may prove to be more advantageous to a particular company than a listing on some of the exchanges. Exchange policies. Certain of the exchange policies may prove too burdensome for some smaller companies.

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PART THREE Lender Financing Another distinctive form of film finance that an independent film producer may want to consider is a loan (as opposed to a gift, grant or investment). Loans may be used to finance the development, production and distribution expenses associated with a feature film. Loans in the context of film finance may take a variety of forms: (1) loans provided by thirdparty lenders (i.e., not film distributors) and not supported by distributor contracts, (2) the negative pickup and its variation, the so-called artificial pickup, (3) presale financing, including the foreign presale, (4) variations on presale financing (i.e., gap and supergap financing), (5) the insurancebacked schemes and (6) securitization. The following chapters treat each of these forms of lender financing for films.


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19 Lender Financing without Distributor Contracts The loans discussed in this chapter are those not involving a preproduction distribution agreement and guarantee (see chapters 20–23). Instead, this discussion focuses on loans that may be provided by banks or other lenders, including individuals, that either require collateral in the form of hard assets or are unsecured loans. A loan is defined as the delivery of a sum of money to another under contract to return an equivalent amount at some future time (i.e., a date certain) with or without an additional sum (interest) agreed upon for its use. The characterization of a transaction as a loan or some other type of borrowing has significance in ascertaining whether usury laws apply to the amount of interest being charged and whether the securities laws apply to the transaction. The securities laws generally do not apply to loans. Debt or Equity Transaction Both the lender and the borrowing producer should be careful to insure that what is intended as a loan to be used for development of a screenplay, preproduction expenses or production costs can be fairly characterized as debt and not as an equity investment, if in fact debt is what is intended. If the transaction is characterized as some form of equity participation, • the lender actually becomes an investor whose investment is at risk; and • there may be no obligation for the producer to repay the loan (which on the surface sounds good for the producer).

However, characterization as an equity investment may also result in • the producer’s having sold an unregistered security to a passive investor, thus triggering securities compliance requirements; and • the creation of an entity (e.g., joint venture or association) that may have to bear unfavorable tax consequences. 149


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The factors that determine whether a transaction creates debt or equity include the following: Recourse. Whether the loan has recourse against (has the right to demand repayment from) the general assets of the borrowing entity (a nonrecourse loan secured only by the film is more likely than a recourse loan to be considered an equity investment). Fixed repayment date. Whether a fixed repayment date has been established (a fixed repayment date suggests that the transaction should be characterized as a loan). Secured loan. Whether the transaction is secured (security suggests a loan). Interest tied to profits. Whether the rate of interest on the “loan” is tied to the amount of profits earned by the film (if the interest rate increases with the level of profits, that increases the chances that the transaction would be characterized as an equity investment/security). Creative control. Whether the lender exercises substantial control over the production (the more control exercised, the less likely the transaction would be characterized as a loan). Subordination. Whether the “lender” subordinates, that is, takes a second position to third parties with respect to payments made from the film’s revenues (subordination suggests something other than a loan). Other lenders. Whether another lender would have lent funds on the same or similar basis. Imputed interest. Whether the interest on the loan was set at or below market rates. If the lender on a film actually provides the producer with a below-market interest rate, the Internal Revenue Service (IRS), based on Code Section 7872, may, in certain circumstances, add interest to the transaction. This only rarely occurs, and such rules would only be involved if the relationship between the borrower and the lender indicates that the lower interest rate was intended to transfer wealth from the lender to the borrower, as is sometimes the case in father/son transactions. Types of Loans To obtain a bank loan of any substantial size, it is almost always necessary to offer some collateral; that is, to place within the legal control of the lender some property that may be sold in the event of a default and applied to the amount owed. Collateral is an asset pledged to a lender until a loan is repaid; that is, property, including accounts, contract rights and chattel paper that have been sold and are subject to a security interest. Third party (nonbank) feature film development loans (1) may be 150


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secured by some form of hard asset and (2) usually have recourse to the borrower; that is, the lender can seek repayment directly from the borrower personally in the event of default. (Again, banks are not likely to make loans for significant amounts of funds unless such loans are collateralized with assets.) If a corporate production company is the borrower, the lender may also make the principals of the corporation personally liable for repayment of the loan. In addition, other guarantors may be required to assure repayment of the loan’s principal and interest. Recourse loans. Often loans to film producers will be made on a recourse basis; that is, the loan will be made only if an endorser or guarantor (e.g., the producer) is made personally liable for payment in the event the borrower (e.g., the production company) defaults. Again, such a loan is extremely risky for an individual film producer, not only because the economic performance of a feature film can never be predicted with any certainty, but also because the likelihood of a movie generating sufficient revenues that some actually get back to the producer is minimal. Most lending originates with banks, although individuals may provide loans for start-up or development costs. Bank loans may be a common type of financing for most businesses, but it is not necessarily a typical form of financing for low-budget, independently produced feature films. As noted above, in most instances a lender, whether bank or individual, making a conventional loan will require that the borrower put up some sort of collateral to insure repayment of the loan. Collateral for most business loans may more specifically take the form of • a pledge of accounts receivable (i.e., money owed to the business), although this form of collateral is not likely to be available to most start-up film production companies; • inventory (also not commonly available for use as collateral by a film production company); • real estate (more likely to be owned by an individual as opposed to a film production company); and • other tangible and intangible property.

As noted earlier, banks making loans to a small, privately owned company will typically require the individual owner or owners to personally guarantee repayment of the loan and to sign one or more promissory notes to help insure that repayment. On the other hand, it is altogether another decision whether a filmmaker seeking such a loan (backed by either some form of collateral or a promissory note or both) should actually go through with such a transaction to raise money for a high-risk venture like producing a feature or documentary film. 151


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Term loan. The term loan is the simplest form of commercial bank financing. With a term loan, the film producer borrows a specific amount of money that is paid back over a specific period of time (usually more than a year). A term loan is usually repaid in equal installments of principal and interest. However, some term loans reduce or eliminate principal payments until the loan is due, at which time the entire outstanding principal amount is payable. A small term loan made to an individual filmmaker may serve to provide some start-up funds. However, such a loan is not likely to be made unless the filmmaker is otherwise employed with a steady income and good credit or has the backing of collateral. Lines of credit. A line of credit is a nonbinding commitment by a lender to lend up to a specific amount of money from time to time. Lines of credit usually do not exceed one year but may, at the bank’s option, be renewed each year. Revolving credit loan. A revolving credit loan is similar to a line of credit. The lender commits to loan up to a specific amount from time to time as required by the borrower. Usually the loan is payable in full within a year or less. The terms of a revolving line of credit are almost always set forth in a formal loan agreement. Unlike a line of credit agreement, the bank is obligated to lend the amount requested by the borrower provided that, at the time of each request, the borrower is in compliance with all the terms and conditions of the loan agreement. Amounts borrowed and prepaid may be reborrowed during the term of the agreement so long as the total amount of borrowed funds at any one time is not more than the preset maximum amount. Revolving credit loans often have other requirements regarding renewing the loan or requiring repayment of the entire amount of the loan. Letters of credit. In addition to direct production financing, some banks allow for film acquisition financing by means of letters of credit. These banks will issue a letter of credit on behalf of a borrower for the benefit of a licensor or supplier of the film. A letter of credit is a financial instrument or document issued by a bank that guarantees the payment of a customer’s bank drafts up to a stated amount for a specified period of time. The letter of credit substitutes the bank’s credit for the buyer’s and eliminates the seller’s risk. Letters of credit are used extensively in international trade. The letter of credit may take several different forms: • commercial letter of credit, normally drawn in favor of a third party, called the beneficiary; • confirmed letter of credit, provided by a correspondent bank and guaranteed by the issuing bank; 152


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• revolving letter of credit, issued for a specified amount and automatically renewed for the same amount for a specified period, permitting any number of drafts to be drawn so long as they do not exceed its overall limit; • traveler’s letter of credit, issued for the convenience of a traveling customer of the bank and typically listing correspondent banks at which drafts will be honored; and • performance letter of credit, issued to guarantee performance under a contract.

Credit Card Lending Obtaining money through credit cards is a form of lender financing. Even though stories are reported in the trade every so often that some lowbudget filmmaker used credit cards to complete a film, such use of credit card financing is, at best, a desperate move. Even though a credit card may offer low or no interest for a brief introductory period, borrowing heavily on a credit card in hopes that a film will provide a return with which the credit card debt can be repaid almost inevitably insures that the debt will still exist when the much higher credit card interest rate kicks in. Thus, credit card financing is likely to turn out to be extremely expensive. There are some advantages to credit card purchases: • more convenient because there is no waiting for check approvals; • easier to track monthly expenses because they all appear on the same statement; • purchases are protected by the credit card company against nondelivery and damage; and • rebates are offered by some credit cards in the form of frequent flyer miles, cash toward the purchase of vehicles or money for charity.

In those rare situations in which a filmmaker feels he or she must use a credit card to finance the production or development costs associated with a feature film, the credit card should be used only as a last resort and only for a small portion of the film’s costs. A filmmaker using credit cards, like any consumer, should always be aware of the interest rate being charged and try to use the credit card with the lowest interest rate. The bank or other institution offering the credit card may be willing to lower the rate upon request. Since the interest rates on credit card debt are typically much higher than rates for other debt, it is best to keep credit card balances at a minimum and to always pay more than the minimum amount due each month, so as to reduce the balance as rapidly as possible. 153


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The Question of Usury Independent producers whose films are being financed by a studio or others who charge interest on the production monies provided may want to consider whether usury laws apply to the transaction. Usury is an unconscionable or exorbitant rate of interest; that is, an excessive and illegal requirement of compensation for forbearance on a debt (interest). State legislatures in each state determine the maximum allowable rates of interest that may be demanded in any financial transaction. However, usury laws generally do not apply to corporate borrowers, so in all likelihood, the usury laws will not apply to lending by a studio since it will usually require that the production company be incorporated. On the other hand, it would be interesting and revealing to know whether the interest rates charged by the major studio/distributors would be considered usurious if the loans were made to individuals, since if the only difference between an individual borrower and a corporate borrower is some paperwork, the corporate vehicle was merely being inserted into the transaction to circumvent the usury laws. Bad Advice Some entertainment attorneys encourage independent producers to simply use promissory notes to raise production money. They claim that such loans are preferred because the transaction can often be structured in a fairly simple and inexpensive manner (i.e., lower attorney fees for that initial transaction, but higher fees for the rest of the production-related entertainment work). A short promissory note, they say, can be used, and the transaction often is not subject to the complex security laws that govern many investments. Thus, as the scheme goes, there is no need to prepare a private placement offering memorandum (PPM), which is really the point: that is, these entertainment attorneys are really saying the producer does not need to pay a securities attorney to prepare a PPM. On the other hand, these same entertainment attorneys often fail to point out that if the promissory note is called a “loan” but in reality is more like an investment, the courts will likely view the transaction as an investment. Giving a supposed creditor a “piece of the back-end,” or other equity in the project not only makes the transaction look like an investment, it may also convert the transaction into a securities transaction for which no attempt has been made by the producer to comply with the federal and state securities laws. In many instances, these entertainment attorneys are merely playing games with the independent producer and inviting them to engage in a scheme designed to circumvent securities law compliance. After all, how 154


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many low-budget independent producers have enough money to pay back several loans (large enough to produce a movie) based on promissory notes? Not that many. Which means that they clearly intend for the loans to be paid back out of the revenues generated by the exploitation of the film, and any entertainment attorney providing this bogus advice knows it. A so-called promissory note that depends for its repayment on revenues being generated by the exploitation of the film is a profit participation agreement (a form of investment contract) and if provided by passive investors it is clearly a security, prompting the need to comply with the federal and state securities laws. Further, what individuals in their right mind would loan money to an independent film producer who has no readily available assets from which to pay back such loans? Such a transaction would be a sham. So independent producers need to be careful when dealing with entertainment attorneys or other attorneys who suggest that promissory notes are useful and less expensive in situations where the producer knows he or she cannot repay the loans unless the film makes money. If the transaction is a security, go ahead and accept the responsibility to comply with the federal and state securities laws like any responsible business person. When an entertainment attorney starts encouraging a producer to avoid complying with such laws, using shady tactics, it is probably best to just walk away. Advantages Lender does not share in net profits. Producers who borrow money from a lender are generally not obligated to allow the lender to share in any of the film’s net profits or net proceeds (or the producer’s share of such moneys); that is, the lender’s consideration for making the loan is generally limited to the fees and interest charged. No lender creative control. Lenders do not generally exercise any creative control over the production of a motion picture. Noncollateralized loans. Loans not supported by collateral may be suitable for development money or the financing of an ultra-low-budget picture. Disadvantages Must be repaid. Loans generally have to be repaid regardless of whether the film makes money. Incorporation requirement. Most lenders will require that the production company organize as a corporation so as to avoid any possibility of usury problems. Incorporating adds additional expense to the transaction 155


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for the producer and creates an entity that must be properly maintained by the producer over the years. Collateral may be lost. A feature film production money loan supported by hard asset collateral, for example, the family ranch, is a good way to lose the ranch. Noncollateralized loans are limited. Loans not supported by collateral are generally not available except for small amounts of money. Specific term. Loans are generally repayable at a specified time, regardless of whether any of the revenues generated by the motion picture in any markets and media have been received by the borrower-producer. Completion guarantor required. Banks generally require that the producer contract with a completion guarantor to protect the lender against the risk of budget overruns, thus causing the producer to spend money on the completion guarantor’s fees and in all likelihood causing the production budget to be increased so as to decrease the chances of exceeding the budget. Personal liability may be required. Some lenders may make the producer personally liable for the repayment of the loan in addition to the liability of the corporate production company. Tax consequences. Tax problems may occur if the lender provides the loan at below-market interest rates.

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20 Negative Pickups and the Artificial Version Negative Pickups A specific form of lender financing that has developed in the film industry is referred to as a negative pickup. The term refers to the commitment made by a distributor to a producer to purchase or license feature film distribution rights from the producer and the distributor’s guarantee to pay an agreed-upon purchase price (pickup price) when the distributor picks up the film negative after delivery of the completed picture. The commitment is usually made prior to the start of production and certainly prior to the completion of the film. If the negative pickup deal is with a distributor that meets the criteria of entertainment lenders—for example, a major studio/distributor or sometimes a financially stable independent distributor—the producer may be able to take the distribution agreement and guarantee to a bank or lender where it can be discounted; that is, for a fee paid to the bank, it is converted into an amount of cash less than the face value of the contract. Such funds may then be used to pay for some or all of the production costs of the film. Since the actual production funding is coming from a third-party entertainment lender, the major studio/distributors consider a negative pickup to be a form of off balance sheet financing. Sometimes, the term negative pickup or pickup is used to refer to a sale or license of distribution rights at any time, even after completion of the film. However, when a film is independently financed and presented to a distributor for pickup, that distributor transaction is more accurately referred to as an acquisition or pure acquisition, which is documented by an acquisition/distribution agreement. It would be less confusing if the term negative pickup were reserved for use with the lender-financed transaction described above and the term acquisition were reserved for use when the production costs of an independent film were financed independently from the distributor and the distributor merely acquired the right to distribute the completed film. Then the term pickup could be dropped from the film industry vocabulary altogether. 157

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Negative pickup deal variables. The important variables in such transactions include whether an advance payment is made to the producer upon signing of the negative pickup distribution agreement (and if so, how much), whether an advance is paid to the producer upon delivery of the completed film (and if so, how much), whether the distributor provides a guarantee to the producer and whether the producer obtains a continuing participation in the revenue stream generated by the exploitation of the motion picture. Producer considerations. In addition to the financial stability of the distributor, a principal consideration for the producer is the pickup price. Usually the price will be pegged to the estimated negative cost of the picture. The amount of the producer’s profit participation, if any, will vary depending on a number of factors, such as the amount committed to be paid by the distributor, the rights acquired, the anticipated prospects for the picture and the perceived risk for the distributor. Typical provisions. The negative pickup distribution agreement is typically a lengthy contract. The principal variable provisions include the rights granted, the territory, the term of distribution, the consideration (pickup price) and the producer’s percentage participation in net profits (see an example of a negative pickup distribution agreement in Film Industry Contracts). Producer’s negotiating strategy. In negotiating the negative pickup distribution agreement, the producer should try to avoid or minimize contingencies to the distributor’s performance. The producer should eliminate as many grounds as possible that the distributor may be able to use as a basis for refusing delivery of the film, for example, because the final picture reflects insignificant differences from the approved script. What the distributor wants. In negotiating the negative pickup distribution agreement, the distributor will typically ask for all rights of every kind in all territories. The distributor will take the position that it is entitled to all rights since its domestic theatrical advertising and promotional expenditures for the film will enhance the value of all other rights. The distributor also will want to be able to use its sole discretion relating to the manner, method and timing of distribution of the motion picture and in the exploitation of the picture’s ancillary rights. Drafting the agreement. One of the major problems involved in drafting a negative pickup distribution agreement is describing in words the motion picture that the producer is obligated to deliver. The script must be mutually agreed upon and adhered to during production, unless provisions are included for distributor approval of necessary changes. Otherwise, deviations from the script during production may render the film unac158

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ceptable to the distributor. The negative pickup/distribution agreement must include references to, and guarantee the involvement of, certain key people in the production of the film, such as the director and principal cast members. The agreement must also define acceptable standards of technical quality for the film. Disputes relating to this issue may be resolved by the film laboratory, although if the distributor picked the lab, there may be some question as to its loyalties. The distributor will also generally want the agreement to include a copy of the film’s budget (as an exhibit) in order to provide assurances that the producer will have enough money to produce the type of motion picture anticipated by the distributor. Contingency plans. Many things can go wrong in the production of a motion picture and often do. Thus, the producer should try to include contingency options in the agreement to provide for some producer flexibility in resolving problems that do occur, such as script changes or actor replacements. Retained rights. In some situations, the distributor acquires something less than all rights, with the producer retaining specified territorial or media rights that he or she has already presold or intends to exploit through separate agreements with third parties. The ability to retain such rights depends first on the producer’s willingness to ask for such concessions and then on the relative bargaining strength of the parties. Unfortunately, few producers have the kind of leverage required to extract such concessions from distributors. Clearance. Producers must ensure that they have or will obtain by the time of conveyance to the distributor all rights that they intend to transfer. They must secure the copyright in the underlying property and must procure any necessary release from persons who may have claims relating to the subject matter of the motion picture. They must also ensure they have complied or will be able to comply with all of the distributor’s delivery requirements, such as lists of credits and insurance certificates (see a detailed list of delivery requirements appended to the sample distribution agreements found in Film Industry Contracts). Delivery requirements. The producer or the producer’s attorney must be very careful in examining the distributor’s description of delivery requirements for the film, as well as the required production elements, such as cast, director, script and budget. If the distributor can refuse delivery on subjective grounds, the negative pickup agreement may not be acceptable to a bank or other financier. The producer should therefore try to eliminate from the negative pickup agreement with the distributor subjective grounds for refusing delivery (such as artistic quality) and try to focus the agreement on objective grounds (such as technical quality). 159

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Negative pickup versus distributor guarantee. The main difference between a negative pickup and a distributor guarantee is that the negative pickup does not necessarily imply that the distributor guarantees the repayment of any production loan or investor funds. Instead, the distributor merely agrees to distribute a producer’s film, contingent upon delivery of the completed picture pursuant to the terms of the delivery schedule. Sometimes the distributor will agree to pay the producer an advance against the film’s profits, payable on delivery of the completed motion picture. Any over-budget costs in a negative pickup deal are solely the responsibility of the producer, who must arrange for a completion bond that will guarantee delivery of a finished film to avoid this overbudget risk. Thus, there is little or no risk for the distributor or the bank if for any reason the film is not finished or in any way fails to meet the requirements set forth in the negative pickup agreement. Laboratory letter. Upon completion of the film, assuming that all the terms of the negative pickup distribution agreement have been met by the producer, the film lab (or other mutually agreed-upon third party) will issue a letter stating, among other things, that the finished film is of acceptable commercial quality, that the script adhered to the standards set out in the agreement and that the preapproved cast members appear in the finished film in their proper roles. Upon receipt of the film and the laboratory letter, the distribution advance, if any, should be released to the producer (or to the lending institution to pay back the production loan). Producer advance is recoupable. Sometimes an advance payment is made, with the balance paid upon delivery of the picture. It is not unusual for a payment made on signing or upon pickup to be considered an advance that is recoupable by the distributor out of the gross receipts or out of the producer’s percentage participation in the net profits of the film. In some cases, the distributor will put the agreed-upon sum (advance) into an escrow account for payment to the producer on delivery of the motion picture. To the extent that the producer is able to negotiate a larger advance, the producer’s percentage participation in the picture’s net profits is likely to be reduced. Requirements of the distributor. The distributor will typically require that the completed picture meet certain requirements: • • • • •

the film is in substantial compliance with the approved script, specified cast members appear in their proper roles, the approved director has directed the film, the ceiling on the film’s running time has been adhered to and the film has a certain MPAA rating.

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Producer participation in net profits. Whether the producer will be able to participate in the picture’s net profits to some extent depends on the size of the advance he or she negotiated, whether any portion of the advance was payable upon signing the negative pickup distribution agreement, whether a distributor guarantee was provided, whether there are any gross participants involved in the picture and how much discretion in making such payments the distributor is given in the distribution agreement. Distribution agreements substantially similar. The terms and provisions found in a negative pickup distribution agreement are very much like those found in the production-financing/distribution (P-F/D) agreement and the acquisition/distribution agreement. The major differences relate to who provides production financing for the film and when the agreement is signed. Many of the more extreme provisions have been ruled “unconscionable” (i.e., so unreasonably detrimental to the interests of a contracting party as to render the contract unenforceable) by courts. On the other hand, distributors continue to use such unconscionable provisions simply because they can (see The Feature Film Distribution Deal). Advantages Comfort for investors. In the alternative, the producer may use the distributor commitment to provide assurances to an investor group (e.g., limited partnership or manager-managed LLC) that distribution for the film is in place and, if a distributor guarantee is included, to reduce the downside risk for investors. A distributor’s pickup commitment letter or agreement documents strong distributor interest in the project and presumably provides the investors with an improved chance to recoup at least a portion of their investment (assuming the distributor has the financial wherewithal to support its commitment). Risk of no distribution. By producing a film without a distributor commitment, the producer assumes the risk that an acquisition/distribution deal may be difficult or even impossible to negotiate for the completed film. Thus, some producers regard a sale after completion of the motion picture as a less desirable method of proceeding than a prior distribution commitment. These producers sometimes prefer to make their distribution arrangements as early as possible, as in the negative pickup arrangement, rather than later, when distribution may be difficult or even impossible to find. By not obtaining a negative pickup arrangement, the producer runs the risk that the film will not be as good as anticipated and that little or no distributor interest will develop after completion.

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May be only alternative. If a studio development deal or a P-F/D arrangement is not available to a given producer for a specific feature film and the producer is not inclined to go the investor financing route, then the negative pickup arrangement may be the only available choice for financing a film. The studio perspective. From the point of view of the studio/distributor, it is not taking much risk in the negative pickup transaction because if the negative is not delivered, the studio/distributor has no obligation. This sometimes makes it easier for a producer to obtain a negative pickup deal with a studio than a production-financing/distribution agreement through which the production funds are actually loaned by the studio. Obligation to pay. If the negative is delivered in accordance with the delivery requirements imposed by the studio/distributor in the negative pickup distribution agreement, but the picture is not very good in creative terms, the studio is still obligated to pay the pickup price, although the distributor’s support for the film may be minimal. Over-budget risk. In the negative pickup arrangement, the distributor does not share in the risk that the film will go over budget, since a completion guarantee will have been provided by the producer. Any advance upon signing is usually so nominal (if any is provided at all), that the distributor runs very little financial risk if the film is not delivered as and when promised. Competing distributors. Often distributors miss out on obtaining rights to a good picture because another competing distributor committed to distribution at an earlier stage. Thus, producers may be able to use this competition to their advantage in extracting a negative pickup commitment from a distributor for what appears to be a promising movie package. Domestic distribution commitment. The negative pickup provides some assurance that the film will be distributed domestically. This may be an important factor in securing foreign or ancillary presales. Risk reduction. From the point of view of a lender or investors, the negative pickup removes most of the risk relating to lack of distribution in financing a motion picture. Disadvantages Production funding. The producer has to obtain production financing for the film from sources other than the studio or distributor. More restrictive terms. Some producers feel the negative pickup agreement locks them into more restrictive terms than if they were to arrange production financing without a distributor commitment, believing that

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if the picture turns out to be as good as they envision, they will be in a position to negotiate more favorable terms in an acquisition/distribution agreement. Risk/reward ratio. As a general rule, the more risk the producer assumes relative to the distributor, the better the deal the producer will be able to negotiate. Thus, there is an incentive for a producer not to enter into a negative pickup agreement if financing can be secured without one. Less expensive for distributor. Assuming the same level of quality for a movie, it is generally less expensive for a distributor to make the commitment to purchase a motion picture before the film is completed as opposed to after the film is completed. With a good movie in the can, a producer may try to create a bidding war between distributors for the right to distribute the film. Speculative deal. From the distributor’s perspective, the negative pickup can be highly speculative. No one can accurately predict the quality of a given film in its completed form as a motion picture. Complex transactions. Negative pickups are complex, document-intensive, time- consuming and difficult to get. For a producer without a substantially packaged property, a negative pickup deal and distributor guarantee are virtually impossible to obtain, and without both of them, a bank loan for production financing is usually out of the question. A circuitous route. The negative pickup distribution deal and documentation can be complicated, particularly since the producer will be trying to take the negative pickup distribution agreement and guarantee, if any, to a lending source to induce it to lend production funds before the picture is made. In that scenario, the producer will have to satisfy the requirements of the distributor in order to secure the negative pickup distribution agreement (and possibly a guarantee), will have to get that agreement from a distributor (and on terms) that the lender approves, will have to obtain a completion bond for the picture from a completion guarantor that the lender approves and may have to provide additional collateral for the production loan, such as presales or hard assets. Favors those with a proven track record. Negative pickups usually go to feature film producers who have an established track record and relationships with studios, distributors, completion guarantors and lenders. Limited availability of suitable lenders. Negative pickup loans are generally only available through banks or other lenders based in Los Angeles or New York since they are typically the only lenders who have the expertise to judge the creditworthiness of the distributor whose paper is being discounted.

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Artificial Pickups A film project originally controlled and developed by a studio/distributor but that has been farmed out pursuant to a negative pickup deal to an outside production company is referred to as an artificial pickup. Artificial pickups are sometimes utilized by the studios partly to avoid the higher costs of certain below-the-line union crews they might have to pay if their projects were produced in-house at the studio or on a production-financing/distribution agreement basis. A controversial article of the International Alliance of Theatrical and Stage Employees (IATSE) union contract allows major studios to fully finance nonunion movies and television shows so long as the studios declare they have no creative control and give the union thirty days’ notice before production starts. Many union supporters contend Article 20 has helped to increase nonunion movie production. IATSE is the parent organization of some one thousand plus local unions in North America representing every branch of film production, including stagehands, makeup artists and wardrobe handlers, as well as employees in film distribution and exhibition. As has been reported in industry trade publications, the studios sometimes pursue this method of cutting costs—develop a picture up to the point of production, then farm it out to an independent producer and call it a negative pickup. It is difficult to determine how many films are produced in this manner, but some estimates have been as high as one-third of the studio releases, especially on lower-budget films. In addition, at times the unions have appeared to go along with the arrangement. With an artificial pickup, crew sizes and rates usually are lower, and indie producers get better union deals than the majors. Also the nonunion shoots pay no health insurance benefits, no pension benefits, no overtime or meal penalties. When the major studios farm out their artificial pickups they claim no artistic control in the picture and make a distribution deal only. In point of fact, however, they are financing nonunion work and cutting off thousands of union members from their pensions and other benefits. Advantages Studios save money. The artificial pickup allows the studio to make a motion picture (which it developed) for less money than would be required if the film were produced as an in-house production or on a production-financing/distribution basis.

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Some producers benefit. The artificial pickup permits some independent producers, who might not otherwise have the opportunity, to produce a studio-developed film. Disadvantages Union relationships. The artificial pickup arrangement is obviously controversial and a producer may be hurting his or her relationships with various unions and guilds by participating in such an arrangement. Less creative control. Even though a completion guarantor will be required to substitute its monitoring activities and judgment for the assigned studio representative, the producer will still likely feel indebted to the studio for the opportunity to produce the project and thus will be more likely to accede to the studio’s wishes on certain creative issues.

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21 Presale Financing Another variation on lender financing involves the use of multiple distribution contracts as collateral for the production loan. Presale financing, in the broadest sense, refers to the funding of a film’s production costs through the granting of a license for film rights by a producer to a distributor in a particular media or territory prior to completion of the film. These distribution contracts are then used as collateral to support a bank loan. Presales may actually take the form of funds, guarantees or commitments that may be obtained or used to obtain funds, in addition to other available production financing in the form of cash advances or guarantees paid by domestic or foreign distributors, pay or cable television systems, DVD producers, television syndicators and bank loans obtained by using such cash advances or guarantees as collateral. For example, if a producer had a contract for the presale of a movie to a U.S. or foreign distributor, a home video company, a pay-TV service or a TV syndicator, the producer might be able to present those contractual commitments to a bank and walk away with cash (for a fee). In this broadest sense, the negative pickup arrangement is a form of presale, although presale transactions are more commonly associated with foreign territories. Some Speculative Numbers A bank spokesperson once estimated that foreign presales are typically involved in 60 to 65 U.S.-made films each year. Assuming that somewhere between 400 and 450 U.S.-made films are distributed in the domestic theatrical marketplace in a given year, only 14 to 16 percent of the motion pictures released in a given year (or about 1 in 6 or 7 movies) utilize foreign presales. To the extent that foreign presales are available for a given film, such sales may typically account for as much as 60 percent of a film’s budget. That, of course, means that other forms of film finance will need to be used to raise the balance of the film’s budget. 166

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Definitions Presale. A presale is an advance sale or licensing of distribution rights in various media and territories. Presale agreement. In the broadest sense, a presale agreement is a contract involving the licensing of a feature film that is signed in advance of completion of the film and often in advance of commencement of principal photography. Such agreements may be used by producers to obtain production loans from banks or other lenders (on a discounted basis). In the view of some lenders, the simplest and most desirable form of agreement is the single distribution agreement that covers all rights worldwide. That type of arrangement is usually referred to as a worldwide negative pickup. In the alternative, such an agreement can be limited to the United States and Canada (domestic territory). That would be called a domestic pickup. As noted above, a negative pickup is a form of presale. Fractured-rights deal. A fractured-rights deal is a film finance and distribution transaction in which the film’s producer (or representative of the producer) presells domestic video and international rights and then engages a distributor to distribute in the domestic theatrical marketplace for a fee. Sometimes the producer also retains all domestic television rights. The presales may cover some or all of the production costs and some or all of the domestic releasing costs for the picture, leaving the producer’s share of theatrical revenues and television rights for potential net profits. Fractured-rights deals worked (1) before video became a significant revenue source for the major studio/distributors (thus, the studios did not demand to participate in the video revenue stream at that time); (2) when independent video companies were still paying substantial fees for video rights, (3) when more banks were prepared to lend money to support these deals and fund production; and (4) when the funds supplied by independent video companies and outside banks were sufficient to cover production costs and a significant portion of domestic releasing costs. The fractured-rights deals have generally been replaced by the so-called split-rights deals. Split-rights deal. The split-rights deal is a film finance and distribution transaction in which the producer presells all domestic rights to a distributor and retains international rights. The split is between domestic and international rights. By keeping the international rights on a promising film that is prepackaged and financed, the producer may be able to sell the international rights on an auction basis to the highest bidder. The total price obtained may exceed the actual costs incurred in making the 167

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film. In addition, the domestic and international rights are not cross-collateralized (i.e., they are uncrossed) with respect to the producer. In the event that the film is well received at the box office either in the domestic marketplace or internationally, the producer may earn more overages than in a crossed situation, such as a worldwide negative pickup or P-F/D deal. The producer may also be able to limit the studio/distributor’s term of rights in split-rights deals, insuring that the film ultimately becomes an addition to the producer’s library of films, not the distributor’s. Note again that lenders do not consider the distribution agreement alone a presale contract. In their view, in order to be a presale contract, that is, one that is lendable, the contract must guarantee the payment of a specific amount of money by a certain date, and a distribution agreement alone (as opposed to a distribution agreement with a guarantee) only provides that the distributor will distribute the film to exhibitors. A feature film’s distribution rights as to separate media may be fractionalized and presold pursuant to separate agreements relating to video rights, pay television rights, theatrical rights, U.S. network television rights and possibly even local television syndication rights. In addition, presales may be negotiated for foreign territories and in fact may begin with the foreign territories (foreign presales). Presales Used to Finance Production Costs The role of the sales agent. The producer typically contracts with an experienced sales agent to make presale arrangements on behalf of a film. Such responsibilities may be divided among domestic and foreign sales agents (see “Know your buyer” below). The foreign (or international) motion picture license agreements are generally entered on a territoryby-territory basis; thus, the foreign sales agent would be helping the producer obtain multiple distribution contracts from foreign distributors in various foreign countries. What the producer gets. The sales agent at one time might have been able to obtain a 10 to 20 percent cash deposit from a territorial distributor at the time of signing the presale agreement (although that is less likely in today’s marketplace) and would seek to obtain a minimum guarantee payable upon delivery of the motion picture to the buyer. It is more likely today that the sales agent will get a presale agreement that is backed by the purchasing entity’s letter of credit or other form of financial guarantee; for example, a guaranty provided by a financially sound third party to insure payment of contracts by foreign distributors who are not considered financially strong by the lender. In this example, the producer might be required to assign a portion of the picture’s net profits to the 168

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guarantor for providing the guarantee; however, that eliminates one of the big selling points for using a loan for production funds. The producer then goes to the lender. The producer then may be able to take the presale agreement to a bank or other lender and use it in conjunction with distribution agreements and guarantees, other presale agreements or other forms of collateral to obtain a production loan, which alone may cover the cost of producing the film or may be used in conjunction with other financing sources (e.g., investor funds) or other financing techniques (e.g., deferrals, government subsidies, etc.). The producer will try to borrow money by pledging the presale agreement itself. However, many U.S. banks will not discount (i.e., lend against) foreign paper. Alternatively, the producer may be required to obtain a letter of credit from a foreign buyer. A letter of credit is generally considered more bankable than a contract to pay the same amount of money. Some banks specialize in discounting the distribution contracts of foreign territorial distributors and may require letters of credit. The lender’s judgment. A lender will make an independent judgment as to whether to lend on a given presale agreement, based on the reputation and track record of the presale purchasing entity and the terms of the agreement itself. A letter of credit put up by the presale purchasing entity would provide the lender with additional security and make it more likely that the lender would be able to lend on the presale agreement. Discounting. Once the bank has determined (through weight analysis) the loan amount, it then discounts that amount to arrive at sums allocated for the production of the film, a production contingency, loan fees, the bank’s legal fees and interest. The bank then sets up a production account and a reserve account (from which to pay all items other than the production monies). The investor alternative. The producer does not always have to take the presale agreements to lenders but may opt for using them to reduce the downside risk for investors who finance the film project. Thus, if for any reason, the presale contracts are not considered lendable by lenders (banks and other lending institutions), the producer may want to consider investor financing alternatives. Sales agent fees. Sales agent fees may range from approximately 10 to 15 percent if the sales agent is not able to negotiate any form of guarantee from the presale purchasing entity (such as an irrevocable letter of credit), but with some form of financial guarantee provided by the presales purchasing entity, the sales agent’s fees may increase to as high as 30 percent. Cash payments, either at the signing stage or as an advance payable upon delivery, may also tend to increase the sales agent’s fees. 169

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Issues that may be negotiated. The prospective quality of the picture (i.e., the strength of the package), along with the competitive environment and the general demand (or lack thereof) for the product in a given market, will help determine whether the sales agent is able to successfully negotiate on behalf of a producer’s film. Questions relating to what rights are included, the film’s genre (e.g., action/adventure or comedy), censorship, price ceilings imposed by local industries, the amount of deposits paid by the buyer to the sales agent on behalf of the film producer, minimum guarantees to be paid on delivery of the picture and back-end participation will typically be considered in such negotiations. A presale strategy. The producer should try to retain as many rights and territories for sale after completion of the motion picture as possible; that is, presell only as many rights and territories as necessary to cover the production costs of the picture. The role of hype. Some suggest that the desire of the distributors to distribute a particular film is to some extent based on industry hype, such as announcements in the trades, and that such hype, typically generated by professional publicists, contributes to a certain level of presumed value for the film among the distributors. When to approach sales agents. Obviously the earlier the producer establishes lines of communication with a reputable sales agent, the better, since those early conversations with an agent who is out there on the front lines of the marketplace on a daily basis could provide invaluable guidance to the producer in developing and packaging the film. Ultimately, the sales agent will need a fairly complete package to be taken seriously by potential presale purchasing entities. Thus, a completed and budgeted script along with firm commitments from a director and “marquee” actors (i.e., with recognizable names) constitute the minimum package with which the sales agent can work. Of course, it also helps if the producer, coproducer or executive producer associated with the project has a reputation for having delivered commercial films on time and under budget in the past. The strength of the writer of the screenplay will also add value to the package. Know your buyer. The producer will, as a practical matter, have to rely on the judgment of the sales agent, but it is critical that the sales agent know how many films the prospective presale purchasing entity (buyer) licenses in a year, whether the buyer is well financed and whether the buyer has defaulted on a presale agreement in the past. Favorable information relating to these questions may decrease the likelihood of the default disaster discussed below. Obtaining letters of credit would also help alleviate the problems of a buyer default. 170

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Some financing in place. Part of the financing for producing a motion picture must be in place before presales can be attempted. In other words, at a minimum, the screenplay must have already been acquired or under option to the producer, and that typically involves an up-front, out-of-pocket expense for the producer (or possibly, investor financing). In addition, some payments are likely to be required to obtain real commitments from the director and actors. The producer’s package. From a presentation point of view, the producer needs to work closely with the sales agent in developing an attractive physical package that the sales agent may use in presenting the project to prospective presale purchasing or licensing entities. Such a package might include glossy photos of committed actors and actresses, their credits, narrative biographies and letters of intent or interest in the project, a movie poster, a synopsis of the screenplay, the credits and biography of the director, producer and other committed personnel, the projected cost of producing the film, location information, press clippings about those involved in the project, information relating to any existing distribution or presale agreements and so forth. Drafting Checklist for Presale Agreements Objective delivery. The completion guarantor and producer will want to insure that the distributor meets its advance payment obligations once delivery is made. Thus, the delivery schedule and obligations of the producer must be drafted as objectively as possible. Script approval. The distributor will generally want an approval right, that is, the ability to sign off on a specific final draft of the screenplay. However, in drafting that provision in the distribution agreement, some flexibility should be provided for the producer in anticipation of required script changes that fall within a reasonable range of directorial creativity or that are prompted by unavoidable problems that occur while shooting. Specified MPAA rating. Generally, the distributor will require that the producer commit to provide a film with a specific MPAA rating; for example, an R-rating. The producer and director must carefully weigh the risk of not being able to provide a particular rating for a movie based on the subject screenplay, since failure to comply with that requirement may allow the distributor to refuse to distribute the film, that is, avoid its obligations under the presale distribution agreement. Television cover shots. Typically, the distributor will ask that the producer commit in the distribution agreement to provide a version of the film that is suitable for broadcast on U.S. free television. This may be difficult, since each of the free television networks in the United States 171

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has a separate standards and practices department that passes on the content of feature films to be aired on its network. Some feature films (particularly R-rated films) do not meet the networks’ more restrictive standards. Thus, the producer should agree to provide cover shots that would be more likely to meet the network standards and should require the distributor to designate in advance which scenes would need them. Production versus distribution expenses. The producer should carefully review the long list of delivery items that is often part of a long-form distribution agreement and seek to eliminate items that should more properly be characterized as a distributor responsibility and expense rather than be paid for out of the film’s production budget. Something the distributor is responsible for will generally be recouped as a distributor expense. An item that is improperly characterized as a production expense, becomes part of the cost of the negative, and interest will be paid on the cost of all such items until the bank loan is repaid. A higher total interest cost can thus result. Running-time requirements. The producer’s counsel should also watch for an unduly restrictive ceiling on the running time for the film, since an arbitrary limit may saddle a producer and director with an unsatisfactory creative result or, in the alternative, provide the distributor with grounds for refusing to distribute the picture. Negotiations over all the issues discussed above, which tend to increase the likelihood that a film will be accepted by the distributor, also increase the receptiveness of a lender to loan production funds based on a presale agreement and guarantee. When presale contracts (with guarantees) form the collateral for a loan, the lender must determine that the collateral and the transaction are lendable. Advantages Presales may raise a significant portion of production financing. As an example, the discounted value of foreign presales (which typically include video and television rights for that territory) may equal 40 to 60 percent of a film’s production budget. Approximately 85 percent of the foreign territorial sales of American films (not just presold rights) come from eight of the forty countries that typically distribute U.S.-made films. Those eight most important foreign territories (listed by market share and assuming that Canada is part of the domestic market) are Japan, France, Germany, Britain/Ireland, Spain, Italy, Australia and Sweden, although these rankings may change from year to year. Less studio creative intervention. From a creative point of view, provid172

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ing financing for a feature film through presales reduces what in many instances is a problem for some producers and directors; that is, the oversight and interference of a major studio or distributor in the production process. However, lenders will require that a completion bond be provided, and the completion guarantor will generally have its representative actively monitoring the production. If problems occur, the completion guarantor’s representative will become very involved in day-to-day decisions that impact the budget, and it is difficult to separate budget decisions from creative decisions. Thus, discounted presales involving loans do not necessarily permit the kind of creative control so important to many producers and directors; that is, much of the studio intervention is merely replaced with intervention by the completion guarantor. No other production financing options may be open. If a producer cannot obtain studio production financing, a production-financing/distribution deal from other distributors, a negative pickup deal with a guarantee sufficient to interest lenders, or other collateral besides presales that is satisfactory to lenders or investor financing in some form (e.g., a limited partnership or manager-managed LLC), then the producer who is determined to make a film has little choice but to resort to fractionalizing or splitting media and/or territories and preselling some of those to generate lendable contracts to raise production financing through loans. No confidence in the upside. If a producer does not really have confidence in the economic upside potential of the picture about to be produced, presales make even more sense. And since very few motion pictures are big box-office successes at any level, how can any producer be that confident of the upside potential of a given film? Furthermore, since most producers do not generally participate significantly in the upside potential of their own films, the loss does not become a disadvantage for them. On the other hand, producers must include those factors in their analysis of the value of their motion picture when making the original deal with the distributor. From the buyer’s perspective. Through presale agreements, the prospective presale purchasing entity (licensee or buyer) hopes to secure the rights to exploit good films before a competitor has had a chance to license the same motion picture. Disadvantages Collection difficulties. Presales are based on contingencies; for example, the actual collection of moneys due from the providers of presale contracts often turn out to be difficult—often more difficult than collecting from domestic distributors. 173

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Market fluctuations. The market for presales comes and goes as the economies of various foreign territories weaken or strengthen and as the number of available films in the marketplace in any given year increases or decreases. Buyer’s market. So long as there is such a great disparity between the number of films produced and the number and capacity for distributors to distribute, the market will be a so-called buyer’s market for distributors (i.e., the law of supply and demand is working against the producers). Increased cost of prints and ads make presales less practical. Fractionalized and split-rights agreements have become less practical in recent years because of the increasing relative cost of U.S. theatrical distribution, including paid advertising and film prints. Domestic presales may eliminate certain distributors. U.S. theatrical distributors often insist upon all, or substantially all, rights to help recoup not only advances to the producer but also their increased distribution costs. That is, any ancillary right that has significant value will be demanded by the domestic theatrical distributor as a prerequisite of distribution. Thus, the producer who presells a film’s cable and video rights runs the risk of its being left out of a domestic theatrical release. And since the cable and video presale contracts will probably require a domestic theatrical release at a specified number of theatres, no domestic theatrical release means the cable and video agreements are likely to be voided as well. Cost-value trends do not favor fractionalized presales. As film production and distribution costs have increased, the percentage of revenue generated through a film’s domestic theatrical release has been reduced in relation to other media or territories. In addition, as the value of cable and video or DVD rights has increased, domestic theatrical distributors have been more likely to insist on domestic cable and video rights as part of any domestic theatrical distribution deal. More offers means less reason to presell. The more value a film is presumed to have, the higher the offers distributors and ancillary buyers are willing to make to keep their competition from buying the same rights. But the more offers the producer gets for ancillary rights, the more confident he or she can be that the film actually has value and that all rights can subsequently be sold to an important distributor. Gives away upside potential. Film production companies relying on presale strategies may succeed in reducing but not eliminating their risk of taking a loss, while giving away much of a film’s potential profitability. Presales bring lower prices. The price that a buyer is willing to pay before seeing a prospective film will generally be less than that which the same buyer would pay for the same film as a completed motion picture; thus, 174

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the upside potential is reduced. This means that production companies relying entirely on a presale strategy will have a difficult time surviving on a long-term basis. The “A” picture dilemma. Many industry observers today suggest that it is difficult to presell rights in major markets around the world without an extremely strong film package, the so-called A picture. But if a producer has an A picture, why should it be necessary to seek presales? On the other hand, the stronger motion picture package will generally require more money to finance; therefore, more presales may have to be made. Higher cost of capital. Companies relying on presales will inevitably have a relatively high cost of capital compared to some other forms of film finance. For example, in a foreign territory presale, a sales agent’s fee will typically be recouped in addition to the costs and fees of the foreign distributor before the producer will receive payments, if any, beyond the producer’s advance. Takes too much time. Since it generally takes much more time to contact and negotiate with multiple interested buyers of presold rights in the various media and territories, producers using presales may encounter a lengthier time lag between the start of production and the creation of library asset values on films produced and distributed through presale arrangements than some other forms of film finance. Contractual quagmire. From a contractual point of view, it is difficult to coordinate the various contractual concerns of the bank, the completion bond companies, the producer and the various media and territories when negotiating and drafting multiple presale agreements. Reversion rights and library values. When preselling rights to a film, the production company or its attorney must be careful to coordinate provisions relating to the reversion of such rights to the producer following exploitation of the film in various markets and media. If not, the film is likely to have less value as a library asset, and confusion over the status of such rights may make it difficult to include such film in the sale of a production company’s film library. Default disaster. If a licensee (i.e., the presales purchasing entity or buyer) sees a rough cut of the film and decides it is much worse than expected (or otherwise unsatisfactory), the buyer may notify the producer that it will not be paying the balance of the minimum guarantee and will forfeit its deposit, if any. In that event, the bank may demand that the producer repay the loan, and the producer may have to seek payment from the distributor. If the producer fails to repay the loan, the bank might foreclose on the negative if it took a lien as further collateral or attach the film and its proceeds even if it did not have an original lien. 175

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Simply not available. The availability of foreign presales vary from year to year, depending on larger economic issues in each of the countries that traditionally offer such presales. As an example, as the marketplace generally is flooded with more and more feature films, it becomes less necessary for distributors in foreign territories to prepurchase the rights. They may opt to simply wait until the films are completed. Survival of the weakest. Presales often support projects that perhaps could not and should not have been made; thus, producers seeking presale commitments may be looked upon with disfavor in some segments of the industry. Macroeconomics. Feature films financed in this manner increase the number of films produced in a given year and thereby increase the demand for, and thus the cost of, various film elements that are theoretically in limited supply (e.g., screenplays, directors, actors, sound stages, etc.). Also, since there are more films produced each year than there are capable and willing distributors available to distribute, the oversupply of films contributes to a significant imbalance in the bargaining strength between producers and distributors. The long-term view. Over the long term, the relatively few films that are highly profitable for a producer using presale strategies are likely to be insufficient in number or in degree of success to recoup the losses of the firm’s many nonprofitable projects. In other words, the thinner potential profit margins of presold films make it less likely that such a production company will financially succeed in the long run.

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22 Gap and Supergap Financing Gap financing is a variation of lender financing on a film for which the presale of territorial rights has yet to cover the entire budget (i.e., funds are still needed to produce the film and there are also unsold territorial rights in some of the top ten markets). In that sense, gap financing is merely an extension of the presale financing technique, in which the bank loans are partly based on unsold territories. As a preliminary matter, the films that are eligible for gap financing generally must be feature-length theatrical motion pictures intended for exploitation worldwide through various motion picture distributors and of a nature that might appeal to international moviegoers. Major studio/distributors will typically provide the financing for their films as in-house productions or through production-financing/distribution deals (see chapters 25 and 35). Some of the production costs for their films are financed as negative pickups, which require third-party bank loans. On the other hand, a significant proportion of independently produced feature films rely heavily on some form of debt, or what is referred to in this book as lender financing. In the current marketplace, it is also becoming common for bank loans to be supplemented by equity contributed by investors and by economic incentives of foreign governments. In point of fact, the financing arrangements may be the other way around, in that investor financing and other forms of film finance have to be put in place first, before a bank loan can be accessed; thus, the bank loan actually supplements the other forms of financing. In any case, several forms of film finance may be required to cover the entire production budget for today’s independent films. Independent producers typically utilize the services of sales agents (some of whom specialize in foreign sales only) to make the arrangements for these distribution contracts and then assign the contracts to a lender as collateral for repayment of the loaned funds. Many sales agents are members of the Independent Film and Television Alliance (formerly

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known as the American Film Marketing Association, or AFMA) a trade association for the independent film and television industry. Most of these various forms of lender financing rely primarily on the promise of specified payments to be made by distributors (foreign or domestic) who sign distribution agreements and guarantees (i.e., distribution contracts) executed prior to the due date for the loan repayment. These distribution contracts grant distributors the right to exploit the film (in various media) within their geographic territory for a fixed period of time. Such contracts stipulate a minimum guaranteed amount that the distributor agrees to pay unconditionally for the distribution rights. While there may be an advance, most of the amount promised becomes due and is payable when the film negative is made available to the distributor, usually by delivery to a bonded laboratory in the same country. As noted above, gap financing refers to bank loans secured by unsold international and domestic film rights in situations where the production budget has not yet been fully covered. Gap financing typically accounts for about 20 percent to 40 percent of a film’s budget. The bank relies on the judgment and experience of a foreign sales agent who makes representations to the bank as to the likelihood of the film being eventually sold in the remaining territories. Without such assurances from a foreign sales agent considered by the bank to be reputable, most banks will not make such loans. In some cases, the gap may be as high as 50 to 60 percent of production costs (so-called supergap financing). At the peak of the trend for insurance-backed deals some years ago (see chapter 23), it was not uncommon to see that form of film finance covering gaps of 40 percent or more. The more reasonable norm for more ordinary gap financing is 20 percent, although a producer who has an established relationship with a bank going back a few years may cover bigger gaps in this way. The extent of the gap may depend even more on the bank’s confidence in the ability of the foreign sales agent to provide reasonable estimates on future sales in the unsold foreign territories and on its own research. In effect, gap financing bridges the difference between revenue guaranteed by presales (or other forms of finance) and the balance needed for the film’s total budget. In a gap financing transaction, a bank advances film production funds sufficient to make up the difference between the agreed budget of the film (including all financing costs) and the other financing already in place through equity, license fees, presales and any other financing arrangements. The bank provides cash to produce the film using distributor contracts as collateral for the repayment of the loan, along with the completion 178

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bond to assure that the film’s production costs will not go over budget. The loans are repaid from the amounts received by the producer from the distributors when the film is delivered to them. Bank criteria. In deciding whether to provide a gap loan, the bank will assess its risks based on several criteria: • whether the future foreign sales estimates are being made by a reputable sales agent with a solid track record; • whether the sales estimates cover between 150 and 200 percent of the value of the gap loan under consideration; and • whether the sales estimates make the loan ratios realistic.

Banks involved in gap financing commonly create and maintain extensive databases of relevant information and often make their own sales projections based on precedent and their analysis of cast, director, budget, genre and other factors. If the bank’s estimates are significantly different from those of the sales agent’s, the transaction is less likely to be approved by the bank. Documentation. The lenders for gap-financed deals (as well as any of these various forms of lender financing discussed in this book) will typically require the following information or documents in addition to a completed application: • title of film; • name of production company, jurisdiction of formation, address, phone number and contact person; • résumé of the film’s producer and director; • literary property from which the film is to be based, including title(s) and author(s); • copies of chain of title documentation demonstrating ownership of the script; • full budget breakdown; • cash disbursement schedule; • copies of signed distribution contracts or license agreements for minimum guaranteed advances or, in the alternative, a list of potential payers interested in the project; • copies of all financing agreements, production services agreements and similar agreements made on behalf of the film; • copies of any contracts with equity investors, if any; • name and telephone number of a contact officer at any financial institution issuing standby or commercial letters of credit, if any; • description of marketable collateral, if any, to be pledged to further help secure the loan; 179

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• letter of intent to issue a completion bond from the completion guarantor, if any; and • copy of the business plan or securities disclosure document (private placement offering memorandum or prospectus), including financial projections, if any.

Film finance scams. Note that the above documentation and information list is similar to the many lists of criteria circulated on the Internet (and for years prior to the existence of the Internet) by film finance scam artists (or the sometimes unsuspecting finders for scam artists) who claim to be able to provide the financing for an independently produced feature film. Typically, they insist on an advance from the producer at the last minute to cover some imaginary administrative fee or other fictitious fee after the producer has been led to believe that the funding is in place and the project has been approved. Be aware that the mere existence of a list of criteria that appears to be credible has nothing to do with the legitimacy of the prospective film financier. In such cases, the independent producer’s due diligence investigation of the bona fides of such film financing sources must be thorough (see the conclusion for a discussion of film finance scams). Expensive form of film finance. Gap financing for a feature film is expensive in that banks will insist on several different risk-adjusted fees in addition to interest. More specifically, banks will commonly insist on • a gap finance fee (typically an amount between 5 and 10 percent of the film’s budget); • an arrangement fee (a flat fee); • a loan fee (also flat fee); • legal fees for the bank’s attorneys; and • interest (typically the current London Interbank Offered Rate—LIBOR + 2.5 percent).

Risky business. Gap financing is risky for banks because there is always the possibility that films financed on a gap basis will not be able to repay the lenders. In the banking world, such arrangements are considered unusual and exotic (i.e., more risky than necessary), therefore, a significant number of banks will not participate in such deals. Many banks simply choose not to make film production loans unless the repayment is guaranteed by presold distribution contracts for various markets around the world. Without question, banks providing gap financing are moving beyond their traditional role by assuming some limited risks with this form of lending. More specifically, these include: 180

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• performance risk. The risk that the film will not be completed on time or within budget or be delivered to the distributors pursuant to the terms of the contract. The banks will typically seek to shift this risk to a completion guarantor (completion bond company). • marketing risk. The risk that the gap will not be covered prior to the loan due date by contracts of sufficient value on the unsold territories. This is a risk typically borne by the lending bank. • credit risk. The risk that the distributors will not pay the balances on their contracts once the film is made available to them due to commercial causes (i.e., bankruptcy or liquidity problems) or political events (currency inconvertibility, i.e., the inability of a foreign distributor to legally obtain U.S. dollars to make payment). This is a risk that the banks seek to minimize by investigating and making sound judgments about the creditworthiness of the distributors involved.

Banks have developed additional ways to protect against risk. For example, some banks do not always provide gap financing. In some instances, they will access nonbank sources to cover a gap, but still make direct loans on existing presale contracts, which they consider to be solid collateral. Also, some banks will “outsource” the gap financing for a single picture, but loan directly on the estimates of reputable foreign sales agents for a multiple film package. In recent years, during a period when several Asian nations were going through an economic crisis, foreign territorial distributor commitments that had previously been counted on to contribute some 5 to 6 percent of a film’s budget (e.g., South Korea) did not materialize. As a result, some of the films that were financed on a gap basis did not recoup their production costs. On the other hand, the bank’s fees and interest spread on a gap-financed film may be enough to allow the bank to make money on the deal even though the film did not recoup. In an effort to avoid gap-related losses, the banks still willing to cover a film’s production budget gap have had to become more discriminating about the films they will finance in this manner. They have started concentrating on so-called higher-quality projects with known stars. In addition, many banks have sought to spread the risk of financing film projects through gap financing a slate of films as opposed to a single film project. Just as the market for foreign presales comes and goes, gap financing does the same. Sometimes, for some banks, it may be considered a mainstream funding technique that helps to overcome the finicky nature of the presales marketplace. On the other hand, even though single-picture 181

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gap financing may not be completely out of the question, lenders have tightened their underwriting standards as compared to the early years of gap financing and typically will allocate little or no value to countries with weak economies. Film financiers indicate that there is ample bank money available for loans on film projects with solid distribution deals. However, the distribution agreements and guarantees needed to support the bank lending have become even more difficult to obtain in recent years due to a continued reduction in the so-called buyer pool (i.e., the number of distributors considered to be creditworthy in the view of the banks) particularly in the important U.S. theatrical marketplace. The number of viable independent distributors has also become smaller over the years. Some have been made subsidiaries of the major studio/distributors, and in other cases, an independent distributor’s capacity to take on other independently produced feature films is limited due to long-term output deals with studio-affiliated and other production companies. In addition, the independent distributors in many of the foreign countries with sufficient moviegoing attendance to support the foreign presales are less willing to make the presale commitments and provide the guarantees they formerly provided based on a movie title, a concept and script and some attached elements, like casting. More recently, these foreign territorial distributors will insist on seeing a lengthy promo reel or even a finished film. The remaining independent distributors in various foreign countries are often much more hesitant to make presale commitments based only on a title, a concept and some casting. As the market for foreign presales has become weaker, that development has also put a strain on gap financing. All of these factors make it more difficult for independent producers to arrange for foreign presales and this, in turn, has an impact on the banking community’s willingness to make production loans of any kind, much less gap loans. As a consequence, the number of banks willing to offer gap financing has been significantly reduced in recent years. Advantages Producers can focus. Gap financing allows producers to focus on filmmaking instead of selling. No limits on locations. This form of lender financing does not typically impose any limits on where the film can be shot.

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Raises money more quickly. Gap financing allows a film’s production costs to be financed sooner, rather than having to wait for the additional distribution contracts to be executed. Production on schedule. With gap funding, a film can begin production on a firm schedule, eliminating delays that may cause cast members to drop out. Disadvantages Economic sensitivity. Gap financing is extremely sensitive to the economic ups and downs of local economies. Sales agent estimates. Gap financing is dependent on the well-informed, good faith estimates of a reputable foreign sales agent and/or the bank’s own research. More risky for banks. This form of film finance adds some risk to the transaction for banks, and banks are not generally in the business of assuming financial risk. Expensive form of film finance. Gap financing for a feature film is somewhat expensive in that banks will insist on several different risk-adjusted fees in addition to interest.

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23 Insurance-Backed Schemes Bank lending practices for slates of feature films eventually took the presale technique and gap financing to their ultimate conclusion—obtaining insurance to help protect against the risk of loss. With these schemes, insurance was used to provide financial backing for gap financing. So, the so-called insurance-backed schemes, in one sense, represent a continuing evolution of lender financing for feature film production. Most of these insurance-backed film finance schemes occurred back in the 1990s, more specifically between the years 1995 and 1999, when many feature film producers were desperately seeking ways to finance their films and somebody (possibly insurance brokers working closely with film producers) came up with a new scheme to use insurance to back film financing. The idea was that a bank or group of banks (a syndicate) would lend the money needed to produce a slate of some five to ten feature films for an established production company (with distribution in place); and instead of looking to the distributor’s payment to repay the loan upon delivery of the films (as with a negative pickup), the loan would come due for repayment out of the film earnings some three to five years after release. The risk of defaulting on repayment would then be insured against through an insurance broker with one or more insurance companies who, in turn, would spread some of the risk with co-insurance or reinsurance, often in the London insurance market. The basic concept was that even though the probability of a single film making a profit was not good, spreading that risk over a slate of films somehow improved those odds. The insurance-backed financing schemes served as an additional risk reduction device for banks financing a slate of films on a gap basis. Alternatively, instead of a bank loan, the funds might be raised from bond investors through securitization (see chapter 24). These insurance-backed financing schemes may have been available and effective for a package of films where risk could be spread over 6 to

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10 titles to be produced over a two-year period, but it is simply not available for a single film project. The minimum budget for such films was likely to be in the $3 million neighborhood, and such financing was only available to experienced producers with fairly established production companies. The gap range on such deals was between 20 and 30 percent of each film’s total budget. Several arguments have been put forward by advocates in support of the insurance-backed financing schemes. They contend that by obtaining the insurance to cover a possible loss on a slate of films, an experienced film producer or production company can transform a budget deficit (or gap) into a bankable asset. Traditionally, in such deals, the producer does not have to give up much equity, and financing a slate of films in this manner allows the producer to produce more films; thus, the producer can hold onto more equity and build the production company’s library much faster. In addition, the expenses involved in this form of financing are also borrowed from the bank and the financing becomes an unofficial line of credit. Plus, the producer may even be paid his or her producer fees when the deal closes. In effect, an insurance-based financing policy acts as collateral for lending institutions, like a bank or a specialist fund. The latter can provide the final production financing, knowing, or at least believing, that the policy ensures the loan will be repaid by a fixed future date. Certain brokerage firms had developed relationships with the banks that would take this paper (i.e., accept it as collateral for a loan). In many instances, insurance brokers would be working with the film producers in putting together these deals. They would line up the insurers and reinsurers and then present the deal as a package to a lender or investment bank. Film production companies from England and the United States were primarily the ones involved in the insurance-backed schemes. Such companies included Screen Partners, Flashpoint (based on the island of Jersey), J&M Entertainment, George Litto Productions, Phoenix Pictures, Destination Films, MGM, Universal Pictures, Paramount Pictures and Sony Pictures Entertainment. Some of the banks included Chase Manhattan Bank, Royal Bank of Canada, Silicon Valley Bank, Fuji Bank, JPMorgan Chase Bank and Imperial Bank (now Comerica). The bottom fell out of the insurance-backed gap financing market quite spectacularly some years ago, although the need for bank-funded gap financing still exists, but with a smaller number of willing participants and without the insurance backing.

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Advantages Significant sums. Large amounts of film production financing have been raised in this manner. Transforms a deficit into an asset. By obtaining the insurance to cover a possible loss on a slate of films, an experienced film producer or production company can transform a budget deficit (or gap) into a bankable asset. Builds library faster. The producer does not have to give up much equity, and financing a slate of films in this manner allows the producer to produce more films, hold onto more equity and build the production company’s library much faster. Cost of capital is also borrowed. The expenses involved in this form of financing are also borrowed from the bank and the financing becomes an unofficial line of credit. Producer gets paid. The producer may be paid his or her producer fees when the deal closes. Disadvantages More expensive money. The insurance adds to the cost of filmmaking. The cumulative cost, including bank fees, loan interest, insurance broker fees, attorney fees, insurance premiums and so forth, can be substantial. Complex transaction. The insurance-backed transactions are extremely complex, requiring the participation of numerous banking, legal and insurance professionals (who may or may not be so professional). Out of reach for many filmmakers. This financing arrangement has generally not been available for first- and second-time film producers or for filmmakers seeking financing for a single film, or even just a few films. When they were at the height of their popularity, the insurance-backed financing schemes offered film producers the freedom to select the films to include in their film production slate (which made sense from a producer’s point of view); but in some instances, producers selected their riskiest projects, because they perceived insurance-backed financing to be guaranteed. But that ability to select the films to be included made the risk less appropriate for insurance. There also appears to have been some dispute as to how many films were supposed to be included in each slate, because the number of films would theoretically change the risks for the insurers. The insurers, brokers and reinsurers were apparently unaware that the excessive discretion built into the film distribution agreements made them unsuitable risks

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for insurance (see The Feature Film Distribution Deal: A Critical Analysis of the Single Most Important Film Industry Agreement). After a time, very few, if any, of the film production loans were being repaid. Most of them defaulted, and even though some of the insurers paid or settled the bank claims on the insurance policies, some of the reinsurers refused to pay, claiming fraudulent misrepresentation and nondisclosure of material facts, as well as breach of warranties relating to the number of films to be included in the slates. Most of these deals ultimately resulted in massive and quite expensive litigation between banks, brokers, insurance companies and reinsurers in New York and London. Many of the parties involved, including film production companies, went into bankruptcy. It is doubtful that any bank, broker, insurance company or reinsurer would try this particular scheme again. This form of film finance can be added to the long list of film-financing schemes in which Hollywood interests have left their outsider financing partners (i.e., contributors of production money) both empty-handed and with silly grins on their faces.

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24 Securitization Some independent film producers have expressed interest in a form of raising capital referred to as securitization. Unfortunately, this form of film finance is only available to a very few of the more established film production companies. Securitization is a process through which an individual or entity pools the rights to future payments being or to be generated by revenue-producing assets and sells this bundle of rights as a security. In other words, securitization is a sophisticated method of raising capital involving the taking of a specific group of assets that generate a predictable, steady stream of revenue, isolating the assets and revenues in a special-purpose vehicle or company, such as a corporation, limited partnership or limited liability company, by having the original owner transfer the assets to be securitized into the special-purpose vehicle and then using those assets and anticipated revenues to raise capital against the credit of, and secured on, the future revenues of those assets. The special-purpose vehicle issues debt securities and uses the proceeds to purchase the securitized receivables from the original owner. In financial terminology, these traditionally unused assets are considered “esoteric asset classes.” Such assets have included municipal tobacco litigation settlements, tobacco lawsuit attorney fees, healthcare receivables, aircraft leases, mutual fund fees, trademark licenses, patent-related royalties, insurance-related premiums, music royalties and film receivables, among others. The basic premise is that if an asset can generate a predictable, steady stream of revenue, it may be a candidate for securitization. Long-term assets such as film rights are most likely to be financed through the issuance of bonds, as opposed to the shorter-term commercial paper. Companies like the film industry’s major studio/distributors and a few others, holding a diverse collection of media copyrights and trademarks that can produce steady, predictable cash flows may be able to access this

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form of financing. A few so-called securitizations have involved singleartist offerings, such as the so-called Bowie Bonds, but these have been fairly limited to date. Securitizations have also been effected by music labels, publishing houses and film studios out of whole media catalogs comprised of diverse royalty streams. Many in the financial industry consider securitizations to be a growth area in the asset-backed securities market. Securitization allows the companies holding the copyrights and trademarks to increase their liquidity as well as potentially provide a lower cost of financing. In the context of film, a distribution company would first sell the actual distribution rights to a bankruptcy-remote special-purpose company (entity or vehicle). The entity is formed to engage in a particular activity, and only that activity, to ensure that other, potentially money-losing activities of the film distribution company itself will not adversely affect the ability of the special-purpose company to meet its obligations to lenders. Money is then loaned by one or more banks based on the value of the distribution rights held by the special-purpose entity, rather than on the financial health of the distributor itself, thereby isolating risk. Such a financing arrangement is highly structured so that it is able to get a minimum “A” rating from the rating agencies. Both Moody’s and Standard & Poor’s assign ratings to commercial paper. That, in turn, allows the special-purpose company to obtain low-cost financing through the issuance of commercial paper in the capital markets rather than relying on the more expensive capital available through traditional bank financing. The commercial paper takes the form of short-term debt obligations that are unsecured and usually discounted, although some are interest-bearing. They can be issued directly or through brokers equipped to handle the back office paperwork. The commercial paper is sometimes backed by bank lines of credit. According to economists, low interest rates, a slowing economy and the growing federal budget deficit have been major factors in the significant increase in asset-backed securities issuance in recent years. This sector has been seen as an alternative for investors seeking securities that were safer than those available in the weakened corporate debt market. Securitization is not a technique suitable for funding the production costs of a single motion picture and may not even be available for a library of films owned by independent producers or distributors. It is a means of raising capital based on the predictable revenue streams generated from the exploitation of a group of motion pictures (or other assets) some time after they have been released and when those revenue streams can

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be demonstrated. Typically, the slate of films may involve some 25 to 50 motion pictures. The effective collateral is ten years of distribution rights on an entire collection of films. DreamWorks, LLC (DreamWorks), structured a $1 billion securitization facility backed by an initial portfolio of 37 live-action and animated films that it produced or coproduced. The facility was syndicated through a group of brokers allowing the special-purpose vehicle issuer, DW Funding, LLC, to borrow, pay down and reborrow on a revolving basis. Notable in this film securitization was the mitigation of the film production and performance risk for future films that was present in the prior DreamWorks transactions (described below). A film is eligible to participate in the facility only after eight weeks of domestic theatrical release, thereby ensuring a certain degree of predictability of its future revenue. DreamWorks had previously utilized a securitization structure to finance its production of future films. In that deal, without an existing catalog of films, DreamWorks would sell to a special-purpose vehicle just-completed films that had yet to be released. Since there was still a fair amount of marketing to be done for these films, it was not possible to render a true sale opinion with respect to them. Notwithstanding the absence of a true sale, this earlier structure enabled DreamWorks to obtain lower-cost financing for the development of its film catalog. DreamWorks has since been purchased by Paramount Pictures, a unit of Viacom, Inc. In 2003, Vivendi Universal Entertainment completed a $950 million revolving facility with a consortium of banks backed mostly by distribution fees and royalties that Vivendi expects to collect from home-video sales and television broadcasts of movies that it produced, purchased or will make in the future. The film catalog currently includes 121 films that have been released since 1995. As with the DreamWorks deal, the anticipated revenues from each of the Vivendi films cannot be securitized until eight weeks after its theatrical release so as to improve cash flow predictability. In addition, a royalty and film securitization scheme was created by the Australian film studio Village Roadshow. It established a $900 million revolving credit facility backed by the studio’s future distribution revenue for future film sequels to The Matrix, Ocean’s Eleven and Cats & Dogs, among other films. The transaction was syndicated and supported by the application of a triple-A financial guaranty as well as a $100 million equity stake contributed by Village Roadshow to support the credit line. Although the issuance of the Bowie Bonds received significant media attention and heightened interest in intellectual property (IP), growth in 190

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the area of securitization has generally been cautious. Single-artist deals, such as the Bowie Bonds, have particularly been limited because of the practical reality that very few artists with a catalog suitable for securitization actually also have a need for the upfront cash generated by it, and those artists most in need of a large infusion of cash probably lack the required collection of music copyrights. However, IP securitization in recent years has experienced growth and innovation, especially where entire media catalogs have been involved. The assets are copyrights and royalties. Securitization may continue for media institutions holding copyright catalogs with a sufficient degree of historical performance and diversity. Securitization of these revenue streams affords music publishers, record labels and film studios a potentially cost-effective manner of financing. The trend of whole-catalog securitization is expected to continue into the future as a viable means of increasing liquidity in the media industry for a limited segment of the industry. Advantages Lower rates. Securitization allows some film companies to access funds at less than commercial lending rates. Tax-free capital. Securitization may be able to provide an immediate tax-free infusion of capital. Disadvantages Not for single films. It is not suitable for funding the production costs of a single motion picture and may not even be available for a library of films owned by most independent producers or distributors. Steady revenue. It requires a predictable, steady stream of revenue, something that most independent film production companies do not have. A real long shot. Securitization is not likely to be useful for the vast majority of independent feature film producers or production companies.

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PART FOUR Studio/Industry Financing Many independent feature film and documentary film producers aspire to produce at least one major studio release at some point in their career. Some try to do that too soon. Others are committed independent producers for life. In any case, that is a judgment call for the individual producer. This section of the book undertakes a comprehensive examination of film-financing options that may be useful to film producers preparing for that bigger budget project, options that are more closely tied to the major studio/distributors and the domestic film industry.


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25 Studio Development and In-House Production One of the ways a film producer might seek to get a film project onto the screen is to enter the so-called studio system at the earliest opportunity; that is, at the acquisition/development stage of a film project. Arguably, this approach might not be considered a form of film finance. The term development in the broadest sense refers to the initial stage in the preparation of a film. Development in its more narrow sense comprises those activities relating specifically to taking a concept or idea and turning it into a finished screenplay. The development phase involves formulating and organizing the concept or idea for the movie; acquiring rights to the underlying literary work or screenplay; preparing an outline, synopsis or treatment; and writing, polishing and revising the various drafts of the script. The studio in-house production usually starts as a development deal initiated by an independent writer, director or producer. The development deal typically begins with the pitching of an idea or film concept to a studio creative executive and the submission of a synopsis, treatment, outline or draft screenplay to the creative department of the studio. Regardless of who claims ownership of the original motion picture concept, if the studio finances the development of the screenplay, the production of the movie and its distribution, the studio will ultimately own most, if not all, rights associated with the project. Elements of the Deal Committing to production. A major studio/distributor will generally not commit to the production financing for a motion picture until a substantially developed package exists; that is, until at least a first draft of a screenplay is completed, a budget has been prepared and a director and actors have been attached to the project. The step deal. A studio development deal is generally referred to as a step deal, because the development financing is handled in stages. The 195


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studio pays the producer and other persons who are contributing to the property’s development (e.g., writer and director) a salary, and sometimes expense money, in increments as the project is developed. The first step might involve developing an outline of the screenplay; the second a first draft of the script; and so forth. The studio will have the right to decline to develop the project beyond any given stage, if it so chooses. Office on the lot. Some deals are nothing more than handshake arrangements between a producer and a studio executive in which the producer is provided with office space on the lot in exchange for a first look at whatever projects are developed by the producer. Having an office on a studio lot gives the producer a certain level of credibility, which in turn presumably helps him or her acquire, develop, package and finance projects. After all, a producer with an on-the-lot deal can invite prospective investors onto the studio lot for lunch at the commissary. Other office-on-the-lot arrangements are more extensive (see chapter 27). The development deal memo. Typically, the development deal is first memorialized in writing by means of a deal memo, which is just an abbreviated version of a more formal written agreement (usually in letter form). It outlines the basic deal points (terms) of the agreement, such as salary, time schedules, screen credit and percentage participation in the film’s profits. The more formal contract containing the details of the agreement is negotiated and prepared by entertainment attorneys while the project is in active development. That agreement might be referred to as an executive producer’s agreement, a producer’s agreement, a director’s agreement or a writer’s agreement, depending on who makes the development deal. Producer’s salary. The salary that the producer negotiates for the development deal is typically the full salary the producer would receive if the movie were actually produced. That figure may be a significant amount of money, but the producer must keep in mind that it is highly speculative whether he or she will ever receive the full amount, because of the nature of the development process, the unfavorable odds of actually going into production and the fact that the studio can stop the process at any stage. Only a small portion of that total salary is usually paid during development. Advantages Studio money. The writer, director, producer or executive producer who goes to the studio is not usually required to put up any of his or her own money to finance the development, production or distribution of

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the film, although without a track record or relationship with the studio, the producer may have to incur some acquisition costs. Major motion picture. In the current motion picture marketplace, the major studio/distributors dominate in the area of theatrical releases. Thus, if anyone associated with a particular film project wants it to be a so-called major motion picture, it will, as a practical matter, have to be developed, produced or at least released by a major studio/distributor. Insider development companies. Certain production and development companies whose owners have strong family, religious or cultural relationships with studio insiders have the best shot at getting studio development deals and making good money, at least for a while, even if few or any of their projects are ever “green-lighted” for production (see Hollywood Wars). Bigger budget pictures. A studio can generally provide more significant resources to aid in the development of a project, offering the promise of a higher production budget and the ability to obtain commitments from bigger name stars at an earlier stage than most other development financing sources. Collaborative process. In some instances, the extensive collaborative process that studios engage in through the development and production of a motion picture (e.g., using several different writers, a producer, a director and studio executives, all contributing ideas during development) actually results in an improved version of the film. Disadvantages Not good odds. The odds against getting an idea, concept, synopsis, treatment, outline or script submitted to a studio and accepted as a development deal (much less given a green light for production) are tremendous. Major studios receive hundreds of submissions a week and thousands a year, only to choose a hundred or so for development and a handful for production. Relationship-driven business. All other things being equal, the studio development or production green light will go to the producer who has the best relationship with the studio or the studio executives making the commitment on behalf of the studio. Some in the industry characterize this phenomenon within the realm of studio “politics” or refer to the industry as a relationship-driven business. This is also one of the situations in which Hollywood nepotism, favoritism and cronyism come into play (see “Hollywood’s Family Ways: Who Can You Trust Better than Kin?” by Terry Pristin).

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Danger of theft. It is very difficult for industry outsiders to protect against theft of ideas, or even the tangible expression of those ideas, while trying to interest a studio, production company or distributor in a film project. The copyright laws provide inadequate protection for writers and producers in this environment. An insider’s game. Studio financing at the development or production stage appears to be pretty much an insider’s game; thus, if an independent producer does not already have a relationship with a studio executive, the chances of obtaining a development deal are even less likely. Merit does not always prevail in Hollywood. Fewer deals available. The major studio/distributors appear to have cut back in recent years on the number of development deals they will accept. Development hell. Most of the time a film project in development at a studio never gets a green light for production but remains in development for what seems like an eternity. This is often referred to as “development hell.” Unfortunately, the writer or producer cannot take the project elsewhere without the cooperation of the studio. Turnaround. In some cases, producers may have a difficult time regaining ownership of the original property if it never receives a “go” to production. Thus, a turnaround provision with a time limit should be included in the development deal so the producer can take the property to another studio or production company. Producer’s fee only. Only a few very powerful persons ever obtain a significant and meaningful participation in the upside potential of a studio in-house production that started out as that person’s project. Not adequately developed. Sometimes movies developed by studios are needed to fill the studio/distributor’s release slots for a given year and are prematurely committed to production to meet those needs even though they are not adequately developed. Bumped by agency projects. Film projects in development at a studio may get replaced by fully packaged projects brought to the studio by a powerful talent agency that has a better relationship with the studio executives. Studio employee. A person submitting a project to a studio for development in effect becomes an employee of the studio and may not only lose control of the project but may be fired under some circumstances.

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26 Studio Production-Financing/ Distribution Agreements In contrast to the studio in-house production, which is typically initiated with a pitch, the studio production-financing/distribution deal generally starts with the submission of a partially or fully packaged film project, including a fairly well developed screenplay. In other words, the development phase of the project is substantially complete. Thus, at this point in the life of the project, there is no longer any need for a development deal. The packaged film project is taken into the studio by an independent producer who has already incurred the acquisition and development costs, or it comes through a talent agency with or without a producer attached. A film package minimally consists of a script, a budget, a shooting schedule and often commitments by a star or stars and a director. It can also be enhanced by including deferments (delayed payment of compensation) from a film lab, performers or a director and having part of the production funding already raised or committed. Some agents, agencies, entertainment attorneys and others engage in packaging film projects with their own clients. Such transactions may at least partly be motivated by the desire to maximize the fees they receive and might not result in the best possible casting for the film. Terms of the Agreement The P-F/D agreement is a contract between the studio/distributor (or other distributor) and a feature film producer that sets out the terms and conditions under which the studio/distributor will provide production financing for a motion picture in exchange for the right to distribute the film in some or all markets. The P-F/D arrangement is one of the principal forms of motion picture production financing, at least for those films receiving a major studio/distributor theatrical release. With the P-F/D deal, the studio assumes the role of the lender of the production money to the production entity. In addition, the studio’s 199

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affiliated distribution arm handles distribution for the completed picture; and, of course, theatrical distribution requires an additional expenditure of substantial sums. Elements of the Deal Studio approvals. The items over which a major studio/distributor has the right to approve or disapprove in the context of a feature film P-F/D agreement are referred to as studio approvals. As a general rule, the more money a producer tries to get from a studio, the more approvals a studio is likely to impose. Such approvals typically relate to the screenplay, budget, producer, director, lead performers, start date, running time, Motion Picture Association of America (MPAA) rating, shooting locations and production schedule. Takeover rights. Typically, the P-F/D agreement will provide that the studio/distributor has the right to take over production of the motion picture if the cost of producing the film has exceeded a certain specified percentage of the budget (for example, 10 percent) or if the production has fallen behind schedule by a certain number of days. Alternatively, the studio may require that the producer obtain a completion bond to protect against the risk of the film’s going over budget. Form of film finance sought. When approaching a major studio/distributor or other potential industry funding source, the producer should have some idea which form of film finance he or she is seeking and what the basic advantages and disadvantages are for each. That will help to make the producer’s discussions with the potential funding source more meaningful and to the point. Thus, with a major studio/distributor, the producer might be seeking a development deal, a P-F/D agreement, a negative pickup or merely talking with the distribution division about a possible future acquisition of an independently financed film. In many instances, those choices help to determine which studio employees actually meet and talk with the producer. Advantages Big budget films. A high-budget feature film developed by an independent producer outside the studio system may have to be produced under a P-F/D arrangement, since the major studio/distributors are generally the only entities in a position to accept or control the financial risks involved. Expensive talent. Many of the high salaries demanded by agents on behalf of their top director, actor and actress clients can only be underwrit-

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ten by the major studio/distributors, who are generally in the best position to make judgments about the financial prospects for a given film. Producer advances. Producer advances are likely to be larger in the P-F/D deal than in any other form of film finance. Distribution treatment. The studio-financed motion picture is more likely to receive favorable treatment in distribution than nonstudio releases, not necessarily because the films are better than other releases but because the major studio/distributors have greater economic power and leverage with the exhibitors. Box office dominance. Releases from the major studio/distributor have provided them and their subsidiaries or affiliates with an average market share of approximately 97 percent of box office gross in the domestic theatrical marketplace in the last ten years or so. Collections. The major studio/distributors also have greater leverage with the exhibitors when it comes time to collect distributor rentals. Thus, they are likely to be able to extract a higher percentage of the box office gross from the exhibitors. Disadvantages Creative control. Studio/distributors that put up some or all of the production money for a film will usually exercise extensive control and approval over the production process; thus, an independent producer relying on the P-F/D method of film finance may be giving up a significant amount of creative control. Unconscionable agreements. P-F/D agreements are notoriously one-sided (in favor of the distributor). Thus, most producers or other net-profit or net-proceed participants have little, if any, chance of participating in the upside potential of a motion picture produced in this manner. It may, in fact, be fair to characterize most of the major studio/distributor distribution deals as unconscionable, or so-called contracts of adhesion (see Film Finance and Distribution: A Dictionary of Terms), as one court has held such agreements to be (see The Feature Film Distribution Deal), but the studios haven’t bothered to make changes, because they don’t have to. Settlement transactions. Notwithstanding the collections advantage (see above) of the major studio/distributors, the settlement transactions between the exhibitors and distributors clearly favor the studio-produced films as opposed to independently produced films, even those distributed by the majors. In other words, certain of the exhibitors and distributors appear to be colluding to deprive the independent producers and all net-

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and gross-profit participants of such independently produced films from their profit participations when distributing and exhibiting their films. The settlement transaction between exhibitors and distributors appears to be one of the principal mechanisms used to further such collusion (see The Feature Film Distribution Deal). Broad commercial appeal. Small or low-budget films are generally not considered suitable for studio financing using the P-F/D arrangement. Projects generally accepted for studio financing in this manner must at least appear to the studio executives to have a fairly broad commercial appeal; that is, appeal to the so-called lowest common denominator audience throughout the world. Higher interest rates. Interest rates charged by studios on P-F/D deals are generally higher than the rates charged by banks and other nonstudio lenders who provide production-money financing for feature films. Longer interest paying period. Not only are the studio interest rates higher than the rates charged on bank loans, the interest on a P-F/D loan is incurred during a longer period of time than in a bank-financed negative pickup deal. That is because the studio-affiliated distributor generally first deducts its distribution fee, then recoups its distribution expenses, then deducts interest incurred to date, before ultimately recouping the negative cost of the picture, whereas the bank is paid upon delivery of the film. Conflicts of interest. The inherent conf lict of interest involved in packaging by entertainment attorneys or talent agents may result in a less-than-desirable combination of film elements that are presented to the studio, sometimes on a take-it-or-leave-it basis. When this occurs, the agent and the talent he or she represents may benefit financially, but the studio, its stockholders, the moviegoing audiences and the rest of the talent arbitrarily excluded from participation in the package may be harmed. Little chance of net profits. Profit participation auditors estimate that major studio/distributor releases generate net profits (or net proceeds) in only about 5 percent of the cases. Although this is merely an estimate, no one outside the studios is in a better position to make such estimates than profit participation auditors. On the other hand, these same auditors also report that all the films they audited owed more profit participations than were reported by the distributor. Less favorable terms for producers. As a general rule, the more financial risk a studio/distributor is asked to take in the production and distribution of a feature film, the more likely it is that it will extract more favorable terms for itself in the P-F/D agreement. 202

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Studio Production-Financing/Distribution Agreements

Overhead charges. The studio/distributor not only will deduct its distribution fee and expenses, interest and the negative cost from the gross receipts but will also generally include a specified percentage (usually 10 to 15 percent) of the negative cost of the motion picture as an overhead charge, which is added to the negative cost and thus incurs additional interest. Copyright ownership. A major studio/distributor that provides all of the production financing along with the distribution expenses for a feature film will in all likelihood insist on owning the copyrights to the film in addition to distributing the film throughout the universe in perpetuity. Thus, the picture becomes part of the studio/distributor’s library of films, as opposed to being an addition to the library of the independent producer.

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27 Studio-Based Production Companies Studio spokespersons report that all of the major studio/distributor organizations (Warner Bros., Disney, SONY [Columbia, Tri-Star and now MGM], Universal, Paramount [now including DreamWorks] and 20th Century Fox) have relationships with independent producers and their production companies, which typically include the provision of offices on the studio lot. In turn, these producers agree to offer the studio a first look at whatever projects they are developing (the so-called first-look deal). Each of the more active studios named above reportedly has about thirty to forty such relationships, which are also sometimes referred to as housekeeping deals or overall deals. The actual numbers may change from time to time. Some industry-insider producers have been known to have a first-look deal at one studio, a next- or second-look deal at another studio and a third-look deal at still another major studio. After all, the studio executives who are making the commitments quite often shuffle back and forth between the major studios during their careers, creating the impression that the studio organizations really function as a single unit, particularly when it comes to competing with outsiders. The studio contribution in one of the first-look deals may vary from a single no-frills office to a more elaborate complex of offices with secretaries, readers, office equipment and development or acquisition financing. Presumably, producers are able to obtain these first-look deals based on their reputations as feature film producers or on their relationships with the studio executives who are authorized to make such commitments on behalf of the studio. The associated development deals are sometimes granted in conjunction with specific projects that have been pitched to the studio and accepted as projects under development (see chapter 25), but others are simply relationships with producers that the studio wants to support. To research which companies have studio deals, see the Hollywood Creative Directory cited at Sources and Further Reading. This directory 204

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Studio-Based Production Companies

provides a list of thirteen hundred production companies, studios, TV/ cable networks; their addresses, phone and fax numbers, produced credits and staff. In addition, it provides more than fifty-one hundred indexed and cross-referenced names of development and production personnel and their titles along with the names of companies and talent who have studio deals. The directory is published and updated every four months (March, July and November). Advantages Relationships in place. Independent producers seeking studio financing for their film projects may find that aligning themselves with other producers already on a studio lot will substantially increase their chances of getting their projects produced. Using an intermediary. Working with someone on the inside who can act as a go-between allows the independent producer to seek studio financing without placing so much emphasis on getting access to and developing a relationship with a studio executive. The indirect approach. It may be easier to get a film produced by a studio going through one of the already established first-look deals than going directly to the studio. The studio executive may, in fact, ultimately refer the producer with an interesting project to one of the producers on the lot. Disadvantages Fewer deals available. In recent years, when the major studios were under pressure to lower costs, fewer housekeeping deals have been offered. Nepotism, favoritism and cronyism. Unfortunately, many of these arrangements for providing independent producers with an office on the lot are awarded to family members or friends of family (see “Hollywood’s Family Ways: Who Can You Trust Better than Kin?” by Terry Pristin). In other words, there is no merit system in Hollywood. It is not a level playing field. Anyone who thinks otherwise is simply uninformed. Special relationships. Some producers have been known to place themselves in an obvious conflict-of-interest situation involving a loan or other form of inducement to a studio executive who may be in a position to grant an office-on-the-lot or production deal to that producer. Thus, more ethical independent producers are at a clear disadvantage in getting the desired studio relationship. Odds still not favorable. If in fact each of the major studios has some thirty to forty office-on-the-lot relationships with producers who are obligated in turn to provide the studio with a first look at the projects 205

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the producers develop, and the studios only release fifteen to twenty-four films a year (some of which have been produced completely outside the studio system), the odds of getting a green light on a feature production using this strategy are also discouraging. The risk of inadvertent loss. The independent producer organizations that have relationships with the studios are often not very organized or well managed; thus, submitting a project to such a group can also result in loss of the project in other ways (e.g., theft of ideas, wholesale lifting of dialogue, confusion of ownership during the script re-writing merrygo-round, etc.). The development scam. Sometimes an independent producer submitting a developed screenplay to a studio is told that the project needs to be developed further. The studio producer on the lot then hires another writer to continue to develop the project, creating a potential ownership interest in the project that might be ultimately used to squeeze out the original producer or writer.

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28 Independent Distributors Independent distributors, by definition, are not regularly or substantially affiliated with a major studio/distributor. In the early 1990s, this group included such distributors as New Line Cinema, Miramax, Samuel Goldwyn, Concorde, Castle Hill, First Run, IFEX, Shapiro Glickenhaus, Expanded Entertainment, Taurus Releasing, Fries Entertainment, Triton Pictures and Greycat. Unfortunately, many of them have either been purchased by one of the major studio/distributors or have gone out of business. Those acquisitions resulted in an increase of box office market share from 92 to 97 percent for the major studio/distributors, leaving an even smaller portion of the domestic market for the true independents. For that reason, most independent distributors tend to specialize in foreign distribution (after all, the vast majority of the desirable theatre screens in the United States are taken up by major studio products, regardless of the quality of their films). Many of the independent distributors are members of the Independent Film and Television Alliance (formerly known as the American Film Marketing Association, or AFMA) a trade association for the independent film and television industry. The IFTA, located in Los Angeles, can provide inquiring producers with a current list of its member companies. Some independent distributors do have production divisions, but they do not have the financial resources of the major studios and thus do not develop and produce as many in-house films as the majors, nor do they offer many P-F/D deals. Thus, generally speaking, an independent producer is less likely to submit an undeveloped motion picture concept to an independent production company or distributor and obtain a development deal, although some low-budget projects would be more welcome at the independent’s shop than at the studios. The independent production companies and distributors also have smaller amounts of money to commit to P-F/D arrangements and quite often require cofinancing deals. This, of course, means that the independent producer must provide a significant portion of the production money 207

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financing for a picture before the independent distributor will commit to putting up the balance of the production money along with funds to cover distribution expenses. Some of the independent distributors will subcontract with a major studio/distributor for a picture’s domestic release on a rent-a-distributor basis. Only a few of the independent distributors are considered creditworthy enough in the eyes of entertainment lenders to support negative pickup or presale production financing arrangements (see chapters 20 and 21). Most of the independent distributors are simply not capable of serving as sources of production financing and either acquire feature film product using a pure acquisition distribution agreement that then obligates them to put up some or all of the money to cover distribution expenses or they accept product on a rent-a-distributor basis, a distribution arrangement requiring that the independent producer not only finance the production of his or her film independent of the distributor but also put up some or all of the money to cover distribution expenses. In the rent-a-distributor situation, the distributor, of course, provides its services for a lower distribution fee and does not recoup any distribution costs since it usually does not incur any. Advantages Available for smaller films. Independent distributors may finance or participate in the financing of a feature film project that the major studios are not or would not be interested in, since in the view of the majors the film does not lend itself to a large enough budget or does not appeal to a broad cross section of the moviegoing audience. More personal attention. Independent distributors can often provide more specialized handling of independently produced feature films, if for no other reason than they have fewer films during the course of a year to divide their attention and resources. Support for the film. Independent distributors are more likely to work closely with an independent producer in the release of a picture and to place a film in theatres that will allow a picture to “find” its audience by leaving it on the screen for a longer period of time. Negotiating leverage. The negotiating leverage of an independent distributor is more closely aligned with that of an independent producer; thus, the independent producer is more likely to be able to negotiate a distribution agreement that is not unconscionable (i.e., heavily weighted in favor of the distributor). Chances of net profits. Independent producers might reasonably assume that since the agreements negotiated with independent distribu208

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Independent Distributors

tors are more likely to be fair than distribution agreements with major studio/distributors, the chances of a film distributed by an independent distributor achieving net profits may be greater than they would with a major studio/distributor. Disadvantages Fewer screens available. Since the MPAA companies (i.e., the major studio/distributors) routinely and regularly work with the NATO members (National Association of Theatre Owners) to arbitrarily limit the number of screens that are available for non-MPAA films, theatrical distribution by independent distributors is pretty much limited to the so-called art house circuit. Limited financial resources. Independent distributors generally do not have the financial resources of a major studio/distributor and are thus less likely to provide development deals, full production financing on a P-F/D basis or discountable distribution agreements or guarantees to support negative pickups or presales. Bankruptcies. Each year a number of independent distributors go out of business, making it impossible for them to fulfill their financial obligations to the independent producers of films currently in distribution. It is difficult for independent producers to make an informed judgment about the financial stability of independent distributors (but see Smaller pool of revenues below). Booking limitations. Independent distributors do not have as much leverage with domestic exhibitors and are thus generally less able to book films in the better theatres. Less collections clout. Independent distributors generally do not have the collection capabilities of the major studio/distributors and are thus not as able to gain favorable treatment from exhibitors in the settlement transaction (see The Feature Film Distribution Deal). Smaller pool of revenues. Collectively, films distributed by independent U.S.-based distributors in the domestic theatrical marketplace on average only garner about 3 percent of the box office gross each year; thus, the pool of distributor rentals for independently distributed films is significantly smaller than it is for films released by the majors.

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29 Domestic Studio Facilities Often in discussions, books or articles relating to the film industry, the term studio is used to refer to the so-called major studio/distributor organizations of affiliated companies, most of which own a physical studio facility, one or more film production companies, one or more distribution companies and in some cases even interests in theatre chains; that is to say, they are vertically integrated. On the other hand, not all of these so-called majors have always had the sound stages or studio lots that technically make it possible to accurately refer to the organization as a studio. Thus, the term studio can be a bit misleading at times. After all, there are a number of pure studios situated around the country that are not affiliated with production companies, have no distribution subsidiary and certainly own no interest in theatres. Those studios are the organizations that own and provide (for film production company use) the physical locations and other facilities, including soundstages, sets, prop departments, offices, commissaries and the like for development, preproduction, production and postproduction of feature films, as well as other film or video productions. Some of the local studios were created without the benefit of a well thought-out business plan. For example, most every state in the United States has a film commission—either at the state, regional or local levels. Those film commissions generally do not get involved in film finance other than possibly helping to sponsor an occasional seminar or encouraging the publication of a directory that may include film finance consultants, attorneys or other specialists who can provide useful information. The primary mission of the film commissions is generally to bring film production to the state or local community, particularly productions that already have funding. Unfortunately for those film commissions, the number of films that have financing and are available to be shot on location is limited, and thus the film commission business has become extremely competitive. As a result, film commissioners have had well-meaning discussions with local business people about what can 210

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Domestic Studio Facilities

be done in the state or community to attract more location shoots in their jurisdiction, and inevitably some of these business people come up with the bright idea of building a movie studio. Regardless of whether the above-described scenario was instrumental in bringing them about, domestic studio production facilities now exist or are being created in California, North Carolina, Louisiana, Hawaii, Florida, Texas, Tennessee and other states all around the country. Again, unfortunately, there simply does not appear to be enough business for all these studios to prosper–thus, the development of the domestic studio facility deal. The domestic studio facility deal, much like the foreign facility deal discussed in chapter 41, involves an offer by a local studio to provide certain below-the-line goods and services for either below-market prices or for an ownership interest in the film or a profit participation in the film’s revenues. Such goods and services might include studio facilities (i.e., soundstages, actor suites and production offices), production equipment, local casting, catering services, some local crew persons, locations, below-cost housing arrangements, postproduction services and so forth. The local studio (in cooperation with the local film commission) ultimately hopes to create a reputation for the local community as a good place to shoot feature films and thus eventually to create jobs and help the local economy by bringing in production companies that will spend money there. However, many feature films can be shot in a variety of locales; thus, enterprising independent producers (and the major studio/ distributors) merely keep shopping around for the best deal available on below-the-line goods and services offered by the domestic studio facilities. Thus, most of the local facilities never seem to become viable businesses that can offer their facilities at more profitable rates. Advantages Production cost savings. The producer is able to shoot a film and spend less money on below-the-line budget items. Improve the studio’s reputation. The local studios hope that the productions brought in through facilities deals will create positive word of mouth for them in the production community and that other productions will follow (hopefully at regular rates). Disadvantages Savings versus quality. The pressure on producers to save money in the production of films may have detrimental effects on the quality of the 211

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motion pictures; that is, the equipment, locations, facilities and the like gained in the domestic studio deal may not be up to par. Savings not offset. The savings gained in the domestic studio deal may not offset the cost of transporting and housing the cast and crew that are brought in from other locations such as Los Angeles. Self-destruction. Producers always trying to get the best deal may be shooting themselves in the foot, since if the studios offering such deals cannot prosper, they will eventually go out of business.

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30 Film Laboratories In the rush to compete for film-processing business, some of the smaller film labs have come up with creative ways to bring in new accounts. As an example, the following may be offered by such a lab: • the lab agrees to provide goods and services valued up to a specified amount on a deferred or profit participation basis; • the lab will receive a deferred payment or a percentage participation at a defined stage of the film’s revenue stream; • the lab’s net percentage participation will depend on the value of the goods and services provided; • the proceeds from sales or distribution will be used to first pay back the lab’s investment (the deferred amount) before that of the other investors and producers (i.e., the lab has to be in a first position—relative to other investors—to recoup the value of its goods and services); • after all expenses of production and all investments have been paid, the remaining distributor gross receipts will be considered net profits and divided as received in accordance with the various applicable agreements; • the lab must be in a para-passu (equal and concurrent) percentage participation position with respect to all cash investors; • the producer agrees to use the distribution services of a feature film distribution company that is affiliated with the lab; • the distributor will have approval rights over the film’s final budget and script.

The lab’s goods and services may include negative raw stock, negative developing, dailies, sound transfers, editorial cutting rooms, film projection, film coding, opticals, titles, sound editorial, negative cutting, ADR and Foley, sound re-recording, optical transfers, color dupe, inter-positive, inter-negative, first trial answer print, release prints and film-to-video transfer.

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Some labs also offer certain film completion services through an affiliated company, and if the producer can demonstrate good credit, the lab may be able to arrange a camera, sound, lighting and grip package together with electronic editing on a deferred financing basis. Knowing that some labs offer such deals, producers looking to finance the production of a feature film may want to make inquiries of a number of labs to determine whether they offer similar arrangements. It should not be difficult for a film lab to establish relationships with film production equipment houses and independent distributors, although the terms of such package deals may vary widely. Advantages Lower production costs. Obtaining lab goods and services on a deferred or profit participation basis lowers the producer’s (or investors’) out-ofpocket production and postproduction costs. One-stop shopping. Depending on the particular lab, a number of related services may be arranged for all at once; for example, lab services, production equipment rental and distribution. Disadvantages Likelihood of net profits. If the producer is locked into a commitment to use the lab’s affiliated distributor and that distributor is ineffective in functioning as the film’s collecting and disbursing agent, the producer and any other investors are not likely to see any net profits. Quality of lab work. A lab that is offering its services on a deferred basis might suggest that there is some question about its ability to provide quality results.

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31 Talent Agencies Talent agencies have traditionally limited their activities to finding employment for actors, directors, writers and sometimes producers. However, some of the more powerful agencies in recent decades have begun to realize that they could substantially increase their fees by attaching two or more of their own clients to the same film project (packaging) and at the same time increase the chances of the film’s being made since a studio might be reluctant to pass on an attractive package offered by such an agency. It was only a matter of time, then, that these same aggressive talent agencies realized that they could take their involvement in film packaging to still another level by also assisting in arranging for some or all of the production financing of their packaged film projects, independent of, or in conjunction with, a major studio/distributor. To accomplish this end, some of the talent agencies brought in or developed in-house expertise in film finance. Another agency might develop an exclusive arrangement with a production company acting primarily as a funding source for an entire slate of films to be cast with agency talent. Such arrangements appear to keep the agencies from crossing the line into production, and thus avoiding conflict with the Screen Actors Guild guidelines. Although talent agencies are not truly a stand-alone form of film finance, it is important for independent producers to recognize that some of them can help assemble financing for a package involving a number of their clients. The talent agencies do not put up their own money to finance the production costs of feature films; instead they become involved in putting together financing arrangements that go beyond the traditional studio sources, such as equity financing, below-the-line facilities deals, international coproductions, foreign government subsidies, presales and so forth. As recently as 2005, the Gersh agency launched a New York-based film finance boutique called Independent Feature Packaging. A former senior vice president for acquisitions at Miramax Films was brought in to run 215

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the new department. Before that, in late 2004, ICM hired film financier Hal Sadoff to head its international and independent film department. Advantages One-stop shopping. It is now possible for the producer of a film project to approach a top talent agency (assuming the project might be of interest to the agency), not only to get help attaching one actor to the film but possibly a director and several actors, while also arranging for production financing and distribution through the agency’s industry relationships. More money for the agency. Combining talent and financing significantly increases the agency’s opportunities to be compensated. Not only can the agency extract its usual 10 percent commission for each of its clients in the package under such circumstances, but it may also be able to build in an executive producing fee for the agency. Disadvantages Multiple conflicts of interest. Not only is there a built-in conflict of interest in a situation where an agency tries to attach two of its clients to the same project, but such conflicts multiply when the agency attaches even more clients and also helps to arrange the film’s financing. The agency’s interests tend to prevail in such situations, and the interests of others (financial or creative), including actors, writers, producers and in some cases financiers, are subordinated. Producer conflict. Talent agency involvement in packaging and film finance means the agents have moved into an activity traditionally undertaken by producers. Quality not assured. Neither agency packaging of talent nor assistance in arranging for production financing can assure that the best casting for the picture has occurred because agency packages draw from a smaller pool of talent (i.e., the agency’s own clients).

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32 Actor Financing Actor financing of a feature film means just that: the production costs are financed in whole or in part by an actor. Mel Gibson’s The Passion of the Christ is an example (see Sean Smith’s article “Put Your Money Where Your Movie Is”). However, such instances are rare, particularly for a big-budget movie. Very few actors have the resources to finance the production costs of a major film or the commitment to the project that it would take. It may be fair to say that such an arrangement is more likely for lower budget films. An ensemble group of actors and actresses have been known to both contribute production funds and raise additional financing from investors. Feature films at all levels continue to be risky ventures. Even the major studio/distributors, a collective of people who presumably have the greatest expertise in selecting commercial film projects, turn out to be wrong most of the time. In any case, actors come forward from time to time to put up some or all of the money needed to produce a particular film that they have a personal interest in, either for the chance to direct or to appear in a desirable role or out of enthusiasm for the film’s underlying message. Actor Deferments A more common form of actor financing for an independently produced film is the deferment of some or all of the actor’s salary for appearing in it. Sometimes an actor may be able to ask for a larger sum if the salary is deferred, meaning a specified amount is paid out at a particular stage in the film’s revenue stream as opposed to out of the film’s production budget. Agreeing to a salary deferment may be triggered by an actor’s desire to appear in a new kind of role that might lead to other challenging roles or by a great script or a particularly interesting cast. Perhaps the actor’s career has peaked and in order to get certain roles, he or she may be forced to agree to a salary deferment at some level. A good casting director may provide

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the producer with information about an actor’s needs that will help that producer arrive at a mutually satisfactory deferral arrangement. Percentage Participation Another form of actor compensation that may aid in meeting the financial needs for getting a film produced, and that therefore may be considered a form of actor financing, is the continuing percentage participation in a defined stage of the film’s revenue stream (i.e., contingent compensation). Ben Affleck was reportedly granted some form of percentage participation in Pearl Harbor, and it apparently worked out well for him (see Tom King’s article “A Big Payday for ‘Pearl Harbor’ Players: No Salary Upfront Results in Multimillions Later”). Note, however, that for these purposes, a major studio and affiliated distributor may be able to contract with an actor to pay a percentage of the distributor’s gross receipts (a rare occurrence), or a percentage of some specially defined level of distributor receipts between gross receipts and net profits (e.g., adjusted gross), but they are not really in a position to commit to pay an actor a percentage of the film’s box office gross. That is because the distributor has to negotiate with theatre chains for its own participation in box office gross, and there is no evidence that exhibitors and distributors feel such pressure from actors and their agent representatives that they find it necessary to give away a percentage of box office gross. Thus, notwithstanding the occasional report in the trades that some actor was granted a percentage participation in a film’s box office gross, it is more likely that the journalist was confused and the actor was really granted a percentage participation in some specially defined level of distributor receipts, not even true distributor gross receipts. Furthermore, without an assumption agreement (in which the distributor agrees to pay percentage participations) with the distributor, an independent producer seeking to partially meet his or her film production costs by granting actors a percentage participation can only do so at that stage in the film’s revenue stream that he or she controls. In other words, an independent producer is not in a position to grant an actor a percentage participation in box office gross, distributor’s gross or even an adjusted distributor gross. An independent producer will not control the film’s revenue stream at any of those stages. It is not even sensible for an independent producer producing an investor-financed film to talk to an actor in terms of “points” since this technical term really refers to a percentage of net profits or net proceeds, another stage in the film’s revenue stream not wholly controlled by the independent producer. Again, the independent producer is very likely to 218

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have to negotiate with the film’s distributor for a percentage of the film’s net profits. Thus, for example, if the distribution deal allows the production company to receive 50 percent of the film’s net profits, 10 points (i.e., 10 percent of the film’s net profits) would actually equal 20 percent of the production company’s share of gross revenues, and assuming the production entity is authorized to make certain deductions from its gross revenues, prior to sharing with other profit participants (i.e., investors), the actual actor percentage participation in the producer’s share would even be greater. If, for example, the independent film was financed with monies raised through an investor-financed LLC, it would make more sense to promise an actor a percentage participation in the manager’s share of the LLC’s net revenues (sometimes called distributable cash). In this instance, the LLC manager is the equivalent of the producer or producer group (as opposed to the investor group), and the producer-manager has control over the producer’s share of the film’s revenue stream. Alternatively, the independent producer might negotiate an assumption agreement with the distributor, who would then assume responsibility for directly paying all net profit participation commitments on behalf of the producer. If that were the case, offering “points” or a net profit participation to talent would make sense. On the other hand, if the producer were to commit to pay an actor a percentage participation in the LLC’s (or other investment vehicle’s) gross revenues (i.e., that portion of the film’s net profits or net proceeds that are paid to the production entity pursuant to the negotiated contract with the film’s distributor), such an arrangement would interfere with the investor group’s ability to recoup and therefore might make it more difficult to raise the money from investors in the first place. Advantages Another source of funds. True actor financing at any level reduces the amount of production funds that have to be raised from other sources. Lower production cost. Granting actor deferments or percentage participations in lieu of larger actor salaries to be paid out of the film’s budget lowers the amount of hard dollars needed to produce the film. Disadvantages Creative control. True actor financing tends to shift a certain amount of creative control to the financing actor. Delayed revenues. Deferral arrangements could also reduce or delay the amount of film revenues that flow to the producer. 219

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Risk for all. Percentage participations create additional risk for all parties, in the sense that an actor may ultimately be compensated more or less than if paid a stated salary out of the film’s budget, depending on the commercial results of the film’s distribution. Union rules. The voluminous and complex rules of the Screen Actors Guild may apply to such transactions; thus, producers must investigate applicable provisions. No attempt is made here to comment on or provide information relating to union rules.

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33 Product Placements Product placement refers to the practice of arranging to include a portrayal of a commercial product or logo in a motion picture in exchange for some form of compensation. The product manufacturer pays the production company to include its product in the film. The objective of the product manufacturer is to manipulate unsuspecting viewers to buy a product because they associate it with their favorite film stars or with the glamour of the movies. The objective of the producer is to help reduce the burden of production costs for expensive film projects. Product placement is little more than a long-standing marketing tactic applied to movies that may provide some financial assistance in getting the motion picture produced. When a product manufacturer places a recognizable product into a film, many people in the audience will tend to look on it favorably, and some will even choose to buy the product. It has been successfully demonstrated repeatedly that movies influence the thinking and behavior of some individuals. Product placement is a commercial of sorts, without the obvious hard sell of a commercial. In many cases, it is an implied endorsement by a celebrity, and advertisers believe such endorsements are valuable. Sometimes a commercial product is so integrated (product integration) with a movie that the product supplier becomes a creative partner in the making of the film. That apparently happened with the Warner Bros. movie You’ve Got Mail. In that case, AOL executives reportedly reviewed the script and made suggested changes. The seamless blending of product and story is, of course, the whole point of product placements. By subtly weaving a product into a scene, marketers hope audiences will connect their brand with the glamorous stars or story they are seeing on the screen. The practice of product placement has apparently been going on for many years. Ford Motor Company reportedly paid filmmakers to use the Model T and Model A in films made during the silent era. In the

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1940s, the advertising agency for diamond giant De Beers arranged for glamorous film stars to be draped in its gems on screen. In the early 1950s, Gordon’s Gin paid to have Katharine Hepburn’s character in The African Queen toss loads of their product overboard. Also, in the 1950s, Ace comb sales soared after James Dean used one to comb his hair in Rebel without a Cause, and Coca-Cola permitted Mickey Rooney’s character to fly a small plane into a Coke billboard in the 1963 film It’s a Mad, Mad, Mad, Mad World. But the practice of product placement did not really take off until the early 1980s, with the placement of Reese’s Pieces in ET: The Extra-Terrestrial. The 1989 movie The Wizard featured kids playing Double Dragon and Super Mario Brothers 3 on the Nintendo Entertainment System. Pepsi got a billboard in Final Fantasy. The Jamaican beer Red Stripe was featured in The Firm. The DeLorean automobile played a prominent role in the Back to the Future movies. The Shell logo on the handle of the gas nozzle was prominently displayed in Roman Polanski’s The Ninth Gate. Ray-Ban sunglasses were sported by the stars of Men in Black. Forrest Gump drank Dr Pepper. James Bond introduced us to the BMW Z3 Roadster in Goldeneye, Austin Powers had a Mini Cooper in Goldmember and Spiderman almost got trampled by a Terminix truck. In The Sixth Sense, Bruce Willis’s character opened the medicine cabinet to look for clues to his wife’s state of mind and considered a bottle of Pfizer’s antidepressant Zoloft. Then, there was that picture-in-a-picture moment in Analyze This when Robert De Niro’s angst-ridden mobster character watched a television commercial for Merrill Lynch investments, right along with the movie’s audience. In addition, the Hollywood-based major studio/distributors conspired for years with the manufacturers of tobacco products to sell cigarettes to teenagers, although that is no longer legal. Product placement has now grown into a multimillion-dollar business. Hundreds of brand-name products, including clothing, jewelry, cars, airlines, liquor, breakfast cereals and cigarettes have been placed in motion pictures. Now there are several “product placement companies” that specialize in arranging for products to be placed in movies, including divisions of some of the major advertising agencies. Also, some of the larger corporations dedicate personnel to scout out opportunities for product integration or placement in films, television shows and even games and music. The product placement deals tend to take two forms: • showing the product being used in the film in exchange for a supply of 222

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the product for use by cast and crew (apparently the most common type of deal) and • direct financial compensation for the product placement.

Payments for product placement will vary depending on how prominently the product is displayed in the movie, how much time (or how many times) it is shown, which star the product is associated with, whether the product is portrayed in a negative or positive manner and whether the film is receiving a major release. Of course, there may well be multiple conflicts of interest between the producer and the director with respect to how prominently a product should be displayed, how often, how long and so forth. But it has come to be a regular feature of the film business. Product manufacturers have reportedly paid $70,000 or more for a straightforward placement in a motion picture, but many of the deals are more complicated and bring in even more money. In some instances, product placement alone is not enough; it is just part of a larger marketing tie-in in which a product manufacturer makes a deal with the motion picture production company to create an ad campaign, a sweepstakes or some other promotion that complements the studio’s own marketing efforts for the film. The idea is not just to get a product into a film but to create a partnership between them and take the promotion beyond the film out to the people. These arrangements are often referred to as “strategic alliances,” and apparently some films could not be made without them. On the other hand, these are not necessarily forms of film finance so much as enhancements of the distributor’s marketing campaign. Examples of these overall marketing campaigns that included product placement are the Heineken beer appearances in Austin Powers: The Spy Who Shagged Me that went along with the promotions in bars, malls and liquor stores where audiences shopped. Also, Burger King reportedly spent $15 million on Men in Black II as part of a deal not only to have their products featured on the screen but for the entire promotional campaign. It is worth noting also that these were major studio releases, not independent films. Before advertisers will pay for product placements, they need assurances that a film is going to appeal to a specific target audience, that the film will be widely distributed and that it will be well attended. For that reason, very few independent productions can significantly benefit from product placements, certainly not the low-budget indie films. Thus, neither product placement nor product integration is a significant source for film financing for most independent feature films. 223

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Advantages More realistic. Having actual brands in a movie makes the movie more realistic (i.e., most people don’t drink brand X, they drink Pepsi or Coca-Cola). Quick cash. Some claim that product placements are an easy way to make some quick cash before the movie is even finished, much less released. Preferred advertising. Advertisers love it because it is a way to get a great plug in without the stigma of an actual commercial. Disadvantages Not a significant form of film finance. Showing a product in a film in exchange for the use of the product is not a significant form of film finance, but it may reduce the cost of the film if the product is something needed to produce the film, and it might help raise a small amount of production funds. Timing of payment. If there is no contractual commitment (and sometimes even if there is), placing a product in a film may not result in a cash payment until the film is completed, since the product manufacturer will want to be reassured by seeing the actual placement in the movie. Production idealization and distraction. In the real world, products are not made to stand out as glowingly and deliciously as they are in movies. Thus, the way movies often idealize a product can be a distraction to the audience. Creative issues. Often, film directors don’t like product placements because it interferes with their effort to make the film they envisioned. Moviegoer manipulation. Many movie patrons recognize a product placement when they see one, and they resent being manipulated in that manner. Violation of audience trust. Product placement violates the audience’s trust in the filmmakers and involves a loss of integrity. Danger to public. Some products (such as tobacco) are so dangerous to the public welfare that when repeatedly shown being used in a movie by movie stars, the film and its producer may be seen as condoning behavior that is dangerous to the general public.

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34 End Users Presales could conceivably be considered a form of end-user financing. However, end-user financing is more generally associated with a cash investment by the end user put up in exchange for an equity percentage participation in the film’s revenues in specified territories and media. In a presale, the end user is not actually putting up any money to be used in producing the movie but instead is putting up a guarantee to pay a specified sum of money upon delivery of the film, and the actual production money comes from a lender. Entities that exploit films in the ancillary markets, for example, video or cable companies, may prove useful sources of end-user financing. Ancillary markets are those geographical or technological areas of demand for film product that are auxiliary or supplemental to the theatrical market. The ancillary markets include foreign, network and syndicated television, pay cable and home video (including DVD). Foreign entities, such as television networks, entertainment consortiums, communication conglomerates or theatrical and home video distributors, who purchase rights to exploit U.S.-made films in their own markets provide another possible source for end-user financing. Some of those entities are capable of financing a domestic film production or distribution company and may do so in exchange for product flow in their base territory and some level of participation in worldwide revenues (or the revenues of specific territories or dividends of the company). Advantages In best position. End users in the marketplace, whether foreign or domestic, theatrical, video or cable, are the business entities best positioned to make money from a movie, since, at the very least, they exercise the most control over that portion of its revenue stream generated in their home territory. Therefore, they should be more willing than most to contribute toward financing the production costs of a given film. It then becomes a

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question of identifying (1) the end users, (2) how much they should have to pay for specified rights and (3) what form the investment takes. Knowing the audience. With end-user financing, the producer’s financing partner is an industry entity that has expertise at the retail level; that is, its representatives are on the front lines when it comes to making judgments about the tastes of the moviegoing public. Thus, it may be safe to assume that such a financing partner will not invest money in projects that it does not believe have commercial appeal in its market. Disadvantages Piecemeal financing. This form of financing typically is piecemeal in nature; it generally will require obtaining commitments from many end users (or some end users plus other financing sources) to cover the costs associated with producing the picture. For producers with a track record. Generally speaking, only producers with proven track records, who have successfully brought recognizable or commercially successful films in on time and under budget, are likely to be able to attract foreign or domestic end-user financing.

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35 Completion Funds Feature film completion funds crop up from time to time. Examples include Cinema America, a $15 million film-and-video financing entity based in Houston and the New York Completion Fund based in Cold Spring, New York. Film Dallas also functioned as a completion fund for some of the films in which it invested in the late 1980s. More recently, the Catchlight Films, LLC (based in Marina del Rey, California), raised approximately $1 million for the purpose of helping to complete films stuck in the lab. The money that made up this fund was raised from a group of passive investors, using the manager-managed LLC as the investment vehicle. Completion funds are designed to provide partial production or postproduction financing. Such funds may be provided for films that • have almost completed principal photography; • are complete except for postproduction; • are complete through postproduction but cannot be taken out of the lab because lab fees have not been paid; or • need additional funds to pay for that extensive list of distributor delivery items.

The completion fund managers understandably assert that it is easier to make judgments regarding the prospects of a film when it is nearly complete than at the script stage. Thus, they feel it is safer to invest in nearly completed films as opposed to investing earlier. An additional part of the completion fund strategy is to spread the risk; that is, such funds seldom put up all of the money required to produce a film, so they share the downside risk with other investors or financiers. Furthermore, these providers of the final dollars are usually successful in negotiating a higher percentage interest per dollar of investment in the film than earlier investors because without the last money in, the early money has no chance of recouping. It is even possible for independent producers to use investor financing to raise money from a group of passive investors to start a small completion 227

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fund of their own. Completion funds tend to get a lot of attention once they are formed and announced to the film community. They often have their choice of many projects in which to participate. Besides recouping their investment, the managers of completion funds typically look for a return on their investment of from 30 percent to 50 percent. On the other hand, the financing of independent film is so risky, it may be unreasonable to expect any participant to accept a ceiling on their participation. In other words, once a certain return has been reached, it may be reasonable to reduce the completion fund’s participation, but not to eliminate it entirely. That, at least, gives them an opportunity to continue their participation in the event the film is a home run. Another related type of fund, not otherwise covered in this book, is the so-called P&A fund. For example, private interests and the State of Florida created the Florida Film and Television Investment Trust Fund, which is supposed to have the authority to invest up to $3 million for prints and advertising on any completed film that spends 40 percent or more of its production budget in Florida. Specific Finishing or Completion Funds Women in Film finishing fund. The Women in Film Foundation has a completion fund called the Film Finishing Fund (FFF). It annually offers grants to assist filmmakers who have completed principal photography and whose projects will be in postproduction by a specified date (student projects are not eligible). Producers do not have to be a Women in Film member to apply for a grant from the fund. The application is available on-line at the Women in Film homepage. The application provides information regarding eligibility requirements and procedures. Global Film Initiative. The Global Film Initiative has been offering grant awards since 2003. The privately-funded grant program was inspired by the Hubert Bals Fund founded by the Rotterdam Film Fest. About 3 films per year are selected for grants from about 35 submissions from twenty or so countries. In addition to finishing-funds grants, the initiative also acquires several finished films from developing countries for showing in the United States through its distribution and education programs. Next Wave Films. Attorney, writer and independent producer Peter Broderick, along with a loose-knit group of directors, producers and film-industry professionals, using seed money from the Independent Film Channel, started a completion fund called Next Wave Films in the late 1990s. As a group, they sought out exceptional ultra-low-budget feature films and offered finishing funds. Next Wave would supply up 228

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to $100,000 each to as many as four films a year. The group also served as a producer’s representative for those features, helping the filmmakers implement a festival strategy, secure distribution and find financing for subsequent features. To be eligible for financial support, the films had to have budgets of $200,000 or less and the principal photography must have been completed. Next Wave funding would pay for things like sound and scoring, editing and a negative cut—postproduction elements that can frequently cost twice as much as principal photography. But in addition, Next Wave sought to offer technical advice, industry contacts and other kinds of intangible assistance. Unfortunately, the fund did not last. It closed its doors sometime in 2004. Catchlight Films. Independent producers Trey Wilkins and Jeanette Volturno (based in Marina del Rey, California) started a completion fund in 2001 by using a manager-managed LLC as the investment vehicle and raising approximately $1 million from a large group of passive investors for the purpose of identifying worthy low-budget films stuck in film labs because the producer could not pay the lab fees. The strategy called for the investment of limited amounts of funds to help complete such films and get them ready for distribution. The fund had some modest success, but later abandoned the completion fund idea and started investing production funds for films at an earlier stage. When researching on the Internet, producers may want to look for the phrases “film finishing fund” and movie “completion fund.” Advantages Financing source of last resort. Producers generally approach film completion funds because they have run out of money on a film project that is nearly complete. Thus, the producer is in a bind, and the completion fund may represent the only possibility for salvaging the film project. Investment versus loan. Many completion funds will invest in film projects and thus share in the risk, as opposed to merely lending money, in which case there is an obligation for the producer to repay such loans at a specific time. Disadvantages Weak bargaining position. Precisely because the producer is having problems, the completion fund entity is generally in a stronger bargaining position and thus can extract more favorable terms from the producer than earlier investors. This means that the producer and possibly the earlier investors or financiers may have to reduce their financial interests in the backside of the picture relative to the completion fund. 229

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Limited funds. Generally speaking, completion funds will not invest large amounts of money per film. Nothing lasts forever. Many, if not most, of the film completion funds that have been created from time to time have faded away after a while.

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PART FIVE International Finance Options Many of the so-called foreign or international finance options discussed in this part of the book were created by local film industries in various countries for the purpose of countering the spending power and business practices of the Hollywood major studio/distributors. These countries sought to protect their local cinema and culture from Americanization (see “Europe’s Tortuous Financial Deals”; “Why Hollywood Rules the World, and Whether We Should Care”; “337 Reported Business Practices of the Major Studio/Distributors”; and Hollywood Wars: How Insiders Gained and Maintain Illegitimate Control over the Film Industry). On the other hand, in many instances, some of these same devices have been used by U.S.-based producers (usually by coproducing with a local producer) to aid in financing the production costs of what started out as an American film. It would be unreasonable to expect the information in a book like this to remain current during the many years it remains on bookshelves in the face of changing policies, phone numbers, and websites of the countries that may offer some form of subsidy or tax incentive to filmmakers (even so, some of the websites are listed in Sources and Further Reading). Instead, this section of the book offers a sampling of these foreign programs so that filmmakers can decide whether they would want such a program to be part of their film-financing strategy for a particular film project. Of course, filmmakers should always seek out the most current information, which may be obtained through contacting an attorney or accountant who has expertise in this area; or by doing an online search using the name of the particular country and such terms as film fund, film tax incentive, film subsidy, international film coproduction and so on; or by contacting the film commission in the country of interest and inquiring about the country’s film subsidy and tax incentive programs, if any.


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36 Foreign Equity Foreign-equity financing is funding provided by foreign (non-U.S.) sources in exchange for an ownership interest or profit participation in the films financed or in the entity producing them. In addition to requiring an equity participation in the film’s receipts, foreign equity investors typically demand that certain territories be reserved for them so they can further benefit from exploiting the films. Foreign-equity financing could also involve raising money by offering equity ownership interests in a production or coproduction entity, such as shares of common or preferred stock for a corporate production company, interests in a limited partnership or units in a manager-managed LLC. Equity financing of a feature film outside the U.S. major studios enables the producer to finance the film unhampered by the creative intervention of studio executives and other pitfalls associated with studio financing. The German Wave In the late 1990s, some German film companies were actively involved in equity financing. They started going beyond purchasing German rights and began purchasing pan-European rights. Others made substantial equity investments in films or provided 100 percent of the budget for some films. Some of these German companies set up their own foreign sales divisions for the purpose of selling the non-German rights they had acquired, while others invested in or acquired distribution companies in other countries. These developments occurred at about the same time that the much-publicized insurance-backed financing schemes started to fail (see chapter 23). The Germans’ zeal for the equity financing of foreign film projects has also subsequently subsided. The British Cinema Fund Another source for foreign equity financing has been the United Kingdom. The UK Film Council is a government-backed strategic agency for film whose main aims are to stimulate a competitive, successful and vibrant UK 233


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film industry and culture and to promote the widest possible enjoyment and understanding of cinema throughout all regions of the nation. The UK Film Council offers a limited amount of production funding through its New Cinema Fund, and independent producers from other countries may have access to these funds by collaborating with UK-based coproducers. The annual budget for the New Cinema Fund is quite limited, however, and it is divided among various projects. In order for producers who are not UK-based to apply for funding, they will need to insure that a UK-based coproducer is attached to the project. If based in another state of the European Union (EU) or European Economic Area (EEA), the producer can apply in his or her own name and subsequently attach a UK coproducer. If the producer is not based in the EU or EEA the application can only be made by the attached UK coproducer. In both instances the UK Film Council will make its offer of funding direct to the UK coproducer and may require the non-UK-based producer to sign the Production Finance Agreement. Potential UK coproducers may be found in the Directory of UK Coproducers, made available through the UK Film Council website under “Publications.” The New Cinema Fund’s promotional literature states that it hopes to encourage unique ideas, innovative approaches and new voices. The fund also intends to finance films with “passion and verve” that connect with a broad range of audiences. It supports feature film production, the making of pilots to illustrate a project’s potential for feature film production and short filmmaking through its various shorts schemes. The following information describes the current UK Film Council’s feature film production funding program, but the information may only be current for a limited time, since all such programs often change from time to time. Thus, other than reviewing this material for purposes of gaining a general understanding of the way a British film funding scheme works, it should not be relied upon as the sole source of information. Instead, a filmmaker should contact the UK Film Council or its subsequent counterpart and obtain the most current version of their equity funding rules. In its promotional materials, the UK Film Council indicates that its New Cinema Fund supports creativity, innovation, new talent and “cutting edge” filmmaking. It has an especially strong commitment to support work from black, Asian and other ethnic minorities. With 15 million British pounds to invest over three years, the New Cinema Fund claims it is committed to innovative and original material from a diverse 234


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range of filmmakers. The fund has also embraced new digital production techniques and formats. Application requirements. A film production entity or filmmaker can apply if it, he or she is • a company registered and centrally managed in the United Kingdom; or • a company registered and centrally managed in another state of the European Union or European Economic Area; or • an individual aged 18 years and over and a national or resident of the United Kingdom (or another state of the European Union or European Economic Area). In this case, if the application is successful, the filmmaker will be required to form a limited liability company before any offer of funding is made.

In addition, the project must be intended for theatrical release and be in the form of a screenplay. In the case of a documentary feature film, a detailed treatment will be accepted. If applying for postproduction or completion support, a DVD or VHS of a rough cut or assembly will be required. Also, as a general rule, the film must be intended for production in the English language (although exceptions may be made under some circumstances); and the film must be capable of obtaining theatrical and video release certificates no more restrictive than BBFC “18” in the United Kingdom and MPAA “R” in North America. The film must be wholly or substantially capable of qualifying as a British film. In other words, the project should be capable of qualifying for certification by the British Department for Culture, Media and Sport (DCMS). Coproductions made under the terms of one of the United Kingdom’s bilateral film coproduction agreements, or under the European Convention on Cinematographic Coproduction may be considered as British for these purposes and therefore eligible for UK Film Council funding. Britains’s New Cinema Fund has a stated preference for film projects that demonstrate one or more of the following: • diversity, innovation, new and “cutting edge” filmmaking talent; • a strong commitment to supporting work from across the United Kingdom and from black, Asian and other minority ethnic groups; and • utilization of the benefits offered by digital technology in the making and showing of films.

It should also be able to show that: • the project has secured, or is in the advanced stages of securing, the services of a director and the principal cast for the film; and

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• the project has secured, or in the opinion of the New Cinema Fund has the potential to secure, a UK theatrical release or a high-profile digital release with a distributor or web broadcaster acceptable to the New Cinema Fund.

The filmmaker must demonstrate a convincing vision for the project in terms of creative direction, financing structure, distribution and marketing. The filmmaker will also need to demonstrate an ability to be instrumental in the realization of such a vision. Projects that cannot demonstrate the above are unlikely to obtain funding from the New Cinema Fund. Level of funding. The level of funding offered varies depending on the type of production involved. 1. Feature films may receive between 15 and 50 percent of the production budget. Funding will usually be provided by way of an equity investment in the film. 2. Pilots are sometimes supported at the discretion of the New Cinema Fund in order to assess further the potential of a project for production or development funding by the UK Film Council. The film council will fund customary direct production costs (excluding above-the-line costs) of up to £10,000 for a pilot film. Pilot film funding will usually take the form of equity investment repayable to the UK Film Council upon commencement of principal photography of a feature film based upon, or connected to, the pilot film. 3. Postproduction and completion fund applications will be accepted for feature film projects that have begun the production process but are not yet complete. Producers can apply at any stage of the production or postproduction process; however, applications for print and advertising costs only are not eligible. The New Cinema Fund application forms should be completed and accompanied by a VHS or DVD of a rough cut or assembly of the film, a budget for completion, details of how the project has been funded to date and letter(s) of interest from UK distributors. If the film is still being shot, the New Cinema Fund’s assessment process will be aided by a selection of footage and the shooting script, if available. All requests for funding from the New Cinema Fund must be accompanied by a completed application form along with the following: • a synopsis of the film project (maximum of 100 words); and • two copies of the script (with the draft number and date clearly marked on the front page), page numbered throughout and in the industry standard format. One copy must be unbound, the other can be stapled.

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In addition, an applying producer may include (as applicable): • the production budget or proposed production budget and cash flow schedule; • finance summary; • sales agent’s estimates; • information about the production company; • details of creative elements already involved; • director’s creative comments; • shooting schedule; • outline of proposed recoupment structure; and • DVD or VHS of scenes already shot or of examples of the director’s work.

Note that the production budget does not have to be submitted with the initial application, but if the New Cinema Fund is interested in the project creatively, it will require a production budget before proceeding with the application. The New Cinema Fund will expect a production budget to be based on industry norms and market rates and, where applicable, to take into account the economic benefits of digital production. The level of production budget should reflect the level of recoupment that the project can reasonably expect to deliver. When the production budget is submitted (either at the application stage or later at the request of the New Cinema Fund), it must contain provision for the following costs and expenses: • clearances of all rights in the film worldwide in all media in perpetuity (except for those sums due with respect to music performing rights); • an independent guarantee of completion (completion bond); • all customary production insurances (including errors and omissions) on which the UK Film Council will require to be named as an additional insured; • a mandatory contribution to the Skills Investment Fund; and • all the delivery items set out in their Delivery Requirements list, including, among others, the access material relating to exhibition for people with sensory impairments.

Once completed and signed, the New Cinema Fund application form and supporting materials should be sent to the UK Film Council marked for the attention of the New Cinema Fund. Materials are sent at the producer’s risk, and the New Cinema Fund suggests that original supporting materials not be submitted. Applications can be sent by courier

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or by post but should not be submitted by e-mail. The New Cinema Fund reserves the right to request and review any other relevant supporting material before making a funding decision. The application will be acknowledged within two weeks of receipt. The New Cinema Fund will inform the producers as soon as possible if the application is not eligible. The project will be assessed initially on its creative merit and its ability to fulfill the New Cinema Fund’s mission. Applying producers will be informed within eight weeks of receipt of the application by the UK Film Council whether the fund is interested in the project or is rejecting it on creative grounds. The selection process is subjective, and the New Cinema Fund’s decision is final. There is no appeal process open to applicants whose projects have been rejected on creative grounds. The UK Film Council is required to retain the application form and a copy of the script, treatment, DVD or VHS, as applicable, for audit purposes. Other supporting materials can be returned to the producers on receipt by the New Cinema Fund of a written request. If the New Cinema Fund is interested in the project but believes that it requires further development, it can, with the agreement of the applying producers, recommend that an application be made to the Development Fund for funding. In such cases, the decision whether to provide such funding will be made by the head of the Development Fund. If the New Cinema Fund believes that the project is unsuitable for its support but merits consideration by another British funding source (e.g., the Premiere Fund), it may refer an application to that fund with the producer’s prior approval. Alternatively, it may offer funding toward the production of a “pilot” film in order to assess further the merits of the project. Producers may also be invited to discuss their projects further, in which case supporting documentation may be requested. Such supporting documentation may include any of the following: • • • • • • • • •

proposed production budget; cash flow schedule; finance summary; sales agent’s estimates; information regarding the production company; details of creative elements already involved; director’s creative comments; shooting schedule; and outline of proposed recoupment structure. 238


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The New Cinema Fund will then work with the Business Affairs and Production Finance departments of the UK Film Council to assess the project. The New Cinema Fund may reject an application at this stage and, if so, the producer will be informed of this decision in writing. The UK Film Council is not obliged to provide feedback on unsuccessful applications. Resubmissions. The UK Film Council will accept resubmissions for funding of the same film project, but only if there have been significant and substantial changes to the script or major new elements have been attached or secured. Any resubmissions should be accompanied by a new application form that clearly shows the alterations made, accompanied by a full explanation of those changes. Resubmissions will not be accepted without such an explanation. Offer letter. The UK Film Council will write an offer letter to the producers to let them know of the approval of the application and the amount of funding to be offered. The offer letter will also outline terms and conditions of the funding. The offer of funding will be for a fixed period and for a fixed amount and will be conditional upon the producers’ entering into a production finance agreement. Once the offer letter is signed and returned and any conditions specified in the offer letter have been satisfied (e.g., other financing elements have been secured in principle), the UK Film Council will prepare the production finance agreement. If both the producer and director on a project are “first-timers” (i.e., without previous feature film production experience), the UK Film Council reserves the right to insure that the film has the guidance of an experienced executive producer or production company, with the relevant costs to be included in the production budget. At this stage, if the producers have applied to the New Cinema Fund as individuals, they will be required to set up or to act through an existing production company. If they applied as a company, they may wish to set up a single-purpose company to produce the film project, in which case they must inform the UK Film Council of that intention in writing. Production finance agreement. The UK Film Council uses its own production finance agreements, adjusted to the specific requirements of each project. The council will not begin the cash flow on a project until the production finance agreement has been executed, all other financial and distribution commitments are in place and the funding conditions set out in the agreement have been satisfied. The terms and conditions of each production finance agreement will differ according to specific arrangements with all the relevant financing partners and distributors. Producers are encouraged to obtain independent legal advice before signing the agreement. 239


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Other British funding sources besides the New Cinema Fund include the Premiere Fund and so-called National Lottery franchise companies—DNA Films Limited, The Film Consortium Limited, Pathé Pictures Limited (for the duration of their respective franchises). However, no two of these funding sources can fund the same project. Australian Direct Investment Australia also provides a form of government-supported equity financing for feature films. The Film Finance Corporation (FFC), which is wholly owned by the Australian government, is the principal agency for funding the production of film and television in Australia through direct investment. The FFC funds feature films, miniseries, tele-movies and documentaries. The government supports film and television production to encourage diversity and to ensure that Australians have the opportunity to make and watch their own screen stories. The FFC will only fund projects with high levels of creative and technical contribution by Australians, or projects certified under Australia’s official coproduction program. Thus, among other requirements, U.S. producers will have to seek out and coproduce with an Australian producer. The following are the stated objectives of the Australian FFC: • finance the production of a diverse range of Australian film and television programs; • maximize opportunities for audiences to view FFC-financed film and television programs; • increase the value of production generated by coinvesting with the market and maximizing recoupment; • provide a centralized source of market intelligence for the benefit of film and television industry practitioners; • efficiently and effectively manage the FFC and its resources for its shareholder, the Commonwealth of Australia.

Since its establishment, the FFC has invested in 875 projects with a total production value of $1.96 billion. The government has funded the FFC on a three-year basis and has committed to annual base funding of $50 million. Supplementing its federal government appropriation are the FFC’s share of revenues recouped from projects active in the marketplace. These funds are used each year to support the production of new film and television programs. The total slate of projects backed by the FFC each year is financed by a combination of FFC funds and finance from private investors and other

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marketplace participants (e.g., distributors, broadcasters, sales agents and state government agencies). The FFC considers its market partner participation to be critical because the FFC not only helps to raise funding, but they also provide opportunities for programs to find audiences. The FFC considers that by cofinancing with theatrical distributors, broadcasters, international sales agents and other such companies, it is tapping into valuable distribution and exhibition networks that can maximize the audience reach of its programs. All Australian film and television producers and production companies can apply to the FFC for funding. To be successful, they must meet the criteria set out in the FFC’s investment guidelines, which delineate the FFC’s policies. The policies are revised each year in consultation with the industry, so it is important that interested producers check the most current set of guidelines. The investment guidelines contain different criteria for each of the four production categories the FFC funds: • • • •

feature films; adult miniseries and tele-movies; children’s miniseries drama; documentaries.

The FFC can provide different types of funding. Under its memorandum of association, it can assist qualifying film and television programs by • undertaking investment; • acquiring, obtaining, dealing in and exercising rights; • making or participating in loans (including print and advertising loans); • providing investment guarantees and underwriting agreements; or • leading or participating in loan syndicates and similar joint ventures.

The FFC does not produce or distribute the programs in which it invests, nor does it develop projects or select which projects should be developed. These roles are performed by the Australian Film Commission, state film organizations and the private sector. The FFC operates under a memorandum of association, a ministerial mandate, a board of directors and a corporate plan. All funding decisions are made by the FFC Board, which meets every six weeks. Additional meetings may be convened to consider urgent investment applications.

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The FFC has offices in Sydney and Melbourne. The Sydney office is the administrative center, with a full-time staff of more than twenty individuals. The Melbourne office has a smaller staff and handles all investment applications originating in the Australian state of Victoria as well as other applications. For further information, go to the FCC website at http://www.ffc.gov.au. Isle of Man Financial Assistance Great Britain’s Isle of Man in the Irish Sea has in recent years offered a couple of types of financial assistance, including an equity participation and a loan secured by a guarantee or letter-of-credit. Under some circumstances, the Isle of Man Film Commission will take a recoupment position behind the principal investor, or agree to recoup its investment out of receipts from the film in a limited number of territories. A minimum amount of production spending on the island will be required. To qualify for the direct investment, • the film must be an English-language motion picture; • the producer has to set up a single purpose company on the Isle of Man to meet the local production company requirement; • at least 50 percent of the project has to be filmed on the Isle of Man (but this percentage is negotiable to meet the requirements of other financing sources); • at least 20 percent of the below-the-line budget has to be spent with local service providers; • both a collection agent and a completion bond need to be arranged for; and • the producer has to employ at least four local individuals as trainees for various film production positions.

One of the principal requirements for the lending program is that the production be carried out by a production company incorporated on the island. However, there are no specific content criteria for shooting on the Isle of Man except for the typical categories of unacceptable material found in most applications for funds from public bodies (see Sources and Further Reading for “Filming in the Isle of Man: A Survey of Incentives Available” by Helen Tulley). South African Film Funds In some instances, private entities join together to create film funds for the purpose of attracting film production to a specific locale. That has occurred in South Africa, where Shyanne Media and Germany’s CD 242


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Medien and Framewerk have partnered to create a film finance fund aimed at drawing production to that country. Advantages Local guidance. When the foreign partners are industry insiders in their home market, they often can provide expertise in exploiting films in that territory and in guiding a particular film production through complex governmental bureaucracy. Local favorites. Movies that are considered partly domestic productions in foreign countries may benefit from some favoritism when foreign partners are aboard. Disadvantages Creative control. Depending on the arrangements, the foreign equity investor becomes the financial and creative partner of the domestic producer. Local entity. A common prerequisite for accessing foreign equity and other forms of international financing is that the film be produced through a truly local entity. Copyright transfer and taxes. Not only will many of the foreign finance options require the transfer of copyrights to a local entity, but the transfer of rights to actually distribute a film, which may also create an obligation to pay significant exit taxes. Foreign currency. These transactions will require some knowledge of the current value of foreign currencies with the attendant risk of such values falling or rising unpredictably. Financial ups and downs. Inconsistent film policies from one governmental regime to another, combined with volatile economies, radically alter the percentage of funds allocated to the cinema out of a government’s total arts budget from time to time.

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37 International Coproductions In the more general sense, feature film coproduction financing involves a sharing between two or more producers, production companies and/or other entities of the responsibilities for the creative decision making and financing of a film production. Numerous items relating to decision-making authority on various production questions must also be negotiated to avoid conflict over issues that are inherent in coproduction relationships. Coproductions can be domestic or international in scope. Distributorfinanciers sometimes make coproduction deals with one or more parties for one or more territories so that the risks associated with financing the production of the film will be spread among several parties. General Purpose International coproduction agreements allow producers from two or more countries to jointly produce a feature film and provide a means to pool financial, creative and technical resources from the participating countries. International coproduction treaties (and sometimes administrative accords) exist between numerous countries, including Canada, Australia, the United Kingdom, Italy, France, Germany, Japan, China and Norway. In order to qualify as an international coproduction, the film must meet the requirements set out in one or more of the various treaties. It then may be eligible for several forms of financial support in the applicable countries, such as tax benefits; government loans, grants, or subsidies; and below-the-line or facilities deals. Such arrangements may also permit a U.S.-based producer, coproducing with producers of other countries, to exceed television airtime quotas in certain countries (since the film may then qualify as a local film). Over the years, the phrase “international coproduction” has not been all that important or meaningful for U.S.-based independent producers. The United States has no coproduction agreements with foreign governments and offers only minimal tax breaks or subsidies to encourage foreign film investment. However, as production finance has become 244

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increasingly difficult, U.S. independent producers have sought ways in which to participate in international coproductions. Among the very first considerations in determining if a proposed film may benefit from an international coproductionis whether the script itself is suitable for shooting on location in one or more of the countries involved and whether it otherwise meets the creative and economic requirements of the applicable coproduction treaties. As a general rule, the international coproduction regulations allow as much as 30 percent of the film’s budget to come from other countries besides those that are signatories to the international coproduction treaties involved and still qualify for local subsidies as well as contribute toward fulfilling national quota requirements. So a U.S. producer could raise as much as 30 percent of the film’s budget (e.g., from a group of passive investors in the United States) and then seek to qualify it in several other countries as an international coproduction. In order to qualify, a film must have a local producer in each of the participating countries. Deal terms. International coproduction deals may simply divide territories between the coproducers or go so far as to split worldwide profits from the film based on some complex negotiated formula. The coproduction treaties themselves may require that the coproduction agreement set out the specific arrangements relating to the financial interests and liabilities of the coproducers and the apportionment of the receipts generated by the film among them. Added value. The international coproduction may add value to foreign rights. As an example, film rights presold in France might bring $1 million, $3 to $4 million if handled through a U.S.-based international distributor, but as much as $10 million if the production were an international coproduction qualifying in France. Also, coproductions may help provide access to foreign subsidies. Qualification. Qualifying for financial support through international coproduction treaties is difficult and requires that the film meet the test of nationality in each of the coproduction territories. Some coproduction treaties are based on a point system in which a specified number of points are required to access benefits and points are awarded for various elements of a film production that use resources and personnel of the countries involved. Upon application for coproduction status and on delivery of the film, all coproductions are subject to audit by the authorities in each participating country to measure the ratio of funding to the creative input of each coproduction partner and whether such ratios are consistent with the treaty requirements. 245

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Tax status in the United States. Often the drafters of coproduction agreements will insert a provision that the agreement is governed by foreign law and that nothing in the agreement should be construed to indicate that a partnership or joint venture has been created between the coproducers. However, such statements do not determine the status of the transaction or entity for U.S. tax purposes when one of the coproducers is a U.S. producer. The IRS will determine whether the transaction has resulted in the creation of a taxable or nontaxable entity or whether it should be characterized as a loan, an equity investment or merely presold film rights. IRS characterization. On the one hand, the IRS will most likely characterize a coproduction arrangement that permits the coproducers to actively participate in the production and distribution of the film and share in the worldwide profits of the film as a joint venture (sometimes referred to as an international coproduction partnership), a corporation or an association taxable as a corporation. On the other hand, the arrangement involving the sale of territorial rights to a foreign individual or entity in exchange for part of the production financing is more likely to be considered merely a foreign equity investment or presale in which no taxable entity has been created. Tax treatment reminder. Joint ventures, limited partnerships and LLCs are not taxed at the entity level; but corporations and associations taxable as a corporation are taxed at the entity level. Producers seeking out coproduction opportunities should identify attorneys with international film coproduction expertise. Canadian Coproductions Canada may be the most active coproducing country in the world, with more than 58 coproduction agreements worldwide. Coproductions are a key component of Canadian film and television production and a favored method of penetrating new markets and facilitating project financing. Canadians are very active in the coproduction area and have earned a reputation for promoting quality projects. Telefilm Canada administers coproduction agreements on the Canadian government’s behalf. The official coproduction agreements enable Canadian producers and their foreign counterparts to pool their creative, artistic, technical and financial resources to coproduce films and television programs that enjoy the status of national productions in each of the countries concerned. The volume of Canadian production activity, amounting to some 100 productions, has in recent years been close to an average of $700 million a year.

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In order to qualify as a Canadian coproduction, the film needs Canadian or British creative components. In Canada, it is possible to access federal, provincial and even animation tax credits all on the same project. In recent years, Canada has had coproduction agreements with all the following countries: Algeria, Argentina, Australia, Austria, Belgium, Brazil, Chile, China, Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Russia, Tajikistan, Turkmenistan, Ukraine, Uzbekistan, Denmark, Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, Ireland, Israel, Italy, Japan, Luxembourg, Malta, Mexico, Morocco, the Netherlands, New Zealand, Norway, the Philippines, Poland, Romania, Senegal, Singapore, Slovak Republic, South Africa, South Korea, Spain, Sweden, Switzerland, United Kingdom, Venezuela and the former Yugoslavia (including Bosnia-Herzegovina, Croatia, Macedonia and Slovenia). For the latest guidelines and requirements relating to Canadian coproductions, go to the Telefilm Canada website. British Coproductions To qualify for British coproduction status, each coproducer’s financial contribution needs to be in reasonable proportion to the creative filmmaking contribution from the country he or she represents except in cases where financial-only participation is allowed. The financial-only participation type coproductions are currently possible only under the UK–France and UK–Italy agreements and the Co-European (“CoE”) Convention. The producer from each country involved in a British coproduction is responsible for raising a share of the total production cost. The percentages are as follows: • for bilateral agreements, no less than 40 percent; • for convention agreements, no less than 20 percent; and • for multilateral agreements, no less than 10 percent.

The film will also have to be certified as a British film. There are two ways a film may qualify as a British film: (1) by fulfilling the conditions set out in Schedule 1 to the British Films Act; or (2) by satisfying the terms of an international coproduction agreement to which the UK is a party. The conditions to be met under the terms of the British Films Act include • the filmmaker must be, throughout the time during which the film is being produced, either a person who is ordinarily resident, or a company that is registered and centrally managed and controlled, in an EU member state;

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• 70 percent of the production cost of the film must be spent on filmmaking activity in the United Kingdom. If the costs of one or two people are deducted from the total labor costs then the same deductions must be taken from the total production cost before the 70 percent test is applied; • 70 percent of the total labor cost (minus the cost of one non-EU/EEA or non-Commonwealth person if desired) must have been paid to citizens or residents in the EU/EEA or Commonwealth or Association countries; or • 75 percent of the total labor cost, after deducting the cost of two nonEU/EEA or non-Commonwealth persons (including one actor) must have been paid to citizens or residents of the EU/EEA or Commonwealth or Association countries.

No more than 10 percent of the playing time of the film should be visual images from a previously certified film or from a film by a different maker. In the case of documentary films, this limit may be extended if an acceptable case is made to the British Department for Culture, Media and Sport. More detailed information can be found on the UK Film Council International or British Department for Culture, Media and Sport websites online. Certification. The British Department of Culture, Media and Sport issues two types of certificates for films: an EC Certificate of Nationality; and a Certificate of British Nature of a Film. EC certificate of nationality. Some EC countries have quotas on the number of non-EC films exhibited in their countries, and exporters of British films may require a Certificate of Nationality to qualify for benefit of the screen quota in such countries. A film must fulfill the criteria set out in the most current EC directive for certification. The criteria typically include • studio filming must take place in EC territory; however, if outdoor scenes are filmed in a third country, up to 30 percent of studio scenes can be shot in the third country; • one of the UK languages (when certificates are issued by the United Kingdom); • a specified number of nationals employed including: scriptwriters, music composers, principal cast, executive producer (or production manager), director of photography, sound engineer, editor, art director and chief of wardrobe.

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If any labor costs for any of the above-listed personnel are paid to a third-country national, • third-country nationals must not comprise more than two-fifths (40 percent) of people employed in all the categories (when the director is a British or EC national); • third-country nationals must not comprise more than one-fifth (20 percent) of people employed in all the categories except scriptwriters and music composers (when the director is a non-British and nonEC national). The scriptwriters and composers must be British or EC nationals.

Citizens of Iceland, Norway and Liechtenstein are now granted the equivalent status as nationals from EC member states with regard to the provisions of the directive as part of the European Free Trade Agreement. Certificate of British nature. To qualify for certification, a film must fulfill the criteria set out under Schedule 1 to the Films Act. The Department of Culture, Media and Sport has the application. The British Film Council and the government have also been reviewing the country’s coproduction agreements in order to stop the abuses and inconsistencies discovered in the existing programs. Thus, Britain’s coproduction rules could change in the future. In addition, there is some talk about the possibility of developing a UK/U.S. coproduction arrangement. European Convention on Cinematography The aims of the European Convention on Cinematography (“Convention”) are • to promote the development of European multilateral cinematographic coproduction; • to safeguard creation and freedom of expression; and • to defend the cultural diversity of the various European countries.

In order to obtain coproduction status, the work must involve at least three coproducers, established in three different parties (countries) to the Convention. The participation of one or more coproducers who are not established in such parties is possible, provided that their total contribution does not exceed 30 percent of the total cost of the production. This is the provision that may allow U.S.-based producers to raise and contribute that 30 percent. The coproduced work must also meet the definition of a European cinematographic work set forth in Appendix II of the Convention.

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Once these conditions have been fulfilled, the Convention assimilates all coproductions, which have been given the prior approval of the competent authorities of the parties, with national films (i.e., they are entitled to the benefits granted to the latter). The Convention also covers the following: • the minimum and maximum proportions of contributions from each coproducer; • the right of each coproducer to coownership of the original picture and sound; • the general balance of investments and compulsory artistic and technical participation; • the measures to be taken by the parties to facilitate the production and export of the cinematographic work; and • the right of each party to demand a final version of the cinematographic work in one of the languages of that Party.

French Coproductions France has generally been the second most active coproducing country with more than 40 such treaties, including Canada and Great Britain. U.S. producers, or other producers from countries not party to these treaties, can sometimes team up with a Canadian or British producer, in order to benefit from specific sources of funding for films to be produced in France. One such fund that U.S. filmmakers seeking to develop projects in France may access is administered by the national government. This “fonds de soutien” can provide about 15 percent of a film’s budget. To qualify for these funds, the film must also satisfy a point system based on its European content (e.g., nationality of the cast, language spoken in the movie and other criteria). Australian Coproductions Film finance in Australia is encouraged in a variety of ways, through direct investment by the Australian Film Finance Corporation, through federal and state government tax incentives and through coproduction arrangements. The Australian federal government has entered into official coproduction treaties with the United Kingdom and Northern Ireland, Canada, Italy, Ireland, Israel and Germany. It has also developed Memoranda of Understanding (MOU) with France and New Zealand. The treaties and

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MOU can be downloaded from the Australian Film Commission website at http://www.afc.gov.au/filminginaustralia/copros by clicking on the heading “Legislation & Treaties.” The guidelines and application form are also available to download. The effect of these two arrangements is that a film or television program approved as an official coproduction is regarded as a national production of each of the coproducing countries and is therefore eligible to apply for any benefits or programs of assistance available. In Australia, official coproductions are eligible to apply for 10B and 10BA tax deductions, the 12.5 percent refundable tax offset (see chapter 38) and investment from the FFC (see chapter 36). The Australian International Co-Production Program was established to facilitate cultural and creative exchange between the coproduction countries; allow the coproduction countries to share the risk and cost of productions; and increase the output of high-quality productions. An official international coproduction must be made under the terms of one of the arrangements in place between Australia and the coproducing countries. There must be a producer from each of the countries and a balance between the Australian financial equity in the project and the Australian creative components (this is generally a minimum of 30 percent under the treaties and 20 percent under the MOUs). Creative equity is determined by • a point system for key cast and crew; • an equivalent percentage of other cast and crew; • an equivalent percentage in the amount of money spent in Australia or on Australian elements within the production budget.

Foreign filmmakers planning to produce a movie in Australia may obtain a development loan or a production grant from the national government (also known as the “Film Bank”), through the International Co-Production Program (ICPP). The Film Bank has approximately $80 million set aside to help encourage, develop and maintain a local film industry. The ICPP program was created by the various coproduction treaties that Australia has entered into with Canada, France, Israel, Northern Ireland, the United Kingdom and other countries. If U.S.-based film producers, or producers from countries not a party to these treaties, want to take advantage of this source of funding, they must partner with a producer from a country that is party to the coproduction treaty. The Australian Film Commission administers the International Co-Production Program and can provide detailed guidelines on how to apply for coproduction status.

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Irish Coproductions Ireland has entered into coproduction treaties with Canada and Australia. In addition, the country has ratified the European Convention on Cinematography. New Zealand New Zealand has coproduction treaties with a number of countries, including the United Kingdom, France, Italy, Canada and Australia. A film qualifying as a New Zealand film becomes eligible for various funding initiatives, including tax incentives, loan schemes and equity financing. Some of such films may receive funds for project development, initial casting and location searches. In addition, a qualifying film may enjoy the removal of trade barriers and administrative assistance in acquiring necessary visas and work permits. However, in order for a film to be eligible, it must comply with certain rules relating to production, distribution and the receipt of revenue generated by the film. For example, there are percentage requirements on the production cost contributions for majority and minority coproducers. Also, the addition of sound and effects and the laboratory work must take place in the majority coproducer’s country. In addition, the duplication of copies intended for distribution in that country must also occur there. And films made pursuant to a coproduction treaty must include language to that effect in the screen credits. Furthermore, the coproducers’ freedom to determine the allocation of revenues and potential markets between them is subject to the respective government agencies in the coproducing countries, and as a general rule these allocations must be made in proportion to the respective initial interests of the coproducers. Finally, all coproducers will jointly own the original picture and sound negative. Czech Republic The Czech Republic has entered into coproduction treaties with Canada, France and Italy, among other countries. Promoters of coproductions in the Czech Republic claim that since its production facilities are inexpensive, Czech crews speak English, there are no unions and locations are picturesque, a qualifying coproduction can save up to 50 percent of the total below-the-line budget. On the other hand, foreign producers in the Czech Republic apparently get the same advantages from filming there as “cross-border producers” that they would if they qualified as official “coproduction partners.” 252

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As is common with international coproductions, the film’s revenues from other territories are generally split between the coproducers in proportion to their respective investments, and the proportion of contributions may vary from 20 to 80 percent. Also, the copyright is shared between the coproducers. An application for certification of a coproduction would need to include the final script, documentary proof that the copyright for the film has been legally acquired and a copy of the coproduction agreement signed by the coproducers. In addition to the Sources and Further Reading, additional information on international coproductions for film may be obtained through the national film commissions of the countries of interest (some of which have offices in Los Angeles) or through their embassies or consulate cultural attaches. Advantages National films. International coproduction agreements allow a film to qualify as a national film in all the countries that are party to the agreement being used. Coproduction films are therefore eligible for the benefits available for national films in those countries. Sharing risks. International coproductions allow producers to share the substantial economic and artistic risks involved in film production. Lower costs. Sometimes, a film can be produced for less money in other countries (i.e., lower production and union costs compared to the United States). Closeness. A country’s proximity to the United States may be an advantage to a U.S.-based producer seeking coproduction partners compared to countries that are more distant (thus shooting in Canada or Mexico may be considered). Performers, crews and production facilities. Many foreign countries offer an ample supply of first-class performers, crews and production facilities. Government support. Qualifying as an international coproduction may allow a film to access various forms of government support. Access to other financing options. The international coproduction may help the producer gain access to other foreign finance options such as below-the-line deals or government subsidies. Increased value. Film projects may be more valuable for some purposes in a foreign country if considered a local project. Natural coproductions. A feature film storyline that occurs and can best be shot in more than one location may naturally lend itself to an international coproduction. 253

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Increased exposure. Financing and producing a feature film through an international coproduction may increase the exposure of the film in the countries or regions of the world that are involved. Disadvantages Shooting away from home. Any film production shot on location or in a studio in a foreign country is likely to require the extra expense associated with transportation to and from, along with housing for key cast and crew. Government rules. Qualifying pursuant to the rules associated with international coproduction treaties involves compliance with the rules promulgated by multiple government bureaucracies. Increased paperwork. An international coproduction imposes a heavy paperwork burden on the producers as they seek to comply with the treaty provisions of the governments involved. More planning required. In addition to all of the planning that goes into producing a feature film, an additional layer of careful planning is required of coproducers to ensure that they are able to adhere to the requirements set forth in each of the relevant treaties. Foreign languages. Unless the cast and crew all speak the same language, communication difficulties might arise. Loss of creative control. Any international coproduction could bring about a loss or diminishing of creative control in the sense that compromises on the script may be required in order to meet government mandated requirements. Withholding problems. A joint venture, limited partnership or international coproduction partnership (even though not a taxable entity in the United States) is obligated to pay quarterly estimated tax payments on behalf of the foreign coproducer partner, and both coproducers could be held liable for this obligation as withholding agents (IRC Section 1446). In addition, the IRS will probably treat such an entity as the employer of all personnel hired by either coproducer. This may make both coproducers liable for the entity’s U.S. wage withholding obligations. No U.S. treaties. The United States does not have formalized international coproduction treaties with other countries. Not for U.S. producers. Unfortunately for some U.S. producers, many of these coproduction treaties are drafted in such a way as to preclude them from qualifying since the Hollywood-based U.S. film industry so dominates the world markets that U.S. producers are not considered to be in need of assistance.

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Genre bias. Just as Hollywood tends to produce and distribute certain film genres, international coproductions tend to favor certain genres also, specifically science fiction and adventure films that occur in a fictitious locale. International coproductions may also be biased against comedies, since humor does not seem to travel across cultures. Capable and solvent partners. It is not always easy or possible to find a capable coproducing partner who is able to share the risk, who is solvent and whose own government provides financial incentives that are both sufficient and mesh well with those provided by another coproducing partner. Added complexity. The international coproduction adds another layer of complexity to an already complex transaction and will inevitably require the expertise of an international attorney experienced in this particular form of film finance. Counterproductive. Coproduction deals tend to defeat the protectionist schemes set up by other countries to prevent their national markets from being overrun by Hollywood films. A nightmare. Even for an ongoing production company, making all of the necessary arrangements for an international coproduction can be a nightmare. Whether a film production company’s cash flow is up or down (or nonexistent), foreign costs can increase as the U.S. dollar falls in relative value. Subsidy laws are also constantly changing, and the transactions take a great deal of time to close. Altogether, this combination often results in tighter budgets, fewer films, higher risks and increased frustration.

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38 Foreign Tax Shelters and Tax Incentives Once again, it is important to note that prospective film investors may need a bit more motivation to invest in a risky film production; thus, many foreign governments have provided tax incentives for the purpose of encouraging financial support for their local film industry. To take advantage of such tax incentives, however, one or more local taxpayers must be involved (either individuals or entities). Thus again, a U.S.based producer will generally need to coproduce a film with a producer or production entity based in the foreign country to benefit from its tax incentive programs. Tax Shelters Defined Generally speaking, a tax shelter is a transaction by means of which taxpayers reduce their tax liability by engaging in activities that provide deductions or tax credits to apply against their tax liability. Thus, the tax shelter is a method used by investors to legally avoid or reduce taxes. The specific tax benefits provided by the foreign motion picture tax shelters for foreign investors are • more rapid depreciation, which in some instances can be increased by borrowing; • deferral of income (tax-deferral deals); and • conversion of ordinary income to capital gains, which is subject to a lower rate of tax.

A tax-deferral type of tax shelter is very attractive to taxpayers who have a large, one-time increase in income in a given year and who wish to defer part of this to future years when their income is likely to be lower. Tax incentive schemes are generally created by governments to encourage the flow of capital into high-risk investments. This, in turn, means that taxpayers generally are being asked by the government to provide financial support for such industries.

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Foreign Tax Shelters

General and Specific Laws The tax laws of many foreign countries permit (and in some instances specifically encourage) motion picture tax shelters or tax-driven motion picture financing. Those countries or regional jurisdictions include Australia, Belgium, Canada, Denmark, the European Union, Fiji, France, Germany, Hungary, Iceland, Ireland, Isle of Man, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, South Africa, Spain, Sweden and the United Kingdom. The Canadian film tax shelter, for example, is the result of intentional tax subsidies for local film production. The German and Japanese motion picture tax shelters have been the unintended result of more general tax provisions. Foreign tax incentives and other programs designed to encourage film production in countries other than the United States have primarily been created in response to the fact that American movies account for a high percentage of the movies seen in those other countries. For example, one study revealed that about 80 percent of European box office receipts are generated by American films, whereas European movies have won only 5 percent of the American market. Further, such studies tend to show that of the 100 highest-grossing movies in the world in any given year, approximately, 88 are likely to be American movies, and 7 more are likely to be coproductions involving American production companies (see “French Kiss-Off: How Protectionism Has Hurt French Films,” by Tyler Cowen). Unfortunately, the tax incentives are withdrawn or reduced from time to time, so it is a never-ending challenge to stay current with the tax provisions of multiple countries. A selection of these tax incentive programs are discussed below. In order to take advantage of most of the tax incentives or subsidies offered by foreign countries, the production company must be based in the subject country. However, some of the owners or executives can be American. In many instances, the company is dissolved when production wraps. Canadian Tax Incentives The Canadian tax shelter leverage is not as great as the leverage that was available in the mid-1980s in the United States, and in order for the investment to pay off, the Canadian films need to generate a profit. Canadian tax incentives were granted to Canadian private investors during most of the 1970s and 1980s. Those tax incentives were then changed so that they were granted directly to film producers in the form of refundable

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film tax credits to encourage “Canadian content” films. Each film has to be produced by a taxable Canadian corporation primarily involved in the production of films, it must be commercially exhibited in Canada by a Canadian distributor within two years of completion and it has to fall within the category of either a treaty coproduction or a film production that meets the point requirements of the regulations. In order for a U.S.based producer to benefit from these Canadian tax incentives, it may be necessary to partner with a Canadian production company. Canada offers two tax incentive programs. One is called the Canadian Film or Video Production Tax Credit (CPTC), under which the federal Canadian government provides a refundable tax credit to qualified corporations for the production of Canadian films or videos. Under this program the government offers incentives to stimulate job growth by encouraging Canadians as well as foreign-based film producers to employ the services of Canadians. The second is referred to as the Film or Video Production Services Tax Credit (PSTC) Program. A special rule prevents producers from being able to claim both the CPTC and the newer PSTC for the same production; thus, producers have to make a choice. The CPTC program. The federal content tax credit is calculated as a percentage of the Canadian labor expenditures incurred by a Canadian producer in connection with an eligible production. When this credit was introduced in 1995, the percentage was 25 percent of qualifying Canadian labor expenditures, which were capped at 48 percent of the eligible production budget, yielding a credit of up to 12 percent of the eligible production budget. In November 2003, the cap on expenditures was increased to 60 percent of the eligible production budget, yielding a credit of up to 15 percent of the eligible production budget. Qualifying corporations. To qualify for the CPTC program, the applicant must be a qualified corporation with a permanent establishment in Canada that engages primarily in Canadian film or video production. Specifically excluded are prescribed labor-sponsored venture capital corporations, tax-exempt corporations and corporations controlled by one or more tax-exempt persons. In addition, the qualified corporation must own the copyright in the film for which a claim is being made. Qualifying productions. To qualify for the CPTC program, the Canadian Audio-Visual Certification Office (CAVCO) must certify that the production is a “Canadian film or video production,” which means one produced by a “prescribed taxable Canadian corporation” that is either a treaty coproduction or that meets the requirements of the income tax regulations. Coproductions between Canada and another country are eligible for the CPTC program only when coproduced under an official 258

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treaty. Telefilm Canada is responsible for the certification of treaty coproductions. However, in order to obtain a certificate to access the CPTC program, the producer must apply directly to CAVCO. Program administration. The CPTC program is jointly administered by CAVCO and the Canada Revenue Agency (CRA). CAVCO is responsible for certifying that the production is a Canadian film or video production, estimating the qualified labor expenditure of a qualified corporation and issuing certificates to allow Canadian producers to claim the production tax credit. The CRA is responsible for providing assistance to claimants, interpreting and applying Section 125.4 of the Income Tax Act (and all other provisions in the law and regulations that may have an impact on the tax credit), reviewing or auditing the federal tax credit (FTC) claims within a reasonable time frame, assessing T2 Corporation Income Tax Returns and issuing timely refund checks. Application procedures. To apply for the CPTC, a qualified corporation must complete the Canadian Form T1131, Claiming a Canadian Film or Video Production Tax Credit. The certificate issued by CAVCO, or a copy of the certificate, must be attached to the Corporation Income Tax Return (Form T2) for the year along with the Form T1131 (attached to the top of the T2). The Canadian PSTC program. The PSTC is calculated as a percentage of the qualified Canadian labor expenditures incurred by the owner of copyright in an eligible production, or by a production services provider engaged by such copyright owner. Following the elimination of production services tax shelters in September 2001, the federal government committed to increasing the PSTC. In February 2003, the PSTC was increased from 11 to 16 percent of qualifying Canadian labor expenditures. Qualifying corporations. The qualifications for the PSTC program are almost the same as for the CPTC. The applicant must be an eligible production corporation with a permanent establishment in Canada that engages primarily in film or video production or production services. Specifically excluded are prescribed labor-sponsored venture capital corporations, tax-exempt corporations and corporations controlled by one or more tax-exempt persons. In addition, the corporation must either own the copyright in the film for which a claim is being made or have contracted directly with the owner of the copyright, where the owner of the copyright is not an eligible production corporation. Amount of tax credit. This refundable tax credit is provided to an eligible production corporation at the rate of 16 percent of its qualified Canadian labor expenditures, net of any government assistance, in respect of an 259

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accredited production for services rendered in Canada by Canadian residents. The rate is different than the one used for the CPTC program. Qualifying productions. In order to receive the PSTC, an eligible production corporation must obtain an accredited film or video production certificate from CAVCO. The accredited production must meet a cost minimum and it must be of an eligible genre as set out in the proposed income tax regulations. Once again, a special rule prevents producers from being able to claim both the Canadian Film or Video Production Tax Credit (FTC) and the PSTC for the same production. Application procedures. To apply for the PSTC, an eligible production corporation must complete Canadian Form T1177, Claiming a Film or Video Production Services Tax Credit. The certificate issued by CAVCO, or a copy of that certificate, must be attached to the Corporation Income Tax Return (Form T2) for the year along with Form T1177 (attached to the top of the T2 return). Canadian provincial programs. In addition to the Canadian federal programs, several provinces in Canada also offer tax credit and incentive programs. The Ontario Production Services Tax Credit provides Canadian or foreign-controlled production companies with a refundable tax credit of 18 percent on Ontario labor expenditures for eligible film or television productions. There is no limit on the amount of labor expenditures that may be eligible, and there are no limits on the amount of the tax credit that may be claimed. The British Columbia Production Services Tax Credit is a laborbased tax incentive that provides refundable tax credits to Canadian or international film and television production corporations that have incurred costs in British Columbia. The company does not have to be a Canadian-owned corporation, and there is no requirement that it have an interest in the copyright. More recently, British Columbia’s liberal government increased its tax credit for foreign production from 11 to 18 percent to match Ontario’s credits after the film and television production industry in British Columbia threatened to move projects out of the province (apparently extortion works). The British Columbia tax credits also went from 20 to 30 percent on local productions, effectively countering Ontario’s earlier increases. Quebec also offers a Film or Television Production Services Tax Credit on labor expenditures, up to a maximum of 14.5 percent of total production expense by an eligible corporation, on services provided in Quebec by Quebec residents or taxable Quebec corporations for the making of an eligible production. 260

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British Tax Incentives For many years, the so-called British sale-and-leaseback transaction served as an important element in British film finance. More recently, the British chancellor of the exchequer introduced a new tax relief provision for film to replace the tax provisions on which the sale-and-leaseback transaction was based. Those provisions expired in July of 2005. The new tax break applies to British qualifying films with budgets up to £15 million and is worth 20 percent of a film’s budget, which a producer can offset against profits, or it can be surrendered to the Inland Revenue for a cash rebate. Also, under the new rules, the tax relief will be granted only to a producer, and not to third-party investors. The new provision has no end-date, as did the previous tax provisions utilized in the sale-and-leaseback transaction. This newest scheme is designed to reduce the role of the various intermediaries that have sprung up in the United Kingdom for facilitating the sale-and-leaseback scheme and to eliminate much of the abuse that has apparently taken place. In some instances, film projects with little or no merit were attracting financial backing when there was really no expectation that such films would be successful or even screened. Under this newest permutation of British film tax incentives, filmmakers will not have to go through a partnership of private investors, but instead can go directly to the government and obtain a rebate equal to 20 percent of the film’s budget. These changes simply illustrate that tax incentives generally are constantly changing and are therefore difficult to incorporate into any longterm strategy for film finance. Section 42 of the finance act, which provides for a three-year write-off of expenditure on British qualifying films, was to remain in place, according to the newer version of the law. Qualifying as a British film. As noted above, the film has to be a qualifying British film (i.e., it must be completed and certified as being a British film by the UK Department for Culture, Media and Sport), and it must fulfill either the conditions set out under Schedule 1 to the current Films Act or the terms of an international coproduction agreement to which the United Kingdom is party. There is presently no method available to obtain certification prior to completion of a film. In general terms, a British film is one on which • the producer was, throughout the time that the film was being made, a person ordinarily resident in or a company registered and centrally managed and controlled in a state that is a member of the European Union or the European Economic Area or with which the European Convention has signed an association agreement; 261

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• at least 70 percent of the total expenditure incurred in the production of the film was spent on film production activity carried out in the United Kingdom; and • the requisite amount of labor costs represent payments for the labor or services of Commonwealth or European Union citizens, or persons ordinarily resident in a country in the Commonwealth or the European Union.

The percentage of labor costs paid, or payable, to citizens or ordinary residents of a Commonwealth country or member state must be the lesser of • at least 70 percent of the total labor costs after deducting the cost of one non-Commonwealth/member state citizen or ordinary resident; or • at least 75 percent of the total labor cost after deducting the cost of two non-Commonwealth/member state citizens or ordinary residents, one of whom must be an actor in the film.

Also eligible for relief are films produced under the terms of an official coproduction treaty between the United Kingdom and another country or under the European Convention on Cinematographic Co-Production. The European Union member countries include Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the United Kingdom. The so-called European Economic Area countries include Iceland, Liechtenstein and Norway. Those countries with associated agreements with the European Convention include Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania and Slovakia. Australian Tax Incentives The Australian federal government offers several tax incentives for filmmakers, an offset program and two tax concessions. Australian film investment is generally regulated by the Australian Corporations Act of 2001. Refundable tax offset for film production. The refundable tax offset for eligible film and television productions is worth 12.5 percent of the production’s qualifying Australian production expenditure and may be claimed by the production company through the company’s Australian tax return. The offset amount is first applied against any federal income tax and other tax liabilities that the production company might have. Any excess will then be refunded by the Australian Taxation Office. The broad definition of qualifying Australian production expenditure 262

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(QAPE) is goods or services supplied in Australia. This may allow a film producer to include all or part of the expenditure on offshore cast and crew fees. Key eligibility criteria. The eligible formats are feature films (including those shot direct to video), tele-movies and miniseries. The Australian federal government announced in May of 2004 that television series would be included. The key criterion to access the tax offset is a minimum level of qualifying Australian expenditure of $15 million (in Australian dollars) on the production of the film. Additionally, where the film’s qualifying Australian production expenditure is between $15 million and $50 million, that must represent at least 70 percent of the film’s total production expenditure. Where a company has spent 50 million or more on qualifying Australian production expenditure, it will qualify regardless of the total amount of production expenditure involved. The 12.5 percent refundable tax offset can represent a cash subsidy of between 9 and 12.5 percent on the film’s total budget, depending on the extent to which a production shoots and spends money in Australia. The definition of total production expenditure provides the basis against which the 70 percent activity test will be assessed, where QAPE is between $15 million and $50 million. There are a number of costs that are excluded from the total budget for the purposes of calculating this activity test: 1. financing 2. development 3. copyright acquisition 4. general business overhead 5. publicity and promotion 6. fee deferments

Each of these items is further defined in the legislation, but if any of items 2–5 are incurred in Australia, the costs may be factored back into the total production costs. The production may also nominate one person whose remuneration is to be disregarded if it is advantageous in the percentage calculation. The application for the rebate must be made by an Australian resident company or a foreign entity with a permanent establishment in Australia and an Australian Business Number (ABN). The rebate will be paid directly to the applicant. The application is submitted with a tax return in the year that the film is completed. A provisional certificate may be obtained from the Minister of the Arts. All expenditure must be arranged by the single entity claiming the tax offset. 263

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A company is not entitled to this Australian tax offset if a provisional or final certificate for the film has been issued under either of the Australian tax concession programs (i.e., 10BA—whether or not the certificate is still in force—or if a 10B certificate has been issued and used—see discussion below). An independent Film Certification Advisory Board assesses applications and advises on the eligibility of films for certification under the government’s film tax offset. In addition, the board advises on a range of policy and industry issues that may affect the offset and that arise from the impact of the offset on the Australian film industry. A fact sheet, guidelines and application form that provide additional details on applying for the tax offset are available online at www.dcita. gov.au. The AusFilm website may also make it possible to download an electronic copy of the application form as a PDF document. In the meantime, a producer can request an electronic copy via email at film. [email protected]. At some point, Australia plans to allow applicants to complete and submit the application form online. Australian tax concessions. The Australian federal government also encourages private investment in screen production through tax incentives under Divisions 10B and 10BA of the Australian Tax Act. However, projects that access the tax-privileged benefits of 10B and 10BA, cannot also access the 12.5 percent federal cash rebate. Division 10B allows accelerated tax write-offs for investors in film and television projects that meet certain criteria and approvals. It allows a much wider range of projects to qualify with respect to Australian content and subject matter than that provided for under Division 10BA. For a project to receive a 10B certification, it must be made wholly or substantially in Australia. The major eligible formats under 10B are feature films, tele-movies, miniseries and episodic TV series. The attraction for investors is that they are able to write off their entire investment over two years, beginning in the financial year in which the project is first completed and exploited for income producing purposes. There is no minimum or maximum budget requirement imposed on a qualifying project. Division 10B, however, is not intended to be utilized as a subsidy on production costs. It is an incentive for a producer to raise funds for genuine cofinancing partnerships and gap equity arrangements, offering real risk-versus-return possibilities for investors. To raise funds, it would generally involve structuring a private or public offer to entities or individuals interested in investing in film and television projects. Such

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investors will usually have Australian taxable income to offset against the accelerated deductions granted. Thus, a U.S.-based producer may want to raise a portion of the financing for a project in the United States, seek out an Australian coproducer who could raise another portion of the financing in Australia and shoot the film in Australia. Producers interested in using this tax incentive must submit an application to the Department of Communications (DCITA) to receive 10B certification stating that the project has met the creative requirements of 10B. The tax office then administers the use of the tax benefits by the investors and issues rulings on unacceptable investment deals involving 10B. The tax benefits can be subsequently withdrawn from the investors if the deals fail to comply with the tax office guidelines, even if the project itself complies with its 10B status granted by DCITA. For detailed guidelines and an application form, see the DCITA website online at www.dcita.gov.au/Article/0,,0_1–2_2–3_491–4_103741,00.html. Division 10BA also allows accelerated tax write-offs for investors in film and television projects that meet certain Australian content criteria and approvals. It allows Australian resident investors and corporations who are owners of first copyright of a film coming within the cultural requirements of 10BA to deduct 100 percent of their investment against their other income in the financial year the investment is made. Basically, the project needs to be completed and first used for exploitation within two years from the end of the financial year in which the investment was first made. Division 10BA requires a higher level of Australian content and participation than 10B, in both the physical production of the project and the elements contained in the script (i.e., characters portrayed, locations and storylines). However, it can be utilized on projects made under any of the international, official coproduction agreements Australia has with several countries. Projects certified as 10BA compliant are also eligible to apply for direct equity investment from the federal government funding body—Australian Film Finance Corporation (FFC). The major eligible formats under 10BA are feature films, tele-movies and miniseries. Episodic TV series are excluded under 10BA (although not under 10B). There is no minimum or maximum budget requirement imposed on a qualifying project. Like 10B, the 10BA tax concession provides an incentive for a producer to raise funds for genuine cofinancing partnerships and gap equity arrangements, offering real risk-versus-return possibilities for investors. To raise funds, it would also generally involve structuring a private or public offer to entities or individuals interested in investing in film and television projects. However, unlike 10B, only

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Australian resident investors are able to claim the accelerated deductions granted under 10BA. Interested producers can submit an initial application to DCITA to receive a provisional 10BA certificate, to allow them to begin sourcing investment funds. This provisionally certifies that the project will meet the creative requirements of 10BA. The producer must also apply for a final certification under 10BA within 6 months of the completion of the project. The tax office administers the use of the tax benefits by the investors and issues rulings on unacceptable investment deals involving 10BA. The tax benefits can be subsequently withdrawn from the investors if the deals fail to comply with the tax office guidelines, even if the project itself complies with its 10BA status granted by DCITA. Additional information is provided online at www.dcita.gov.au/Article/0,,0_1–2_ 2–3_491–4_103740,00.html. State-based incentives and rebates. Several of the Australian states offer support and financial assistance in addition to the various federal rebates and incentives. The state assistance comes in the form of payroll tax rebates or exemptions, cast and crew wage rebates, location attraction cash grants and the free or subsidized public service resources. The range of assistance and qualification criteria varies from state to state, and more complete details on the incentives may be obtained from each of the state film offices. For more information see http://www.afc.gov. au/filminginaustralia/govassist/state/fiapage_7.aspx. Argentina Argentina has taken steps to ensure that Argentinian movies can be produced and compete successfully with U.S. movies being shown on Argentinian movie screens. Argentina offers exemptions from duties for celluloid print imports, state subsidies, soft loans and state-backed international promotion. In addition, the country imposes screen quotas for locally produced motion pictures, thus allowing for longer runs at peak moviegoing hours. Belgium In Belgium both individual and corporate investors can deduct up to 50 percent of the taxable income of the investor (with a ceiling), and the investment can amount to as much as 50 percent of the total budget of a film production. The producer is allowed to bring together a group of investors. On the other hand, there is a requirement that the film has to generate revenues.

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Brazil Brazilian support for its film industry includes granting foreign producers the option to invest in local movies or pay an additional tax on the revenues they take out of the country, allowing nonfilm companies to invest part of their income tax on local films and imposing screen quotas that obligate theatres to play Brazilian motion pictures for a specified minimum of days. Brazil’s Audiovisual Law 8685/93 grants tax incentives that could be applied by the taxpayers in Brazilian cinematographic audiovisual works, including feature films. The incentives are defined in articles 1 and 3 of the law. Article 1 establishes that Brazilians can deduct 3 percent from their income tax that is due in any given year, provided that this deducted amount is deposited in a special account at Banco do Brasil S.A. and utilized to buy Audiovisual Investment Certificates for a determined production or a film of their own choosing, among those projects that have already been approved by the secretary for audiovisual development in the Ministry of Culture. The issuance of these certificates is handled by the Stock and Exchange Committee, and the buyers are entitled to a participation in the film’s revenues according to the offer of each project. Article 3 establishes that any foreign producer, distributor or intermediate who receives any royalties or payments of whatever nature, derived from the exploitation, sale or licensing of foreign audiovisual works (theatrical, television, video, transmission of events—sports shows in Brazil), can deduct 70 percent from the withholding tax applicable to any credits or remittances of such royalties or payments, provided this deduction is deposited in a public account to be utilized in a project of a Brazilian producer for an audiovisual work (feature film, series, etc.) and this project is approved by the secretary for audiovisual development in the Ministry of Culture. Normally, the withholding tax is 25 percent on the royalties or payments, credited or executed, and once the decision is made to utilize the 70 percent deduction under the terms of Law 8685/93, from the date of each deposit, the non-Brazilian (foreigner) has 180 days to elect a project and allocate the deposited amounts to it. The foreign producers, distributors or intermediates may choose their projects, and a contract is signed with the Brazilian producer defining, case by case, their participation and rights (first negotiation or first refusal for distribution, vehicles, territories, etc.).

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The limit for deposits in each project is approximately $3 million in U.S. dollars, and this amount can not represent more than 60 percent of the whole budget. France In an effort to dissuade productions from flocking to neighboring Belgium, the French have introduced a scheme inventively called “bring back production.” Film producers receive a 20 percent tax rebate on labor and lab costs from the government as long as most of the money is spent in France and employs a local crew. The ceiling on each film was set at $600,000, but has since been raised to $1.25 million. The French producers’ organization, Centre National de la Cinematographie (CNC) has also been working with French banks to create a program through which the banks can lend against the tax credit. In France, private individuals and corporations can invest in a film up to 50 percent of their tax liability in a given year and write it off 100 percent. Such private investment is limited to 25 percent of the individual’s taxable income. Even though the investment is tax deductible, the profit the investor may make on the film investment is subject to being taxed. Also, the investor is in a first recoupment position. A group of companies (known as SOFICA) work as intermediaries in arranging these deals for producers and taxpayer-investors. In addition, France has more recently created another form of tax incentive for investing in film by allowing up to 20 percent of the total cost of the film as a tax deduction. Hungary Hungary offers a tax rebate scheme in which producers can recoup up to 20 percent of their production costs spent in that country. There is no limit on the size of the budgets that may qualify, except that films with budgets above $740,000 may claim their rebates more quickly by asking for quarterly audits, as opposed to the annual audits provided for the lower-budget films. No system has been created for making it possible to use the tax rebates as the basis for bank loans, although such facilities may become available in the future. In other developments, a large studio complex has been built near Budapest (at Etyek), and several film schools have been established to help meet the need for more crews. Ireland In Ireland, private individuals and corporations can deduct 80 percent of their investment in a qualifying film from their respective Irish tax liability. To qualify, at least 60 percent of the film’s production costs must 268

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be spent in Ireland and 75 percent of the film shoot must take place in Ireland. The legislative provisions are contained in Section 481 of the Taxes Consolidation Act of 1997 (formerly Section 35 of the Finance Act of 1987, as amended). Section 481 has been extended to 2008, and the ceiling on the level of investment that can be raised has been increased. Because the law allows 80 percent of the amount invested to be written off, investors look for a return on the net cost rather than on the full amount invested, and this typically results in a contribution of up to 12 percent to the film’s budget. The amounts that can be raised vary by project size. Most investors seek projects with a possibility of securing presale agreements that will give them a reasonable return on their net investment when the film has been delivered. Section 481 investment is only available for the production amounts spent in Ireland. A minimum of 10 percent of the work on the production of the film must be carried out in Ireland. An Irish production company can only raise investor funds when it has been certified by the minister for arts, sport and tourism, which issues a certificate when satisfied that the production of the film will benefit the national economy and the Irish film industry. Benefits to Ireland’s economy result from direct expenditure on Irish services, facilities and goods, including hotels, transportation and catering. Benefits to the industry include the use of Irish producers, directors, scriptwriters, principal cast and crew, studio facilities, equipment and postproduction facilities. Foreign producers can partner with resident Irish independent producers who can offer assistance in maximizing the amount of Section 481 finance for a production, as well as facilitating the smooth operation of the production schedule. Ireland’s Department of Arts, Sport and Tourism is the certifying body for Section 481 tax relief. Guidelines for applications may be obtained at http://www.gov.ie/arts-sport-tourism/. Isle of Man The Isle of Man offers a 100 percent tax write-off for private investors and for the producer. It also offers up to 25 percent of the budget as a direct equity investment (see chapter 36). Luxembourg To qualify for Luxembourg’s tax incentive program, a producer must attest to the government that a specified percentage of the production will be spent in Luxembourg. After evaluating the producer’s claim, the 269

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government provides the producer with a certification as to the amount. The producer can then sell this government certification to a bank in Luxembourg, which uses the certification for its own tax deduction while paying cash to the producer. In effect, the bank is buying the tax benefit. Per the government regulations, the producer is not supposed to receive the money until the film is completed and the actual amount spent within the country is known, but some Luxembourg banks will cash flow such film productions. The Netherlands The tax incentive program in the Netherlands requires that single-purpose, limited partnerships be created for film projects. Private investors’ investment in the LP is tax exempt. In order to qualify, • • • • • • •

the film or films must have at least 50 percent Dutch participation; the copyright must be held by Dutch interests; a collection agent must be in place; a completion bond has to be arranged; a release guarantee is required; a sales agent has to be involved; at least one or two presales outside the Netherlands must be effected; and • sales estimates for other territories have to be submitted.

New Zealand Private investors in New Zealand films may take advantage of special tax incentives provided in the Income Tax Act 1994. To qualify for these tax incentives, the film (or TV program) in question must first be certified as a New Zealand film by the Film Commission because it contains significant New Zealand content as set out in Section 18 of the New Zealand Film Commission Act 1978. Those provisions provide that 1. in carrying out its functions, the Commission will not make financial assistance available to persons involved in the making, promotion, distribution or exhibition of a film unless it is satisfied that the film has or is to have a significant New Zealand content; 2. for the purposes of determining whether or not a film has or is to have a significant New Zealand content, the New Zealand Film Commission will consider a. the subject of the film; b. the locations at which the film was or is to be made; 270

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c. the nationalities and places of residence of: i. the authors, scriptwriters, composers, producers, directors, actors, technicians, editors and other persons who took part or are to take part in the making of the film; and ii. the persons who own or are to own the shares or capital of any company, partnership or joint venture that is concerned with the making of the film; and iii. the persons who have or are to have the copyright in the film. d. the sources from which the money that was used or is to be used to make the film was or is to be derived; e. the ownership and whereabouts of the equipment and technical facilities that were or are to be used to make the film; and f. any other matters that the Commission considers relevant.

Certification allows investors to take a one-year write-off of their pro rata share of film production costs at the time of the film’s completion (i.e., when the film has been completely edited to its final length). Of course, New Zealand tax incentives are for New Zealand taxpayers, meaning that in order to be useful to U.S. producers, some of the production funds need to be raised from New Zealand residents. This, in turn, suggests that a coproduction with a New Zealand production company capable of providing some of the investor funds might be appropriate. Mexico The Mexican Congress has passed an incentive aimed at encouraging investment in local films. The incentive allows individuals and entities to deduct the equivalent value of their investment in a Mexican film from their Mexican federal income tax. This deduction is capped at 3 percent of the total tax bill, and a nationwide annual cap of 500 million pesos ($45 million) is imposed. In addition, Mexico offers a film-related fiscal incentive that gives foreign productions a full rebate on the country’s 15 percent value added tax, which is applied to nearly all goods and services. South Africa South Africa provides tax breaks for investment in film through Section 24F of the Income Tax Act of 1962. The law provides for tax deductions for expenses incurred in the production and postproduction of a film if such costs are incurred by the owner of the film. This South African tax deduction provides for the full amount of the production and postproduction costs of a film. To qualify, the taxpayer must be a film owner, 271

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that is, have sole or a shared interest in the film. Thus, a U.S. producer may coproduce with a South African production company. A provision, however, excludes investors who use loans to be repaid out of the revenues of the film. In practice, the government generally only grants the tax deduction if the production is deemed to be a commercial venture that will make a profit. The investments structured to take advantage of the South African tax incentive typically involve a special-purpose entity, such as a limited partnership. Some variations on the transaction include sale-andleaseback arrangements that can help finance or partly finance the film production and facilitate cash flow. Independent film producers benefit because the availability of the tax incentive can be used to help attract investors. Individual South African film producers have been offering financing opportunities to investors designed to maximize the tax benefits permitted. In addition, South Africa offers a tax credit that allows foreign producers to recoup up to 15 percent of their South African expenses, so long as the production spends at least $3.8 million locally and completes 50 percent of principal photography in the country. The amount available on a single production is capped at $1.5 million. Banks have not yet created facilities for lending against the tax credit. These tax incentives help South African producers to raise their share of coproduction budgets for projects produced with foreign producers. Reports indicate that there are a limited number of quality film crews in South Africa and sound stages need improvements. In recent years, however, production costs have, on average, been about 40 percent less than in the United States. South Korea South Korea offers film companies a 50 percent reduction in their corporate tax for five years. The incentive, however, only applies to companies with 5 to 10 employees. Sweden In recent years, Swedish laws have been structured so that if Swedish investors bought distribution rights in a film, that investment would be 100 percent deductible in the year of the investment. Ever-Changing Landscape The laws upon which these tax incentives are based are subject to change from year to year. As an example, Brazil once withdrew its tax incentives 272

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for films, and the Brazilian film industry suffered a significant retrenchment. The reintroduction of tax-driven incentives allowing companies to write off up to 3 percent of their income tax in movie investments produced a resurgence. The point is, do not expect a book such as this to serve as the most current source for rapidly changing tax incentive information, especially in the area of foreign tax incentives. Instead, utilize the services of an international tax attorney or accountant to confirm the current rules in the countries of interest, or contact the applicable government agency itself. Advantages Help with the budget. An attractive tax incentive can ease some of the financial pressure on a film’s budget and be reason enough to move production to a far-flung overseas location. Investor interest. Investors may be more inclined to invest if significant tax benefits are available. Specialized assistance available. Law and accounting firms with expertise in international tax shelters and tax incentives are available to assist in structuring film finance opportunities utilizing such techniques. Access to tax incentives. Most foreign tax incentives can be accessed with a local coproducer. Disadvantages Benefits may be local. The available tax benefits of the various tax incentive schemes are usually limited to investors who are residents of the country offering them. Copyright ownership. The qualified corporation claiming the tax benefit may have to own the copyright in the film for which a claim is being made. Sometimes no cash. With some tax incentives, producers do not actually receive any cash. A bureaucratic nightmare. A tax incentive that might look good on paper can turn into a bureaucratic nightmare with uncooperative officials, unskilled crews and regulations that are intricate and difficult to understand. Changing tax laws. The tax laws of each country change from time to time (sometimes suddenly and often in unpredictable ways); therefore it is difficult, if not impossible, for any written description of such tax incentives to stay current without an ongoing subscription service. Dependence on political climate. The availability of tax incentives may depend on the political climate in a particular country. Governments have 273

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been known to suddenly close what are perceived to be tax loopholes, and such actions can leave a producer without the tax benefits on which he or she has relied. Not good basis for long-term strategy. Because of the ever-changing nature of these tax incentives, it is extremely difficult for a producer to primarily rely on tax advantages for any sort of long-term film financing strategy. Professional help expensive. Most producers will almost certainly require the assistance of a professional accountant or attorney who specializes in international tax law in order to properly structure a taxsheltered deal for another country, and such specialized assistance does not come cheap. Abusive tax shelters. Film tax schemes have been notoriously abused by some taxpayers who take advantage of special film subsidies and tax breaks as lucrative tax shelters. Part of the motivation in such cases is not investment in the film industry. Some films partly financed through tax incentives are of such poor quality that they have never been released. Risky investment. Even with tax incentives, many investors continue to view investments in the film industry as risky and many are reluctant to get involved. Cost to economies. By allowing a tax deduction for an activity like film production, the economy of a country offering such tax incentives is looking to other taxpayers to make up the difference in its tax revenues; thus, the impact of such programs can be seen as a cost to the other segments of the economy.

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39 Blocked Currency or Blocked Funds Although not likely to be a source of significant financing, so-called blocked funds—monies that cannot leave a country because of currency restrictions—present another possible opportunity for an independent producer whose film could be shot in a foreign locale. Many developing countries around the world have very little hard currency in circulation, and foreign companies operating in these countries are often unable to convert their retained earnings into hard currency, or to spend these earnings on imported goods and services they need or to repatriate them to the parent company. When monies earned by foreign companies cannot be removed from a country (except under limited circumstances) because of limitations imposed by local law, these earnings are said to be “blocked.” The currency restrictions are designed to help the local economy. Generally, such funds have to be spent within the borders of that country to buy certain products or materials within that country, or in producing a product or commodity that can then be taken out of the country. In most instances, regardless of how much a company buys for its use in that country, it will still have earnings left over. Accumulating blocked funds is of little economic value. Specifically in the film industry, blocked currencies may occur in the form of film rentals on U.S. films released in that country, and often distribution deals will provide that such funds be deposited in an account in that country for the benefit of the distributor (sometimes for the benefit of the producer). Blocked funds are also referred to as restricted currencies. Restricted currencies are more formally defined as foreign currencies that are or become subject to moratorium, embargo, banking or exchange restrictions or restrictions against remittances to the United States. Blocked funds that accumulate in the bank accounts of U.S. and other foreign companies in one of these countries can sometimes be used to finance a film, which will generally qualify as a product produced with funds spent in that country and the film (i.e., product) can then be removed. 275

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So-called blocked funds deals are a variant method of motion picture financing that may be able to provide some below-the-line savings. In a blocked funds deal, a film producer purchases blocked funds or currency at a discounted rate from banks or corporations doing business in a specific country. The producer may even raise a portion of the financing from investors in the United States with the specific strategy of identifying and purchasing blocked funds in a country suitable for location shooting. A producer seeking to finance the production costs of a motion picture through the use of blocked funds must first determine whether the film can be suitably produced in the target foreign country. Then the producer must locate a sufficient amount of blocked funds in the same country for the particular production. In order to locate blocked funds, producers or their representatives should identify and contact persons functioning as the treasurers or chief financial officers of U.S. corporations, including film distribution companies, that do a significant amount of business in foreign countries. Major international law firms and the larger commercial banks with specialists in this field may be able to provide useful information and assistance in putting together such deals. Directly contacting the foreign banks holding such funds is not generally productive since the banks themselves would not be able to disclose the names of depositors at the bank with blocked funds. Some U.S. companies specialize in developing the worldwide expertise and information to overcome the blocked funds obstacle. Some of those may be located online. In an effort to narrow the prospects, the producer may first want to determine which foreign countries providing suitable locations and production capabilities for the planned film also impose the limitations on the removal of currency from the country. Then the producer can try to identify U.S. companies that do a significant amount of business in those countries and perhaps conduct an online search for companies providing solutions for blocked funds or restricted currencies. It may be possible to obtain a list of U.S. companies doing business in a given country from the foreign trade commission of that country. Another approach is to contact the film commission in that country to inquire whether its government imposes currency restrictions and what foreign companies might have blocked funds there (see “Official AFCI Directory” in Sources and Further Reading). Foreign coproduction deals utilizing blocked currencies have been effected in recent years in Russia, Ireland, the former Yugoslavia and Algeria. Brazil and India have also imposed restrictions on the amount

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of their currencies that can be converted into U.S. dollars and taken out of the country, but like tax incentives, these restrictions are constantly changing. An alternative, which would not involve the requirement that the producer come up with purchase monies for blocked funds, would be to convince the corporation holding blocked funds to use such funds as an equity investment in the production of the film. However, a company with blocked funds will not typically want to enter into such a deal with a producer who does not have a track record for producing films that generate sufficient funds to allow the company to recover its investment. That tends to narrow the field considerably. A blocked funds deal is even more attractive in a country where the U.S. dollar is strong and has a favorable exchange rate with the local currency. A producer should also seek to negotiate a purchase price with the companies holding blocked funds that is more favorable than the official exchange rate. This increases the buying power of the blocked funds in the foreign country; thus, a producer could ostensibly increase the production value of the film even more in such a situation. It is helpful if the producer can find a company that has been sitting on blocked funds in a given country for a number of years. In that situation, the corporation with blocked funds may be anxious to convert those funds into U.S. dollars; in other words, the company holding the blocked funds is a motivated seller. Advantages Discounted monies. Blocked funds are often available on a discounted basis: for a $1 million investment, it might be possible to produce a $2 million film on location in a foreign country. In combination with investor financing. Blocked funds opportunities may be combined with a feature film limited partnership or managermanaged LLC such that U.S. investor funds are first used to purchase the blocked funds at a discount and are immediately leveraged into greater purchasing power. Not highly publicized situations. Companies with blocked funds try to be discreet with regard to whom they disclose the existence of their blocked funds. They do not want to be flooded with requests for blocked funds deals. Although that may appear to be a disadvantage at first, it may be considered an advantage for feature film producers since not many producers are likely to be aware of these opportunities; thus, the competition for such monies may be limited.

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Disadvantages Blocked funds cost money. The producer will have to have enough money to purchase the blocked funds at whatever discounted rate they are offered. Production problems. Many of the problems typically associated with any foreign film production will also be encountered in a blocked funds deal; namely, restrictive regulations relating to the cast, crew and script, language barriers, frequent delays, unstable governments, riots, civil war, less than adequate housing facilities for the cast and crew. Of course, some of these same problems may be experienced in Los Angeles. The right amount of blocked funds. The producer will also have to find a company that has blocked funds in a given foreign country sufficient to meet the film production needs of the particular film. Other costs. Unless the producer is able to conduct all of the necessary research, phone calls, inquiries, negotiations and documentation required to put together a blocked funds deal, the producer’s representative, a blocked funds specialist or an attorney will have to be compensated for conducting those activities on behalf of the producer.

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40 Foreign Currency Another modest film finance benefit may be gained through a so-called foreign currency deal—a film-financing arrangement in which a foreign country will offer to provide goods and production services for belowthe-line costs for a small amount of “hard” currency (U.S. dollars). Currencies may include anything that is in circulation in a given country as a medium of exchange, including coins, paper money, government notes and bank notes. A currency conversion occurs when the money of one country is exchanged for an equivalent amount of another country’s money. The measure of value of currencies traded between various countries is referred to as the exchange rate. An exchange rate is considered favorable to a particular currency when its purchasing power is on the rise, relative to the value of the currencies of other countries. At times, if a country’s currency, relative to gold or the currencies of other nations, declines in value far enough, the government may be forced to change the exchange rate unfavorably, in which case a devaluation of the local currency is said to have occurred. Devaluation can also result from a rise in the value of other currencies relative to the currency of a particular country. The countries that may offer foreign currency deals to filmmakers have most likely suffered recent or long-term downturns in the value of their currency and are interested in accumulating hard currency to prop up their treasuries. Producers interested in this strategy of film finance will want to identify international currency traders or international attorneys who may be able to assist in selecting countries that offer such exchanges. In addition, a producer interested in such deals may want to monitor the reported currency exchange rates in business publications. Once again, in order to take advantage of the currency exchange opportunity, the independent film producer will first have to raise a sufficient amount of U.S. currency so that it can be traded for a significant amount of another country’s weaker currency. Then the other country’s 279

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currency can be used to produce some or all of the film on location in that country. Producers who have experience with these sorts of arrangements suggest that in order to justify the use of this financing technique the desirability of the location must be a more important consideration for the particular film than saving money. So, in the event that a film project is suitable for shooting in a foreign country, the producer may want to check the currency exchange rates to see if such a deal might be worthwhile. Advantages Possible increased production values. Foreign currency deals may permit the producer to leverage a quantity of hard currency production dollars to acquire an increased quantity of goods and services that can be used in the production of the film for the same amount of cash. Combined with international coproductions. The foreign currency deal is another technique that may be combined with international coproductions to enhance the value of an internationally produced feature film. Disadvantages Potential problems with foreign locations. Aside from being rare, foreign currency deals, as with many film-financing arrangements involving foreign locations, typically mean that the film’s producer may have to navigate through a difficult and archaic bureaucratic system, that the technical production expertise and equipment made available may not be up to par, that living standards may be unacceptable to many of the film’s above-the-line personnel and that extraordinary logistical problems may be encountered. Further devaluation. If the currency was so weak (and the economy so poor) that the government had to devalue it once, it could happen again, leaving the producer stuck with increasingly worthless paper.

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41 Foreign Below-the-Line or Facilities Deals Once again, if some or all of a feature film or documentary can be shot in a foreign locale, the producer may want to investigate the availability of so-called below-the-line or facilities deals. Some foreign governments from time to time have offered to provide the crew, locations, local cast, studio facilities and cameras so that a significant percentage (sometimes as high as 70 percent) of the film’s below-the-line costs are met. In exchange, these countries usually ask for distribution rights in their own country, perhaps including the nearby region. Of course, a significant portion of the film would need to be shot in the host country to make such arrangements worthwhile. Usually film stock is not included, and the cameras may not be very good. Most U.S. productions utilizing below-the-line facilities deals have also taken their own lighting. In the past, below-the-line and facilities deals have been offered in the former Czechoslovakia, Poland and Russia, but a filmmaker should always check with the film commission or agency in a country of interest to see if such arrangements are available (see “Official AFCI Directory”). Some of the below-the-line or facilities deals may be accessed through international coproduction deals if foreign coproduction treaties are involved (see chapter 37). Advantages Reduced out-of-pocket costs. Since a significant portion of the belowthe-line budget may be contributed in this manner, the producer does not have to come up with as much money to produce the film. Greater value. The value of the below-the-line facilities offered may be more important to the producer than the film distribution rights given up.

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Disadvantages Sometimes an active partner. If a country provides more than 50 percent of the below-the-line costs, it is likely to want to have some creative input; that is, it may become an active partner. Production problems. Again, many of the problems typically associated with any foreign film production will also be encountered in a below-theline facilities deal, namely, restrictive regulations relating to cast, crew and script, language barriers, frequent delays, unstable governments, riots, civil war and less than adequate housing facilities for the cast and crew.

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42 Foreign Government Subsidies Another possible part of the film-financing puzzle for any given production may include foreign government grants. These are specific donations by foreign governments to filmmakers to assist in the production of a film that is deemed advantageous to the country or a given locale within the country that is served by that government. In other words, production of the movie will provide jobs and possibly favorable publicity and thereby help the local economy. Information relating to foreign subsidy film programs is available through each country’s embassy or film commission (see “Official AFCI Directory”). In all likelihood, it would be helpful (and in many cases necessary) to have a coproducer associated with the film project seeking funding who is a citizen and resident of the country from which the grant is being sought. General Eligibility Criteria The following is a generic example of the eligibility criteria that must be met by a production company in order to receive the kind of foreign subsidies commonly offered: • at least one of the production companies producing the film must be established in the country where the subsidy is sought and authorized to carry out production activities; • the management of one of the production companies must be composed of citizens of that same country; • the production must also use studios and labs in the same country; • the film must satisfy a specified number of points on a point system relating to technical and artistic content; • the total amount of financial aid that can be granted by the government, including the production subsidies and other aid, cannot exceed 50 percent of the final production cost of the film; and • the production company must invest the granted production subsidy amounts within a specified period of time. 283

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Canadian Funds Other than the tax incentives offered through the Canadian federal and provincial governments (see chapter 38), there are four other Canadian government programs that benefit the television and film industry: • The Canadian Televison Film (CTF) Fund. The CTF has an annual budget of approximately $250 million to be used for the purpose of enhancing the creation and broadcast of high-quality, culturally significant, Canadian television programs. • Culture Industries Development Fund (CIDF). The CIDF program seeks to support Canadian cultural production by providing a range of financial services, especially term loans. • Feature Film Fund. The Feature Film Fund seeks to encourage the making and marketing of Canadian feature films that have high boxoffice potential, while supporting a range of genres, budgets, companies and regions. • New Media Fund. The New Media Fund is designed to aid in the development of Canadian companies and professional associations (organizations or agencies representing Canadian new media) active in new media content production and distribution on-line.

German Federal and State Funds Subsidies have also been provided in the past by the German Film Board. German movies generally only make up about 12 percent of the country’s national box-office take. Recent increases in federal funding of film subsidies have provided more funds for producing films, developing scripts and supporting new talent. German Film Board subsidies, however, are generally given to veteran film producers in that country, and future subsidies are tied to a producer’s success at the box office. If the moviegoers buy tickets at the box office to see that filmmaker’s movies, his or her chances for getting subsidies for another film are improved. It is likely that a non-Germanbased producer would have to partner with such an experienced German producer to access such subsidies. As might be expected with any government program, there have been complaints. Some German producers feel that their federal system does not work the way it should. As it now stands, a German filmmaker is eligible to obtain funding from the German Film Board if his or her film is seen by 100,000 or more moviegoers. Some German filmmakers see that as a system that rewards the “haves” (those with the least need)

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and punishes the “have nots” (those with a greater need for assistance). In other words, the German national film subsidies reward commercially successful films, and in effect, punish new filmmakers without a track record. The German Film Board, however, is not the only source of funds in that country. Each of the German states has its own film board and distributes funds also. A film subsidized by a state program has to be shot in that same state. On the other hand, at least one of the German states (North Rhine-Westphalia) significantly reduced funding for film and other media projects in 2003 because of severe budget shortfalls. The state media funding division had been providing infrastructure and film subsides since 2001. French Subsidies The French film subsidy program is centralized. French filmmakers send their applications to one address at the National Center for Cinematography (CNC) in Paris, which distributes nearly all French film-related subsidies. The CNC funds production as well as preproduction and development. The French also grant large sums of money for festivals, promotion, training new talent and investing in movie theatres. The French have created a system whereby some 11 percent of box office receipts for all films exhibited in France is sent back to the CNC, including the box office receipts of U.S. and other foreign films shown in that country. In addition, since the French recognize that a significant portion of television programming is film (i.e., television benefits from film), the French television broadcasters are obligated to contribute toward subsidizing the French film industry (i.e., about one-third of the money that subsidizes the film industry in France comes from the French television broadcasters). Austrian Regional Funds Government-approved films in Austria once received 80 percent of their budget from that country’s government, leaving the producer responsible only for the 20 percent balance. However, Austria’s right-of-center ruling coalition eliminated nearly 40 percent from their federally funded Austrian Film Institute (AFI) in 2001. Subsequently, the country’s regional film boards were able to offset those cuts by boosting their own spending. Thus, in Austria, funds like the Vienna Film Fund have become the main sources for film money in that country. These developments further illustrate how unreliable all forms of government subsidies can be.

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The Vienna Film Fund provides financing for projects completed in association with an Austrian producer. It has a yearly budget of $20 million and requires a foreign producer to develop films with a local Austrian film producer. The Austrian Film Commission maintains a list of local producers in Austria with international coproduction experience who are qualified to enter into coproduction arrangements with foreign filmmakers under the Vienna Fund. Also, each film project funded by the Vienna Fund must spend at least 100 percent of the funded amount in the Vienna community (e.g., filming costs, talent, hotel and travel expenses, etc.). Another regional fund in Austria, the Cine Tirol Film Fund, provides assistance for projects completed in the Tirol region of Austria. The Cine Tirol Fund, started in April 1998, provides money for films with one of the following criteria: • the project is developed in the Tirol region; • the underlying story concerns an event or the people in the Tirol region; or • a sufficient number of the people who live in the region work on the project.

The Cine Tirol Fund has a small annual budget (approximately $1.4 million), and there is a ceiling on the amount of money that can be awarded per film (about 20 percent of the film’s production budget). Each production company must spend at least 100 percent of the amount provided within the region. Unlike the Vienna Film Fund, no coproducer arrangement is required. However, the Cine Tirol Fund is not a grant; it is an interest-free loan to the production company. However, the production company is only required to repay the loan if the movie is commercially successful. And, for that reason, the administrator of the Cine Tirol Fund requires that producers receiving such grants periodically provide financial reports relating to the film’s earnings. Spanish Subsidy Programs Distribution and screen quotas have been relaxed in recent years in Spain after the market share of local films reached 11 percent. Amazingly, such a low percentage is considered good for Spanish films in that market. On the other hand, the Spanish government has been leaning toward cutting their program of advance subsides, one of the important subsidies for first films in Spain. Instead, the government has been looking to concentrate on other subsidies linked to a film’s box-office performance. Most

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observers feel that would work well for the big producers but would be a disaster for the small production houses. Jamaican Film Grants Jamaica has established a grant fund program for foreign filmmakers interested in developing projects in Jamaica. The Jamaica Film Fund is administered by the National Investment Bank of Jamaica (a government entity). Grants can be for as much as 20 percent of a film’s production budget for films made in Jamaica, although a ceiling may be imposed on the total amount. The Jamaican Film Commission actually selects the grant winners. As of this writing, there were no copartner or coproducer requirements, but check with the Jamaican Film Commission for the current and more specific guidelines. The Jamaica Film Fund is designed to encourage the use of Jamaican technicians and professionals, in addition to help fund projects that portray Jamaica in a favorable light. Who said film is merely entertainment? Advantages Another possible funding source. Government subsidies provide another possible source of funding for films that are at least partly shot in the granting country. The right movie. The right movie that can be partly shot in the subsidizing country can obtain some financial assistance in this manner. International coproductions. A producer’s chances of obtaining a foreign government grant may be increased if the production qualifies as a coproduction in the country from which the grant is being sought. Disadvantages Limited funds. All government subsidy programs provide only a limited amount of funds, which may or may not be enough to fully fund a given film production project. Funding levels change. The level of funding by federal and state government sources do change from time to time, depending on budgeting factors that may have nothing to do with film. Takes a long time. The time it takes to get a decision on funding can be lengthy. Foreign locations. Foreign film subsidies granted by foreign governments usually require that most of the film be shot in the subsidizing country, using almost exclusively native technicians, facilities and actors. Such requirements may result in a reduction in quality.

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Staff expertise. A producer (or someone like the production attorney or a consultant) seeking to utilize such film-financing techniques has to become very familiar with the foreign regulations governing such subsidies and the production of the film. Violate trade agreements. The subsidy programs that other countries offer to lure film production may not be consistent with World Trade Organization (WTO) trade agreements.

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43 Foreign Debt Capitalization Programs Although of limited use to most filmmakers, foreign debt capitalization programs might be another component of a production budget for some independent producers. Quite a few third-world countries owe large amounts of money to foreign banks, and those countries have adopted so-called debt capitalization programs in an effort to encourage the purchase of that debt at a significant discount in exchange for foreign currency that can be used for production activities in the debtor country. The discounts typically range from 40 to 60 percent. The debt will be exchanged for its full face amount in the foreign currency. Countries with debt capitalization programs in recent years included Mexico, Brazil, Costa Rica and the Philippines. The producer with a motion picture that can be shot on location in a foreign country and who desires to consider using a debt capitalization program should first contact the U.S. office of a representative of that foreign country to inquire whether it has such a program (see “Official AFCI Directory”). If such a program is in effect, the producer will have to complete an application that must then be approved by the foreign country. Once approved, the foreign currency is contributed to a corporation incorporated in that country, the stock of which is owned by the U.S. producer. The foreign corporation then produces the film in that country. The completed motion picture is actually owned by the foreign corporation, but it can be licensed back to the U.S. producer. In some instances, it is possible for all ownership rights to remain with the U.S. producer. Depending on the country involved, the specific manner in which the transaction is structured and the way the U.S. production company conducts its activities, unfavorable tax consequences may arise from a debt capitalization program. For example, income to the U.S. producer may be recognized immediately when the purchased debt is converted into the foreign currency. Also, in some cases, foreign taxes may be imposed on income earned on the motion picture. Thus, the advice of an international

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tax attorney or accountant should be sought in structuring this sort of film finance transaction. Advantages Economic consequences. The producer is reducing third-world debt while also making a film and contributing to the local economy. Discounted funds. Monies are available at significant discounts. Investor enhancement. Plans to take advantage of a specific foreign debt capitalization program may prove to be an effective selling point to prospective limited partnership or LLC investors, since their money can then be leveraged to purchase significantly greater production values. Disadvantages Specialized expertise. Generally speaking, the services of someone who has expertise in this area of finance will be required. The Debt-forDevelopment Coalition, based in Washington, D.C., provides consulting services relating to debt capitalization programs. Takes money to get money. The third-world debt has to be purchased, thus some level of up-front funding is required.

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Conclusion: The Broader Film Finance Environment A book about film finance is not complete nor entirely honest unless it also provides some perspective on the broader film finance environment. In truth, all factors that have an impact on the ability of an independent producer to finance a given film (i.e., make it easier or more difficult to raise money for a film project) are part of that broader film finance environment. Thus, this section focuses on the “big picture” (i.e., on those factors that clearly have a significant impact on who gets a film financed and who does not, or why film finance is often so difficult for many). Several of the most prominent of these factors are discussed below. The Law of Supply and Demand The American film industry has long been out of balance in a competitive sense. For many years it has produced far too many movies, many more than could possibly be distributed theatrically or profitably. Too many films in the marketplace tends to keep prices low and make it unnecessary for territorial distributors to pay advances or even commit to purchase films prior to their completion. So long as there exists such a profound imbalance in the supply of motion pictures, film distributors will continue to offer contracts of adhesion on a take-it-or-leave-it basis. Many institutions contribute to the film industry’s imbalance between supply and demand, including the far too many film schools, film festivals and film commissions who feed into and support the greed of the Hollywood major studio/distributors. Lots of people in the industry talk about this oversupply of feature films, but few, if any, individuals or organizations are doing anything about it. The very first step in resolving this problem is for some organization in the industry to step up and undertake an annual study of just exactly how many films are being produced versus how many films obtain a theatrical release or other distribution, and then to disseminate this factual information to all concerned interests, including film schools, 291

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film commissions and film festivals, so that, at least, the young people considering careers as film producers will have more than mere speculation on which to base that career decision. The World of Film Finance Scams There are other aspects of the film industry environment that indirectly (and sometimes directly) impact the independent producer’s ability to fund film production activities. Many of these are actually scams (fraudulent or deceptive acts) at one level or another and are intended to separate the producer from his or her money. A review of the history of Hollywood reveals that scam artists were there from the beginning, preying on unsuspecting producers, actors, actresses and all of the dreamers seeking fame and fortune in this business. The following scams are directly or indirectly related to film finance and have been occurring in the so-called film community for many years. Unfortunately, none of the organizations purporting to represent various interests within the film industry have seen fit to effectively deal with such scams. In fact, some of the scams are being committed by film industry organizations. Thus, independent producers need to reorganize and work on these problems affecting their vital interests or, at least, be aware that such scams are ongoing and try to avoid them. Studio business practices. Major studio/distributors based in Hollywood engage in hundreds of well-documented unfair, unethical, unconscionable, anticompetitive, predatory or illegal business practices that permit the major studio oligopoly to dominate the domestic film marketplace, squeeze the films of independent producers off the available screens and make it more difficult for independent producers to get their films financed. Manipulated risk. A significant part of the risk associated with the production of independent films is artificially created by the overly wide releases of major studio/distributor films and the excessive power of these majors to get their films (some of which are of mediocre to poor quality) on theatre screens in place of independent films regardless of the comparative quality of the competing films. NASAA survey. The North American Securities Administrators Association recently released its annual survey of the most common ploys being used to cheat investors. Six of the ten are being used to cheat investors in film deals. Those include unlicensed individuals selling securities, unregistered investment products, promissory notes, senior investment fraud, high-yield investment schemes and Internet fraud. Most of such deals are being offered by telemarketers. 292


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Finder scams. Finders sometimes advise independent producers that they will raise money for the producer’s film regardless of whether the federal and state securities laws apply to the transactions. Finders also sometimes work the Hollywood networking scene in search of independent producers desperately seeking production financing and offer to introduce the producer to the manager of an off-shore trust fund interested in financing feature films. Ultimately, all of what appears to be legitimate activity leads to a request that the producer pay some sort of fee to the purported financing source prior to funding. Once that fee is paid, the finder and all others associated with the supposed funding effort disappear. Securities law dodge. Some entertainment attorneys advise independent producers to ignore the federal and state securities laws when raising money from a group of passive investors, by using promissory notes that are repayable out of the film’s revenues. Unfortunately, such transactions involve the sale of unregistered securities. Misuse of business plans. Entertainment attorneys or other film finance consultants sometimes encourage filmmakers to raise money from passive investors with only a business plan, when a securities disclosure document is required. Investor come-ons. Attorneys and film finance website services sometimes use the suggestion that they may be able to help bring investors to client film offerings as a come-on to get the client’s offering business (if the producer hires them), when they either have no intention of bringing investors to the table or the independent producer has no way of knowing whether it might happen. Tie-in arrangements. Entertainment attorneys sometimes offer to prepare a securities offering memorandum for a smaller fee, so long as the producer agrees to hire them for the production documentation and other entertainment work associated with the production and distribution of a feature film, without being knowledgeable in the area of securities offerings and also while raising the amount normally charged for the production work to make up for the smaller offering fee. Misinformation for dollars. Film industry organizations that sponsor film finance seminars sometimes assemble panels of people who do not have bona fide expertise in a given area (e.g., equity financing) and thereby provide not only inadequate coverage of the subject matter but false and misleading information. Unreliable information. Attorneys, film finance consultants and producers serving as panelists on film finance panels sometimes actually give out erroneous information to unsuspecting independent producers. 293


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Independent producers need to step up and demand better and more reliable information. Biased seminars. Almost all film finance presentations are biased in one way or another. That’s because no single individual possesses bona fide expertise in all areas of film finance. But some film industry organizations cross the line and knowingly provide false and misleading information, because they are more interested in making money on their seminars by selling the right to serve as a seminar sponsor to people who do not have bona fide expertise in some of the areas presented. Other groups are biased in the sense that they consistently provide seminars extolling the virtues of one form of film finance (e.g., lender financing) but failing to provide equal time for other forms of film finance (e.g., investor financing). Such groups are thus failing to fairly meet the information needs of their own members. Hollywood Is an Insider’s Game The Hollywood-based U.S. motion picture industry is dominated by a small group of so-called major studio/distributors. The studio and affiliate releases are the movies seen by some 97 percent of the domestic moviegoing audience and a significant percentage of most foreign audiences. Aside from the fact that various creative people, including screenwriters, directors, producers and actors, contribute to the content of individual motion pictures, the people in Hollywood who have the power to decide which movies are financed, produced and released, to determine who gets to work in the key positions on such movies and to approve of the screenplays serving as the basis for these movies are the three top studio executives at the major studio distributors. (For more information on this topic, see my books Hollywood Wars—How Insiders Gained and Maintain Illegitimate Control over Hollywood and The Feature Film Distribution Deal: A Critical Look at the Single Most Important Film Industry Agreement.) Without a doubt, Hollywood is a very challenging environment for would-be filmmakers. With most aspects of movie making—from financing to distribution—largely controlled by a small group of Hollywood insiders, and with a raft of misinformation, scams, bad advice and other potential pitfalls looming, the odds are against independent filmmakers. This book was written to help even those odds, by providing those who are not insiders—whether they be producers, executive producers, attorneys, screenwriters, investors or others—with information, strategies and advice that may help them succeed in financing their feature films.

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Appendixes Sources and Further Reading Index

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Appendix A: Finding Investors Investors for film projects may be business entities like corporations or partnerships, but more often than not they are individual people. Filmmakers often ask where they can find investors. The answer is that they are everywhere—everywhere people are found. Filmmakers must understand that there is no particular physical place on earth where investors interested in investing in an independent film gather, except occasionally some of them may attend film festivals and film-financing seminars for the purpose of learning more about the industry. Purported lists of investors specifically interested in investing in film are notoriously inaccurate, out of date and otherwise worthless, and so are the broader lists sold by list purveyors of so-called wealthy investors. In addition, a producer must know when it is permissible to cold call a prospective investor and when such a general solicitation is prohibited by the securities laws. The relatively new do-not-call restrictions also apply and severely limit a producer’s ability to call a prospective investor out of the blue. Telemarketers often fail to comply with both the securities laws and the do-not-call limitations, so beware. The best approach is to be aware of when it is appropriate to approach prospective investors that you do not know (see “Marketing Considerations” below), and in your conversations or other communication with individuals, watch for any of the common motivations often associated with prospective film investors that are listed below. At least one of the keys to finding investors (i.e., looking in the right places) is analysis of 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 unique to a specific film project. Some of these descriptions of investor motivation are closely related and may even overlap. They are presented in no particular order. Career support. An investor has close ties with the filmmaker and is interested in supporting the filmmaker’s career.

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Glamour. An investor is enamored with the glamour of the film industry or the idea of owning a piece of a movie. Cocktail chatter. An investor feels the investment has a certain amount of “cocktail chatter” value, (i.e., it’s more interesting and fun to talk about than most boring investments in their portfolio). Association. An investor wants to be able to spend some time on the set and rub elbows with the cast and crew (this needs to be carefully controlled so that it does not get out of hand). Learning experience. An investor 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. Extras. An investor would like for a son, daughter, niece or nephew to appear as an extra in the movie. Appear in movie. An investor wants to appear in the movie as an extra or in a small part. Local economy. An investor realizes that by investing in the movie, it will help bring the movie to a specific locale, which will benefit the local economy. Movie message. An investor is interested in one or more of the messages being communicated through this significant medium for the communication of ideas (i.e., all movies communicate something). Tax incentives. An investor is in a position to take advantage of federal, state, or international tax incentives for film production expenses. Screenwriter. An investor is a screenwriter and wants to get his or her script produced. Direct. An investor is also a director and (in rare and unusual circumstances) may want to direct the movie. Make a profit. Although not usually the sole reason for investing, even investors who invest in films for some of the other reasons may also still hold out hope that such a risky investment will result in a profit.

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Appendix B: Limited-Use Business Plans Filmmakers are often advised to create a business plan to help them raise money. But it may not be appropriate in many situations. In all fairness, the business plan is not a financing vehicle or entity, and investors cannot invest in one or buy shares in it. However, a business plan can be used in conjunction with several other investor-financing techniques to raise money for film projects. For example, it can be used with an investor-financing agreement to raise money from a single active investor. It can be used with a joint venture agreement to raise money from another entity also acting as an active investor or joint venture partner. It can also be used as a means of identifying possible founding shareholders for the initial incorporation (a strategy discussed in chapter 5). Another important use of the business plan is in establishing a preexisting relationship with prospective investors for a possible subsequent privately placed securities offering (see chapters 10–12). In this sense, the business plan becomes a method for conducting a general solicitation while looking for active investors (see chapters 3–6), and if the active investor campaign does not prove successful, then the undertaking, after a several-week waiting period, can be converted into a securities offering (seeking 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 them is likely to be sufficient to establish that a preexisting relationship exists, which, although not technically required by the federal securities laws, still is an important element in proving that no general solicitation occurred during the period in which the securities offering was being conducted as an exempt/private offering. The business plan, however, is not all that useful for seeking financing from studios or other industry sources. Industry professionals are more interested in a producer’s package (i.e., the script, evidence of copyrights, information relating to attachments and the budget). As a 299

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Appendix B

general rule, a business plan is more useful for approaching financing sources outside of the film industry (limited by securities considerations, as discussed below). Also, a business plan is not appropriate for use in seeking to raise money from a large group of passive investors, since that activity tends to involve the sale of a security and a securities disclosure document is required. 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 (with a cover, table of contents and exhibits). The business plan is sometimes the first step in procuring investor financing, whereas the producer’s package is 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 (except that it includes offering expenses, clearly a non–film budget item). A business plan can be as simple or as sophisticated as the producer and his or her advisers choose to make it. Completion Bonds Note that the completion bond is also not a form of film finance but merely a financial arrangement that helps to facilitate certain film-financing transactions. For example, on most lender transactions (i.e., negative pickups, foreign presales, gap and supergap financing and the insurance-backed schemes—all forms of lender financing), the banks will always insist that the producer obtain a completion bond to assure that the bank will not have to worry about the film going over budget. That is simply a risk that the bank will not assume. Sometimes the studios will also choose to purchase a completion bond on some of their films, and some independent producers may choose to purchase a completion bond for an investor-financed film. However, the vast majority of the low- and ultra-low-budget motion pictures produced by independent producers each year probably do not use a completion bond. Business Plan or Securities Disclosure Document Based on numerous conversations with independent feature film producers, there appears to be a considerable amount of misunderstanding and misinformation in the film community regarding when to use a business

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plan as opposed to a securities disclosure document to raise money from investors to develop, produce or distribute one or more independent feature films. The following discussion addresses that question. First, the filmmaker needs to understand what a business plan is and how it differs from a securities disclosure document. Although there may be some similarities and overlap between them, these two documents are not the same things. The differences are both in the content and in the appropriate uses of the documents. A business plan is a written statement that describes and analyzes a business (in this particular case, a proposed, independently produced feature-length movie) and gives detailed projections about the future of that business. A business plan is not an investment vehicle: shares in it cannot be sold. Nobody can invest in a business plan. If it is used to actually raise money, it must be used in the proper circumstances and must be combined with an appropriate investment vehicle. Thus, a business plan, combined with an appropriate investment vehicle, can be used to raise money, but only in limited circumstances; for instance, to raise money from one, two or a few active investors. But it cannot be appropriately used to actually raise money from a larger group of passive investors, except in the case of so-called institutional investors (i.e., organizations that regularly trade large volumes of securities, such as mutual funds, banks, insurance companies, pension funds, labor union funds, corporate profit-sharing plans and college endowment funds). So, what’s the difference between an active and a passive investor? An active investor is someone who is regularly involved in helping the filmmaker make important decisions with respect to the film: helping to select and make changes in the script, to select the director and lead actors, to choose the line producer and director of photography, to solve problems that come up during production, to make decisions relating to distribution, and so forth. The active investors need to be capable of making valuable contributions on important questions (i.e., they need to have some knowledge of, and experience in, the film industry that is relevant to what the filmmaker is doing) and be actively involved in helping to make such decisions on a regular basis. That does not mean they should have veto power, although some investors who put in most of the money to produce a film, for example, may insist on such control, and in that instance, it may become a problem for a producer. In addition, unless an entity is created to provide limited liability, active investors may not have the limited liability protection that most people who invest a substantial amount in a high-risk venture

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Appendix B

like an independent film would prefer to have. That is another factor to consider when determining whether to use a business plan and seek financing from a small number of active investors. On the other hand, a passive investor is someone who is not regularly involved in helping to make those important decisions. This is an important distinction, because it represents the essence of the difference between a nonsecurities offering and a securities offering. Essentially, any time filmmakers or producers are seeking to raise money from one or more passive investors, they are engaged in selling securities, no matter what you call it. So, their decisions to raise money from active or passive investors have important implications and consequences. If you are really trying to raise money from one, two or a few active investors, who are both capable and willing to be regularly involved in helping to make important decisions, you can use a business plan combined with an appropriate investment vehicle to provide them with the information on which to base their decision. But, if you are raising money from one or more passive investors (other than the institutional investors noted above), you are required by law to provide those investors with a properly prepared securities disclosure document (not a business plan) prior to their investment. In addition, using a business plan to raise money from a small number of active investors should not suggest in any way that you are really seeking to raise money from passive investors. In other words, either leave out the discussion about the specific financial arrangements or, at the very least, avoid references to interests in limited partnerships or units in a manager-managed (passive-investor) limited liability company (LLC). Furthermore, the language in the business plan should not state or imply that the investors will not be permitted to be regularly involved in helping to make important decisions, since that is at the very heart of what makes them active investors. It may be the better practice to specifically state that the business plan is being used in conjunction with one of those investment vehicles appropriate for the purpose of raising funds from one, two or a few active investors. In any case, absolutely do not include language that you either plan to or possibly may later create a limited partnership or manager-managed LLC, because that would clearly indicate that you are planning a securities offering. Also, do not suggest by the language in the business plan that you intend to raise money from more than a few active investors, because at some undefined point, it is no longer possible to keep a large number of investors “actively” involved in a business venture in any meaningful way, and if even one of the investors is passive, the interest sold becomes a security. 302

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Now, what are those investment vehicles that can appropriately be used in conjunction with a business plan for seeking funds from one, two or a few active investors? As discussed above, the four vehicles are: (1) the investor-financing agreement (for an example, see Film Industry Contracts), (2) the joint venture agreement (an example of which also appears in Film Industry Contracts), (3) the initial incorporation (see chapter 5 in this book) and (4) a member-managed (active-investor) limited liability company (which, in addition to the filing with the state’s secretary of state, must also have an LLC operating agreement to be properly formed). So, to repeat, there are some obvious disadvantages to seeking funds from active investors: (1) they may interfere with your creative control, (2) the investment vehicle chosen may not offer any limited liability protection to your investors and (3) it may be more difficult to find prospective investors who are both capable of and willing to be lead investors in a highrisk investment like independent film. It is also important to recognize that by seeking active investor financing, you are eliminating at least two of the advantages of a securities offering: spreading the risk among a larger group of passive investors, none of whom will typically be hurt too badly if they do not get their money back or make a profit; and, of course, passive investors do not interfere with the filmmaker’s creative control. Now, a quick note about terminology. Securities disclosure document is a broad term that applies to the required written information that must be provided to prospective investors before they invest in most securities offerings. The terms prospectus and offering circular are used to describe the securities disclosure documents associated with various types of public (registered) offerings. These securities offerings are usually too expensive, complicated and time-consuming to be of much interest to low-budget independent filmmakers. On the other hand, private placement offering memorandum, or PPM, is the term used to describe the securities disclosure document associated with an exempt/private offering, and this is the securities disclosure document most commonly used by low-budget indie filmmakers. Specific rules promulgated by the federal Securities and Exchange Commission (SEC) and, in some instances, by state securities regulatory authorities provide guidance on what information must be disclosed in these securities disclosure documents and how that information must be presented. There are no such rules for business plans, and that is why there is both such a wide disparity in the content of business plans and why that content is always different in some respect from the content of a securities disclosure document, even though elements of the two are the same or similar. 303

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Appendix C: Financial Projections 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 they receive. Financial projections provide the prospective investor and the film producer seeking investor financing with an additional point of discussion and serve as an excellent way for the producer to visualize 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 asked by 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 and to understand and to be able to explain it as clearly as possible. Where 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 nonsecurities and securities offerings. Pursuant to the SEC’s Regulation S-B, Part 228 (Integrated Disclosure System for Small Business Issuers), 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. The following guidelines set forth the SEC’s perspective on important factors to be considered in preparing and disclosing such projections. Basis for Projections A film producer (i.e., management, in this example) 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 written 304

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Financial Projections

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 projections may furnish additional support in this regard. If a film producer 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 (or loss), and earnings (or loss) per share or unit); however, projection information need not necessarily be limited to these three items. On the other hand, a producer 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 twoor three-year period may be entirely reasonable. Other companies may not have a reasonable basis for projections beyond the current year. To be meaningful, projections for a film offering may extend to 5–7 years. Also 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 is enhanced by disclosure of the assumptions that in management’s opinion are most significant to the 305

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Appendix C

projections or are the key factors upon which the financial results of the enterprise depend, and it encourages disclosure of assumptions in a manner that will provide a framework 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 might be safer to offer several calculations (e.g., using a three-column format to show “Poor Performance,” “Good Performance” and “Excellent Performance”). That way, it is made 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, he or she is 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 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 necessarily 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 information about the financial performance of prior feature films, much less for the markets and media beyond the theatrical marketplace, and worse yet for the independent sector. For that reason, it may be impossible 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 level of overall performance 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.

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Appendix D: Securities Marketing Considerations Sometimes independent film producers and their advisers blur the lines between marketing considerations and compliance obligations when selling securities, partly because the two commonly overlap, but sometimes because neither the producer nor the film finance adviser are aware that the producer is even selling a security. The rules relating to the sale of a security (i.e., manner of offering) differ significantly from how a nonsecurities investment may be marketed. And the specific rules relating to the manner of offering, particularly for the sale of a security pursuant to a private placement/exemption, differ depending on the specific exemption being used. So the producer’s decisions relating to which investment vehicles or entities are to be used and the specific approach to film finance that is being used will help determine what marketing techniques may be appropriate. As used here, the term marketing considerations refers to the appropriate ways in which securities are offered or sold. The emphasis is on compliance with the law, as opposed to selling techniques. Nevertheless, keep in mind that, as has been said, securities are generally not bought, they are sold. On the other hand, there are plenty of books available on how to sell almost anything. This section is about how to sell securities in a legitimate manner, so that no laws or SEC rules are broken and the filmmaker can avoid a nasty legal entanglement or a huge, unpayable debt to investors. Essentially, securities (whether corporate shares, interests in a limited partnership or units in a manager-managed LLC) are sold in three distinctly different ways: broker/dealer sales, issuer sales and finder sales. Broker/Dealer Sales The SEC’s Regulation D, Rule 502(c), places certain limitations on the way in which sales of securities can be marketed pursuant to this exemption. The following discussion provides the text of the Regulation D provi307

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Appendix D

sions relating to the manner of offering, along with certain of the SEC staff’s interpretations of such provisions, and is followed by discussion of related issues. Limitation on manner of offering. Except as provided in Rule 504(b)(1), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following: (1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio: and (2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.

Rule 504(b)(1), referred to above, provides that the provisions of Rule 502(c) do not apply to offers and sales of securities under Rule 504 that are made exclusively in one or more states, each of which provides for the registration of the securities and requires the delivery of a disclosure document before sale, and that are made in accordance with those state provisions. This Rule 504 exclusion would not apply to offerings relying on state exemptions from registration (i.e., private placement offerings). According to the SEC staff in an opinion letter (SEC No-Action Letter, E. F. Hutton & Co., December 3, 1985), procedures for a planned private offering would not run afoul of Rule 502(c) so long as the issuer’s or the broker/dealer firm’s preexisting relationships with the offerees were not established through a recent general solicitation. The offerees need not have invested previously in securities with the issuer or the broker/dealer firm. In addition, the staff conceded that “substantive relationships” may be established with persons providing satisfactory responses to questionnaires designed to elicit their sophistication and financial circumstances. Such “Suitability Questionnaires” and “New Account Forms,” however, must provide sufficient information for the broker/dealer firm or issuer to make the suitability evaluation. In a similar no-action letter made available the same day (SEC NoAction Letter, Bateman Eichler, December 3, 1985), the SEC’s Division of Corporation Finance advised the firm of Bateman Eichler that its proposed solicitation, which would be generic and not make reference to any specific investment currently offered or contemplated for offering by the company, would not involve an offer of securities. Bateman Eichler had represented in its inquiry that it would maintain records of all mailings so that no person who was originally contacted through the generic mailing would receive offering materials for a specific investment currently 308

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Securities Marketing Considerations

offered or contemplated. The mailing included a questionnaire designed to elicit financial and other information about the prospective customer to enable the broker to evaluate the suitability of future investments. The SEC advised Bateman Eichler that later offers to persons who responded to the mailings would not be deemed a general solicitation as a result of the initial solicitation, provided that “a substantive relationship had been established with the offeree between the time of the initial solicitation and the later offer.” Another SEC no-action letter (H. B. Shaine & Co., Inc., May 1, 1987) confirmed that satisfactory responses by strangers to an adequate questionnaire will itself establish the requisite preexisting substantive relationship. Also, it would appear that an isolated slip-up in the offering process (e.g., an inadvertent cold call by a broker) probably does not constitute a general solicitation that would destroy the Regulation D exemption, since the SEC has opined (Securities Act Release No. 6825, March 14, 1989) that “if an offering is structured so that only persons with whom the issuer and its agents have had a prior relationship are solicited, the fact that one potential investor with whom there is no such prior relationship is called may not necessarily result in a general solicitation.” The issuer or broker/dealer firm should maintain control over the number and qualifications of investors to whom limited partnership interests (or units in a manager-managed LLC) will be privately offered. The more registered representatives participating in the offering, the greater the potential for attracting unsophisticated or otherwise unqualified investors and, hence, the greater the need for a uniform and documented system of making such offers. To accomplish the goals of control over the investor pool and uniformity in their methodology, the issuer or broker/dealer firm should develop offering and investor selection procedures. These procedures should ensure that offering materials are sent only to prospective offerees with whom the issuer or broker/dealer firm has established a business relationship or who have indicated they wish to form a relationship such that the firm knows the prospective investors’ suitability. Such procedures not only comply with but exceed both the statutory and regulatory requirements imposed on the manner of offering securities in exempt transactions, according to the SEC staff. No investor should be offered securities in a private placement type offering unless the issuer or broker/dealer firm has on file a new account form or something similar and a fully completed suitability questionnaire dated within the last year. 309

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Appendix D

Furthermore, to ensure the private nature of the offering, strict and uniform distribution procedures should be maintained. The issuer or broker/dealer firm should provide detailed instructions to each upperlevel manager, selling agent or registered representative regarding the categories of persons who may be contacted regarding a private offering. Only authorized preoffering and offering materials should be provided to the prospective investor. If a prospective investor expresses an interest in a future offering, a confidential private placement offering memorandum should be assigned to the registered representative for delivery to that party when the memorandum is ready. For 5 years following the sale of such securities, the issuer or broker/dealer firm should maintain the following information for each purchaser: • • • • •

source of contact or referral; nature of the relationship with the offeree; previous investments with the issuer or broker/dealer; list of the informational materials provided; and copy of the client’s suitability questionnaire relied on.

Offerees should be prequalified on either the basis of information obtained through a preexisting business relationship or the data provided by the suitability questionnaire and the new account form indicating that the offeree not only desires to form a business relationship with the issuer or broker/dealer firm but also has the requisite sophistication and financial resources to be a suitable purchaser. The SEC staff emphasizes the importance of the existence and substance of prior relationships between the issuer or its agents and those being solicited. It is crucial, the staff points out, that (1) substantive relationships be created with offerees and (2) that the relationships be preexisting (i.e., exist prior to a solicitation relating to a specific private offering). As any such relationship may have been established as a result of a general solicitation or advertising, it is important that there be sufficient time between establishment of the relationship and an offer so that the offer is not considered made by general solicitation or advertising. In the SEC staff’s view, if the relationship was established prior to the time the broker/dealer firm began participating in the Regulation D offering, an offer could be made without violating Rule 502(c). Catherine McCoy, associate director (legal) of the SEC Division of Corporation Finance, summarizes staff positions in SEC no-action letters on interpreting Rule 502(c) as follows:

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There is no requirement for a preexisting relationship between the person making an offer to sell securities and the offeree. Rather, a preexisting relationship is one factor among others to be considered in determining whether a general solicitation has been avoided. A broker/dealer firm does not have to have sold deals to an investor before selling the Regulation D offering, but should have gathered satisfactory responses to informationgathering techniques that indicate the broker/dealer may sell the security in an exempt transaction to the investor.

The SEC no-action letters referred to do not take any position on the number of offerees. However, such letters address the stage when the offeror is soliciting potential offerees and not a later stage when actual offers are made. Issuers may have a more difficult time in trying to copy the factual circumstances involved in these no-action letters, which were aimed at broker/dealers. Issuers should only solicit potential offerees at a time when the issuer is not actually conducting an offering, unless the preexisting relationship already exists. Suggested Regulation D Soliciting Procedures 1. Upper-level management of the issuer, registered representatives or selling agents should inquire as to the prospective investors’ general interest in the type of investments being considered by the issuer or broker/dealer firm. 2. A new account card and prospective offeree suitability questionnaire or similar information should be completed and placed on file with the issuer or broker/dealer firm. 3. A designated principal of the issuer or broker/dealer firm must later examine the new account card and prospective offeree suitability questionnaire and determine whether the prospective investor is suitable for the subsequent private placement offering. Such approval should be noted on the card. 4. If the designated principal approves the prospective investor as suitable, then and only then should an offering memorandum be checked out to upper-level management, the agent or representative for delivery to the prospective investor. 5. Once a specific offering has begun, no new account forms or suitability questionnaires dated after the date the issuer or broker/dealer firm begins its participation in such offering (and therefore no prospective investors represented by such forms and questionnaires) should be ap-

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Appendix D

proved for the offering that has commenced. Such prospective investors must wait until a later offering is begun. 6. A date for the issuer or the broker/dealer firm’s participation in each offering must be established. 7. Dates should be affixed to each new account form and suitability questionnaire. 8. The designated principal should initial the approved space on each prospective investor’s new account card and indicate the offering for which each such prospective investor is approved. 9. Any preoffering materials, such as a corporate brochure, should be approved by counsel and should not include any information that could be construed as relating to a subsequent private placement. 10. Upper-level management of the issuer, registered representatives or selling agents should stop making contacts with new prospective offerees at least several weeks before the issuer or broker/dealer firm starts selling a specific private placement offering. Compliance recommendation. Review all procedures and activities relating to the private placement offering and be certain that the conduct of such offering is in compliance with the above stated rules. Also review all provisions of Regulation D and discuss with counsel any activities relating to the conduct of the private offering that may raise Regulation D compliance questions. NASD Guidelines on Compensation The NASD’s Rules of Fair Practice (which specifically apply to public offerings, but which may be applied informally by some state regulators to private placements) provide that NASD member broker/dealer firms or persons associated with such firms must not participate in a public offering of a direct participation program (such as a limited partnership or LLC offering) except in accordance with the NASD’s Rules of Fair Practice, Appendix F. These rules provide limitations on the amount of money that can be expended on such an offering: “No [NASD] member [broker/dealer firm] or person associated with a member shall . . . participate in a public offering of a direct participation program if the organization and offering expenses are not fair and reasonable, taking into consideration all relevant factors” (Appendix F, Section 5). In determining the fairness and reasonableness of organization and offering expenses, the arrangements are presumed to be unfair and unreasonable if the total amount of all items of compensation from whatever source payable to broker/dealers or affiliates thereof that are deemed to be in connection with or related to the distribution of the public offering 312

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exceeds currently effective compensation guidelines for direct participation programs. Also, the NASD presumes offering arrangements to be unfair and unreasonable if organization and offering expenses paid by a program in which a NASD member firm or an affiliate of a member firm is a sponsor exceeds currently effective guidelines for such expenses. The NASD guidelines regarding compensation are 10 percent of proceeds received, plus a maximum of 0.5 percent for reimbursement of bona fide due diligence expenses. The NASD guidelines limit offering expenses (i.e., organizational and syndication costs) to a total of 15 percent (Section 5, Appendix F). The NASD also considers it unfair and unreasonable for commissions or other compensation to be paid or awarded either directly or indirectly to any person engaged by a potential investor for investment advice as an inducement to that person to advise the purchaser of interests in a particular program unless such person is a registered broker/dealer or a person associated with such a broker/dealer. Furthermore, all items of compensation paid by the program directly or indirectly, from whatever source, to broker/dealers or their affiliates, including, but not limited to, sales commissions, wholesaling fees, due diligence expenses, other expenses, broker/dealer’s counsel’s fees, securities or rights to acquire securities, rights of first refusal, consulting fees, finder’s fees, investor relations fees and any other items of compensation for services of any kind or description, which are deemed to be in connection with or related to the public offering, are taken into consideration in computing the amount of compensation. Compliance recommendation. In contracting with broker/dealer firms, make sure that the terms and actual implementation of the selling broker/dealer or managing broker/dealer agreements comply with these NASD rules for public offerings, or if in a private offering, use these rules as a guide and look to the state exemptions for guidance as to limitations or ceilings imposed on broker/dealer commissions or the total offering expenses (including commissions). Some states apply the public offering guidelines to private placements on an informal basis; therefore it may be necessary to call the securities regulators and inquire about such limitations. Private Securities Transactions In dealing with persons who hold themselves out as broker/dealers or registered representatives of a broker/dealer firm, the NASD Rules of Fair Practice, Article 3, Section 27, prohibits transactions in which an associated person (a person associated with an NASD member broker/dealer 313

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Appendix D

firm) is selling to public investors on behalf of another party (e.g., as part of a private offering of limited partnership interests or LLC units, without the participation of the person’s employer firm). In the view of the NASD, such transactions present serious regulatory concerns because securities may be sold to public investors without the benefits of any supervision or oversight by a member firm and perhaps without adequate attention to various regulatory protection such as due diligence investigations and suitability determinations. In some cases, investors may be mislead into believing that the associated person’s firm has analyzed the security being offered and “stands behind” the product and transactions when in fact the firm may be totally unaware of the person’s participation in the transaction. Under some circumstances, a firm may be held civilly liable for the actions of their associated person even though the firm was not aware of such person’s participation in the transaction (NASD Notice to Members 85-21).

1. Applicability of the rule. This rule would apply to any situation in which an associated person of a member proposes to participate in any manner in a private securities transaction. Private securities transaction is defined broadly and specifically includes private placement offerings. 2. Written notice requirement. The rule requires an associated person to provide written notice to the NASD member broker/dealer firm with which he or she is associated prior to participating in any private securities transaction. The notice must include a detailed description of the proposed transaction and the individual’s proposed role therein. Because the rule treats compensatory transactions differently, it would also be necessary for an associated person to state whether he or she will receive selling compensation in connection with the transaction. 3. Transactions for compensation. The most serious regulatory concerns relate to situations in which an associated person is receiving selling compensation and therefore has an incentive to execute sales, perhaps without adequate supervision and without adequate attention to suitability and due diligence responsibilities. The rule requires that, in the case of transactions in which an associated person has or may receive selling compensation, an NASD member broker/dealer firm receiving written notice from one of its associated persons should respond in writing, indicating whether the firm approves or disapproves of the person’s participation in the proposed transaction. If the firm approves of the person’s participation, it is then required to treat the transaction as a transaction of the firm, to record the transaction on the firm’s books and 314

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records, and to supervise the person’s participation in the transaction to the same extent as if the transaction were executed on behalf of the firm. If the firm disapproves of a person’s participation, the associated person is prohibited from participating in the transaction in any manner. 4. Definition of selling compensation. The definition of selling compensation is broad in scope and includes “any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security” (Rules of Fair Practice, Article 3, Section 27). This definition includes compensation received or to be received by one acting in the capacity of a salesperson or in some other capacity, including in particular the capacity of a general partner. The definition is intended specifically to address a practice in which associated persons function as general partners or managers in forming limited partnerships or manager-managed LLCs and then sell limited partnership interests or LLC units in private securities transactions. Compliance recommendation. If the issuer is considering using the services of a person who is associated with a broker/dealer firm, make sure that the rules stated above relating to private securities transactions are followed. Issuer Sales The issuer of the securities to be offered by a film or video limited partnership (limited partnership interests) is the partnership, including for practical purposes its general partners and the upper-level management of the general partner, if any. The issuer of the securities to be offered by a film or video manager-managed LLC is the LLC itself, including for practical purposes its manager and the upper-level management of the manager. Issuer sales of limited partnership interests or LLC units are permitted under certain circumstances. However, if any such person or entity engages “ either for all or part of his time, directly or indirectly, as agent, broker or principal in the business of offering, buying selling or otherwise dealing or trading in securities issued by another person,” then that person or entity may be considered a broker/dealer and as such may be required to register with the SEC, the NASD, and in each state in which such activities occur. See the definition of dealer in the Securities Act of 1933, Section 2(12) and the definitions of broker and dealer in the Securities Exchange Act of 1934, Section 3(a)(4) and (5). The Securities Exchange Act of 1934, Section 15(a)(1), requires anyone defined as a broker or a dealer to register: “It shall be unlawful for any broker or dealer . . . to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce 315

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Appendix D

or attempt to induce the purchase or sale of, any security . . . unless such broker or dealer is registered.” The issuer sales rule. Neither the officers or directors of a general partner nor an individual general partner for a limited partnership offering, and neither the officers or directors of an LLC manager or an individual LLC manager should be considered broker/dealers if their activities are in compliance with provisions of the Securities Exchange Act of 1934, Rule 3a4-1. The General Rules and Regulations promulgated under the Securities Exchange Act of 1934, Rule 3a4-1, sets forth the circumstances under which the associated persons of an issuer of securities may be deemed not to be brokers and therefore do not have an obligation to register as brokers. An associated person of an issuer of securities will not be deemed to be a broker solely by reason of his participation in the sale of the securities of such issuer if the associated person • is not disqualified pursuant to the so-called bad boy provisions (see “NASAA’s Model Accredited Investor Exemption” in chapter 13); • is not compensated in connection with his or her participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities; • is not at the time of his or her participation an associated person of a broker or dealer; • primarily performs, or is intended primarily to perform at the end of the offering, substantial duties for or on behalf of the issuer otherwise than in connection with transactions in securities; • was not a broker or dealer, or an associated person of a broker or dealer, within the preceding 12 months; and • does not participate in selling an offering of securities for any issuer more than once every 12 months.

Thus, persons or entities that have not engaged in any of the prohibited activities within the time period may engage in the sale of securities on behalf of an issuer, and the issuer of the security may rely on the preexisting relationships of such persons for purposes of a private placement. Thus, for marketing purposes, the pool of prospective investors for such an offering can be significantly expanded through reliance on the issuer sales rule. Compliance recommendation: Review all relationships with all persons associated with the issuer or its general partners (or managers) that fall within the scope of these rules and make sure their status and activities are in compliance with this issuer sales rule. 316

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Finder Sales There seems to be quite a bit of misinformation on the streets regarding the use of finders in a securities offering, such as with feature film or video limited partnerships or manager-managed LLCs. Finders are persons who assist an issuer in some way in identifying a prospective investor. Finders are not licensed as broker/dealers or registered representatives of a broker/dealer firm, and they generally seek to be compensated for their activities in a transaction-related manner (i.e., a commission). Some will even ask for retainers up front, which in many instances is no more than a scam. Bad advice Here is an instance of bad advice that was given in the area of finder sales. One unidentified author posted an article at the Securities Law Institute site titled “Capital Formation via Private Placements” (the article is located at http://www.securitieslawinstitute.com/Capital%20Formation %20Release.html). In the article, the statement is made that a “finder may be a company, service or individual such as a broker/dealer who may receive a fee in connection with the solicitation of potential investors.” Quite to the contrary, it would be far better to draw a clear line between the definitions of finders and broker/dealers; after all, they are distinctly different and those distinctions are important for purposes of securities law compliance. It is perhaps fair to state that a finder may be a company, service, or individual who receives a fee in connection with the solicitation of potential investors, but it is hardly accurate to suggest that broker/dealers are merely one form of finder. It is also fair to suggest that finders may be compensated for helping to identify possible investors in nonsecurities transactions, but when the sale or offer of a security is involved, a virtual minefield of federal and state statutory, regulatory, and case-made law is applicable. It is also important to note the differences between the federal and state laws on finders. The online article cited above is based entirely on federal law and thus does not fully cover the subject. Unless a securities offering is exempt from state jurisdiction pursuant to Regulation D, Rule 506, and NSMIA (see chapter 12), state law generally prohibits any form of transaction-related remuneration to be paid to persons not licensed as broker/dealers or registered representatives of broker/dealers (i.e., finders). Securities broker/dealers are generally firms, not individuals. The principals of these firms are trained, tested and supervised by the National Association of Securities Dealers, and their activities are regulated 317

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Appendix D

by the SEC. The individuals who work for SEC- and NASD-qualified broker/dealer firms are generally referred to as registered representatives. These individual registered “reps” (as they are called) are trained, tested, licensed and supervised by the broker/dealer firm for whom they work. All securities sold by these individual registered reps must be approved for sale by the broker/dealer firm. Individual registered reps cannot sell securities that have not been approved by the firm’s due diligence office (see “Private Securities Transactions” above). On the other hand, finders are not necessarily trained, tested, licensed, or supervised by anyone. Many of them do not know whether they are selling a security or not and do not even care. A careless finder can easily get an issuer of a security in trouble with the law. Part of the confusion seems to stem from the fact that the federal Regulation D exemptions do not specifically limit who may be paid commissions. In addition, the Form D and the S-18 disclosure guidelines make specific references to finders, suggesting that it might be permissible to use their services. However, as noted above (see “Issuer Sales”), the federal securities laws (as well as the state laws) require the registration of those acting as brokers or dealers, and many of those performing the services of a finder may well be in violation of such registration requirements. A similar problem of analysis occurs in the online article “Legal Lens: Bringing in the Money—Legal Issues on Working with or Being a Finder in the Film Business” written by Boston entertainment attorney Vinca Liane Jarrett (see Sources and Further Reading). The article and its conclusions are entirely based on federal law. State law is not even considered. The federal law relating to finders is also more lenient than state law. Thus, it is important for producers to consider whether their particular offering is subject to state law jurisdiction before following the suggestions found in such articles. In point of fact, many of the state exemptions relied on in a private placement specifically prohibit the payment of any form of transactionrelated remuneration to persons who are not licensed as broker/dealers. The language of the specific exemption in each state must be examined. For example, in Michigan the available transactional exemption requires that “A commission is not paid or given directly or indirectly for soliciting any prospective purchaser in this state, except to a broker/dealer registered pursuant to this act which is not affiliated with the issuer or its affiliates” (Michigan Securities Act, Section 451.802[b][9]). A violation of such a prohibition may void the exemption from registration and thus place the issuer in the position of having sold an

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unregistered security. It would be an understatement to report that an issuer cannot rely on a finder to always properly advise the issuer as to whether the finder is in compliance with the federal and state securities laws that legally regulate his or her activities. In fact, this author has on several occasions requested that finders who proposed to raise monies for client producers provide a legal opinion regarding the legitimacy of their status, and not one of them has stepped forward to provide such a favorable legal opinion to date. Compliance recommendation. Do not use the services of finders in states other than California (see discussion of finders in California below) without a counsel’s opinion as to the status of finders pursuant to those states’ securities laws and specifically the provisions of those states’ exemptions from registration being relied on for the offering. Finders’ fees in California. Quite often in California the prospective general partner or manager (and producer) in a feature film or video limited partnership or LLC offering will want to know (1) whether compensation in some form may legally be paid to a person in California for the sale in California of a limited partnership interest or LLC unit in a privately placed feature film or video offering if such person is not licensed as a securities broker/dealer, or an agent of a broker/dealer, or an agent of the issuer of such securities; (2) under what circumstances such compensation may be paid; (3) what form of payment is permissible; (4) what amount of payment is appropriate; and (5) what other considerations the issuer of such securities should take into account. For purposes of this discussion, a privately placed limited partnership or LLC offering is defined as one exempt from registration in California pursuant to Section 25102(f) of the California Corporations Code (the “Code”) and at the federal level, pursuant to Regulation D. Such unlicensed persons are referred to as “finders” and their compensation as “finders’ fees.” California’s limited offering exemption (Section 25210(f) of the Code] provides that persons acting on behalf of an issuer shall not effect any transaction in, or induce, or attempt to induce, the purchase or sale of any security in the state of California unless such agent has complied with such rules as the California Securities Commissioner may adopt for the qualification and employment of such agents. The California Code, Section 25003, in defining an agent, excludes from such definition any individual who only represents an issuer in effecting transactions in securities exempted by Section 25102. Therefore it appears that under California law, issuer sales of limited partnership

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Appendix D

interests or LLC units exempt pursuant to the California Limited Offering Exemption, Section 25102(f), do not fall within the definition of agent and therefore are not required to be registered or qualified as such. In addition, California’s Section 25102(f) and the regulations promulgated thereunder, unlike many other state exemptions from securities registration, do not provide any limitations on who may be paid compensation for the sale of securities pursuant to such exemption. Thus, in California, it would appear at first blush that the Limited Offering Exemption is not voided if compensation is paid to unlicensed persons (i.e., finders). California case law, however, narrows the issue relating to this discussion by holding that one who negotiates the sale (even in a single or isolated sale) for an issuer of securities must be licensed as that issuer’s agent (Evans v. Riverside International Raceway (1965), 237 CA2d 666, 47 Cal Rptr 187). In addition, the California courts have held that an unlicensed person acted as a broker (and therefore would be required to be licensed as a broker) where such person was authorized to procure prospective purchasers with whom the issuer could negotiate for a sale thereof and assisted in the sale of the security by offering it at a certain price to the purchaser and negotiating with the purchaser for such sale over a period of months (Rhode v. Bartholomew (1949), 94 CA2d 272, 210 P2d 768). In Nationwide Investment Corporation v. California Funeral Service, Inc. ((1974), 40 Ca3d 494, 114 Cal Rptr 77), an investment company that negotiated the purchase of all the outstanding securities of another company on behalf of a client pursuant to a written contract was held to have acted as a securities broker/dealer and was therefore subject to the licensing requirements set out in Code Section 25210, even though the securities themselves were exempt from the registration requirements. Under such circumstances, the written contract was void and unenforceable, and the investment company could not recover compensation for its services as a so-called finder. The Rhode v Bartholomew case, cited above, provides additional guidance by pointing out that a person who merely brings a buyer and seller together so that they are able to make their own contract without any aid from that person may be regarded as a “middleman” but will be considered a broker if he or she takes any part, however slight, in the negotiations. Also, in McKenna v. Edwards ((1937), 19 CA2d 327, 65 P2d 810), the court held that a person not engaged in the business of dealing in securities, whose only activity consisted of (1) soliciting a purchaser, (2) conveying to the issuer the suggestion of a possible buyer and (3) arranging for a conference between the seller and the prospective purchaser (in 320

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which the person did not participate and that resulted in an agreement for the sale of the security) was entitled to promised payment for the services rendered, even though that person had no broker’s license. In addition, in the cases of Tenzer v. Superscope, Inc. ((1985), 216 Cal Rptr 130) and Lyons v. Stevenson ((1977), 65 Cal App 3d 595, 135 Cal Rptr 457), the courts continued the approach that the question of whether a socalled finder acted as a broker is a question of fact, requiring an examination of the person’s conduct after the introduction of the buyer and seller, to determine whether that person participated in their negotiations. All of these cases seem to focus primarily on the question of whether and under what circumstances one acting as a finder may successfully sue for compensation offered or promised by an issuer in the sale of a security. The issue of whether the payment of such compensation to finders may void the exemption from registration for the security transaction is not addressed, presumably because the California Limited Offering Exemption (Section 25102(f) of the Code], as mentioned above, does not contain such prohibitory language. In addition, none of these cases seems to focus on the question of other potential risks to the issuer of utilizing the services of a finder (i.e., a person not licensed as a broker/dealer). The primary risk to the issuer, other than possibly voiding the exemption in many other states (but not necessarily in California), is the question of the issuer being responsible for the proper supervision of the activities of the finder with respect to the statements made by the finder regarding the offering of such security in procuring a prospective purchaser. Clearly the issuer is responsible for any misstatements of material fact made by a finder to a prospective purchaser on which such prospective purchaser may have relied in the purchase of the security, and such misstatements of material fact may provide a subsequent purchaser with grounds for a civil right of rescission of the purchase contract based on securities fraud. California securities regulators have informally expressed the opinion in private conversations with the author that they consider it virtually impossible or at least very unlikely for a finder to keep his or her activities within the narrow parameters of this so-called finder’s exemption. Thus, even though the statutory and case-made law seem to suggest that there is a very narrow opening for the use of finders in the sale of a security in the state of California, the state regulators charged with the responsibility of enforcing state law on the matter seem to disagree. More recently, the California legislature has, in effect, codified the case law relating to finders and made the applicable provisions even more strict. Assembly member Correa introduced AB 2167 to amend Section 321

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Appendix D

1029.8 of the California Code of Civil Procedure, effective January 1, 2005, authorizing an action for rescission of the sale or purchase of a security resulting from sales activities for which a broker/dealer license is required. In addition, under existing California law, an unlicensed person who causes injury as a result of engaging in specified activities for which a license is required is liable for treble the amount of assessed damages. Thus, utilizing the services of unlicensed persons (i.e., finders) in the sale of a security no longer seems to be a good idea in California, if it ever was. Telemarketers. Note that telemarketers are not the same as SEC/NASDqualified securities broker/dealers or the registered representatives of such broker/dealer firms. Telemarketers may or may not be securities issuers. There is no securities law compliance regulation, licensing, training or supervision provided for telemarketers. Thus, in order to conduct legitimate sales of securities, telemarketers would either have to fall within the guidelines for finder sales or issuer sales. Traditionally, telemarketers go far beyond what is permitted pursuant to finder sales in presenting the investment opportunity to their prospective investor clients, so that also does not seem to be a viable option. Even worse, a telemarketing organization operating independent of an issuer of securities and being compensated for the sale of securities in a transaction-related manner (i.e., taking a percentage of the money raised, which is the traditional method for compensating such persons) does not fit within the issuer sales rule either, because it does not involve upper-level management of the issuer, transaction-related remuneration is involved and possibly more than one securities offering may be conducted in a 12-month period. Thus, it would appear that bringing telemarketers in to raise money through a securities offering is problematic. Further, it may be expecting too much to ask that telemarketers observe conditions and limitations associated with the sale of securities, since they are much more sales oriented than compliance oriented. In addition, telemarketers these days also have to be concerned with the “do not call” rules relating to cold calls. Compliance recommendation: Do not use finders in California in the sale of private placements unless the above limitations have been thoroughly discussed with such finders and a written pledge has been extracted from them that they will comply with the stated guidelines. Such written agreement should include an indemnification provision in favor of the general partner or LLC manager (and producer), for what it is worth. An issuer may want to further insulate an offering of securities by limiting the use of finders to Regulation D, Rule 506, offerings made 322

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in conjunction with NSMIA. Another possible strategy is to limit sales activities to persons who are upper-level management of the issuer and who meet the other requirements of the SEC’s so-called issuer sales rule previously discussed. Selling Securities over the Internet Many independent film producers seeking financing for their feature films now believe that the Internet is the answer. Some of them have sought ways to use the Internet in raising money without considering the securities law implications, while others recognize that the securities laws do apply in certain situations. The truth is that the sale of securities over the Internet raises several very specific and unique problems with respect to compliance with both the federal and state securities laws, and the SEC is not only actively monitoring the Internet but has brought criminal charges against issuers violating those laws with Internet sales or offers. As a general rule, the offer and sale of securities is subject to the regulation of both federal and state jurisdictions. Both the federal government and the various states reserve the right to regulate the offer and sale of securities to protect their citizens from unscrupulous individuals seeking to promote the sale of worthless paper. Each state has a regulatory authority (with names that vary from state to state) that oversees the offer and sale of securities, much like the federal government has the SEC, and all of them seek to prohibit fraud and misleading practices in the sale of securities. For a current listing of the state regulatory agencies, visit NASAA.org online. A state’s jurisdiction is triggered whenever an offer to sell a security occurs in that state. Regardless of whether the offeror or the offeree is in that state, an offer occurs there when it either originates in or is directed to and received in that state. Because of the pervasive reach of the Internet, an offer to sell a security posted on the Internet would, by that line of reasoning, trigger the jurisdiction of every state in the United States as soon as the information is posted online. As noted elsewhere in this book, securities can be offered and sold generally (and on the Internet) if they are first registered with each of the applicable state and federal jurisdictions as public (registered) offerings. Public (registered) offerings permit the use of all forms of advertising and general solicitations, so Internet sales and offers are allowed. The alternatives to the initial requirement of securities registration occurs when the offer and sale of securities complies with all of the conditions and limitations imposed on one or more of the available exemptions from 323

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Appendix D

the securities registration requirement (private placements/exempt offerings). The private/exempt offerings generally do not allow advertising or general solicitation; thus, except in the special circumstances discussed below, Internet sales are not permitted for private/exempt offerings. The most recent regulatory wrinkles are the so-called public/private hybrid offerings, but those also technically fall into the category of exemptions. The same is true for the “covered” securities offered and sold in compliance with the federal exemption (Regulation D, Rule 506), pursuant to the National Securities Market Improvement Act, or NSMIA (i.e., state jurisdiction is preempted by the federal law). So, the initial choice is still the same with Internet sales. Securities either need to be registered or their offer and sale must qualify for available exemptions from the registration requirement. Now, however, the kind of exemptions that are available has been expanded to include some that allow a limited form of advertising and general solicitation, including sales and offers over the Internet. As noted earlier, the registration of securities is expensive, time-consuming and complex, so that option is not commonly used to raise the financing for independently produced feature or documentary films. If the public (registered) offering option is chosen, then the issuer must follow the written rules applicable to either the S-1, SB-1, SB-2, or Regulation A federal filings, combined with the applicable state registration requirements, or for public (registered) offerings of $1 million or less, the state SCOR form, combined with Regulation D, Rule 504, at the federal level (see chapters 14–17). These registered offerings can be offered over the Internet pursuant to the specific rules associated with each form of registration. If the issuer or producer wants to conduct a multistate offering and can limit the offering to $1 million or less, the NASAA Model Accredited Investor Exemption (a public/private hybrid offering) is available. A limited amount of information can be posted in any form of advertising, including on the Internet, and sales can be effected through the Internet (see chapter 13). The California Section 25102(n) exemption, however, is of little use in multistate film offerings and not even that helpful for intrastate film offerings because of the limitations of the relevant federal rules. On the other hand, the producer or issuer who needs to raise more than $1 million from private investors may choose to comply with all of the conditions and limitations imposed on the use of Regulation D, Rule 506. Such securities are considered “covered” pursuant to the NSMIA, and thus state jurisdiction (other than the requirement of a notice filing on such sales) is preempted by federal jurisdiction. In a series of cases involving Internet sales, the SEC ultimately determined that Internet sales for a private placement can be permitted if, 324

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pursuant to a Regulation D, Rule 506, offering, all prospective offerees of the securities are precertified as either accredited (see the Regulation D definition of accredited investor), or as nonaccredited but sophisticated (i.e., investors who either alone or together with their purchaser representative have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment), through the use of a generic questionnaire posted on the issuer’s Internet website. A generic prospective investor questionnaire does not refer to any specific securities transaction. It simply inquires about the accredited status or sophisticated investor status of prospective investors for purposes of qualifying them for the offering, which they have not yet seen. Once prospective investors have been prescreened and judged qualified, then the offering information can be made electronically available to them through the use of passwords. In other words, the actual offering memorandum (securities disclosure document) is posted on the producer’s or issuer’s website, but on a password-protected page, which is not accessible to anyone unless and until they have been prescreened and qualify as either accredited or nonaccredited but sophisticated, and otherwise meet additional investor suitability standards for the offering (e.g., the investor’s investment must not exceed 10 percent of his or her net worth). For additional information, see Joseph J. Kornblum’s online article “Offering Securities on the Internet.” Unfortunately, the Internet does not solve the basic problem of independent filmmakers seeking investor financing for their project; that is, the investment they are offering is still highly risky, they may not have big-name actors attached to the project, and they are not likely to have any distribution plans in place. Even though the theory of selling on the Internet makes some sense, because it can give a filmmaker who does not know a lot of people greater access to more prospective investors, years of practical experience suggest that the independent filmmakers who are successful at raising money from investors have done so in face-to-face meetings with people they and their associates knew before the start of the offering. One likely exception to that rule, based on practical experience, is the film with a message that some people are passionate about and want to see communicated through film. Electronic Delivery of Securities Disclosure Document Recognizing that its own antifraud rules require that all material aspects of the transaction be disclosed in writing to prospective investors prior to investing, the SEC has reasoned, by drawing an analogy between the 325

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Appendix D

distribution of securities information by electronic means and through the print medium, that it “would view information distributed through electronic means as satisfying the delivery of transmission requirements of the federal securities law if such distribution results in the delivery to the intended recipients of substantially equivalent information as these recipients would have had if the information were delivered to them in paper form” (SEC Release #33–7233, Section II.A, October 6, 1995). In the same ruling, the SEC goes on to say that electronic disclosure of information must provide adequate and timely notice to investors, afford effective access to the information, and give reasonable assurance that the information in fact has been delivered. For example, merely posting a document on a website will not constitute adequate notice, absent evidence of actual delivery to the investor. This requirement of “evidence of actual delivery” may be satisfied by two paper methods—letter or postcard—but also a directed Internet message (e-mail) can satisfy such actual delivery requirements. If an investor consents to electronic delivery of the final disclosure document for an offering by means of a website but does not provide an electronic mail address, the issuer may post its final disclosure document on the site and mail the investor a notice of the location of the disclosure document on the Internet along with the paper confirmation of the sale. (SEC Release #33–7233, Example 10). It is also necessary that investors have access to required disclosure that is “comparable” to postal mail and that the investor has the opportunity to retain the information or has ongoing access equivalent to personal retention (SEC Release #33–7233, Section II.A, Note 22). Issuers should have reasonable assurance, akin to that found in postal mail, that the electronic delivery of required information is satisfied. The delivery requirements can be satisfied by the investor’s informed consent to receive information through a particular electronic medium coupled with proper notice of access (SEC Release #33–7233, Section II.C). Sufficient evidence of delivery can also include • an electronic mail return receipt or confirmation that a document has been accessed, downloaded or printed; • the investor’s receipt of transmission by fax; • the investor’s accessing by hyperlink of a required document; and • the investor’s use of forms or other material that are available only by accessing the document.

A document posted on the Internet or made available through an on-line service should remain accessible for so long as any delivery re326

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quirement under SEC rules applies (SEC Release #33–7233, Section II.A, Note 26). The SEC requires issuers to make paper versions of their documents available where there is computer incompatibility or computer system failure or where consent to receive documents electronically is revoked by the investor (SEC Release #33–7233, Section II.B). The SEC permits an offering to be limited entirely to persons who consent to receive a disclosure document electronically, but if it is not so limited, a paper version of the disclosure document must be given to broker/dealers to be made available to investors (or be made available to investors by the issuer) who do not have online access (SEC Release #33- 7233, Section II.B). State compliance. As noted earlier, Congress has preempted state regulation of those security offerings that are exempt from the 1933 act registration by virtue of SEC exemptions adopted pursuant to Section 4(2) of the 1933 act (the exemption for nonpublic/private offerings). In effect, this deprives states the authority over certain private placements, including those made in reliance on the SEC’s Rule 506 of Regulation D. Even so, states have retained the right to require notice filings for such offerings. The federal preemption of state jurisdiction for such offerings is based on the authority provided by the National Securities Markets Improvements Act of 1996 (NSMIA). In any case, publicly accessible website postings may not be used as a means to locate investors to participate in a pending or imminent U.S. offering. Accredited and sophisticated investors. The SEC has taken the position that the prequalification of a number of accredited or sophisticated investors on a website and electronically notifying them in a secure manner of subsequent private placements would not involve a “general solicitation” or “general advertising” within the meaning of Rule 502(c) of Regulation D, and therefore would allow the building of investor data-banks for private offerings under the SEC’s Regulation D [IPOnet, SEC No-Action Letter, 1996 WL 431821 (S.E.C.) July 26, 1996; Lamp Angel Capital Electronic Network, SEC No-Action Letter Sec. L. Rep (CCH 77,305, October 25, 1996; Technologies, Inc., SEC No-Action Letter, May 29, 1997]. The SEC’s response to the IPOnet no-action request indicated that the following procedures would need to be in place: • both the invitation to complete a purchaser questionnaire used to determine whether an investor is accredited or sophisticated and the questionnaire itself must be generic in nature and not reference any specific transactions posted or to be posted on the password-protected page of the issuer; 327

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Appendix D

• the password-protected page will be available to a particular investor only after a determination has been made that the particular investor is accredited or sophisticated; and • a potential investor could purchase securities only in transactions that are posted on the password-protected page after that investor has been determined to be qualified for the offering by the issuer.

A sophisticated investor must have a history of venture capital and restricted investments. Nonaccredited investors. While the IPOnet no-action letter makes repeated reference to “sophisticated investors,” it does not specifically address an Internet-based offering to nonaccredited investors. Presumably, the logic of the IPOnet letter would also apply in the context of an offering to nonaccredited investors (i.e., investors who do not fit within the definition of “accredited investors” under Regulation D) if they have been determined to meet the suitability standards for the particular offering. However, this set of facts was not addressed by the SEC in the IPOnet letter. Credit card sales. The SEC has provided a no-action letter relating to credit card sales of securities. The SEC provided an exemptive order for Technology Funding Securities Corp. (a nondiversified investment company under the 1940 Act) allowing the company to accept payment for its fund shares over the Internet by means of credit card [Technology Funding Securities Corp., SEC No-Action Letter, May 20, 1998). The SEC’s staff approval stressed that the credit card purchases would be allowed under the following circumstances: • credit card sales occur only through the Internet; • a prominent warning is displayed on the website to dissuade investors from carrying a balance on their cards as a result of a purchase of the securities; • another statement is prominently displayed showing how related interest costs could exceed any increase in the value of the securities; and • the issuer’s selling employees are not compensated on the basis of shares (or units) sold.

Limit on number of investors. Also note that Section 12g of the 1934 Securities Act provides that issuers of securities cannot sell any class of security to five hundred or more persons without registering such security by filing a registration statement with the SEC. Preoffering and supplemental materials. Written materials used by film producers to communicate with prospective investors prior to the start 328

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of a securities offering (e.g., a business plan, executive summary, fourcolor brochure, etc.) should not include any information which could be construed as relating to a subsequent private placement offering (i.e., nothing should be stated in the preoffering material that indicates that the issuer is even contemplating a subsequent offering to passive investors). Thus, no mention should be made regarding limited partnership units or interests in a manager-managed LLC. Further, no language should be provided suggesting that the amount of money being sought will be accepted from a large group of investors in small amounts. In addition, the use of any preoffering materials to raise money from one or two active investors needs to be discontinued 3 to 4 weeks prior to the start of a subsequent private placement offering. Often issuers of securities are concerned that a properly drafted offering memorandum (i.e., with the risk factors section in the forepart of the disclosure document as required) will not serve as an effective selling document. In such instances, they sometimes seek to supplement the offering memorandum with other materials, commonly a four-color brochure or portfolio. Such supplementary materials are part of the offering materials and still must comply with the antifraud provisions. Thus, the language contained in such materials should be reviewed by securities counsel in order to protect the interests of the issuer and help prevent the dissemination of misleading materials. As a general rule, the fewer offering materials utilized the better. Limiting the offering materials to the offering memorandum, its accompanying exhibits and a separate packet of subscription documents would be safest. The better practice is to work with securities counsel in balancing the information in the disclosure document appearing in internal and external summaries of the offering, or in the exhibits section, so that the attractiveness of the offering is enhanced without conflicting with securities disclosure obligations. In timing the use of offering summaries, a program-highlights sheet or other sales materials should be strictly controlled in accordance with the above suggested procedures.

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Sources and Further Reading

Association of Independent Video and Filmmakers. http://www.aivf.org/ independent. Audiovisual Services of the French-Speaking Community (Belgium). http:// www.cfwb.be/av. Ausfilm.com. http://www.ausfilm.com.au/cgi-bin/show_page.pl/2/60. Australian Department of Communications, Information Technology, and the Arts. http://www.dcita.gov.au. Australian Film Commission. http://www.afc.gov.au/filminginaustralia/ copros/fiapage_2.aspx. “Banking on Success: ‘That’s Where the Money Is’” (entertainment finance special report). Hollywood Reporter, August 1990. “Banks, Investors Still Shy on Indies.” Linda Keslar. Variety, November 16, 1992. “Barings Over as Film Finance Onslaught Kicks In.” Lawyer (London), April 7, 2003, 13. “The Beach: American Film Market 2002.” Paul T. Boghosian. Imagine News, April 2002. “Behind Closed Set: Hollywood’s Romance with Tobacco Exposed.” http:// www.realitycheckny.com/RC_links/ProductPlacement.htm. “Big Payday for ‘Pearl Harbor’ Players, A: No Salary Upfront Results in Multimillions Later.” Tom King. Wall Street Journal, June 7, 2002 (Eastern edition), W7. Bio/Pics: How Hollywood Constructed Public History. George F. Custen. Rutgers University Press, 1992. The Biz: The Basic Business, Legal and Financial Aspects of the Film Industry. Schuyler M. Moore. Silman-James Press, 2000. “Black-Belt Yen Men Gird for Lean Times: Pipeline to Hollywood Running Dry.” Garth Alexander. Variety, September 21, 1992. Blue Sky Law. Joseph C. Long. Clark Boardman, 1986. Blue Sky Law Reporter. Commerce Clearing House. (updated every two weeks) Blue Sky Laws: A Course Handbook. Jack H. Halperin and F. Lee Liebolt Jr. Practicing Law Institute, 1990. “Blue Sky Laws and the Recent Congressional Preemption Failure.” Rutherford Campbell. Iowa Journal of Corporate Law 22 (Winter 1997): 175. “The Boston Film and Video Foundation: Grants Available.” Afterimage, January–February 2002. “Box Office Champions.” Paul Kagan. Paul Kagan Associates (updated annually). “British Columbia Ups Prod’n Tax Credits.” Don Townson. Variety, January 20, 2005. http://www.variety.com/story.asp?1 =story&a=VR1117916673&c=19. 332


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British Council. http://www.britfilms.com. British Department for Culture, Media and Sport. http://www.culture.gov.uk. British Film Business. Bill Baillieu and John Goodchild. Wiley, 2002. British Film Commission. http://www.britfilm.co.uk. British Film Institute. http://www.bfi.org.uk. British Film Office–Los Angeles. http://www.britfilmusa.com. “Brits Nail Down a New Scheme while Others Enter Fray.” Katja Hoffmann. Variety, October 31, 2004. “Buchwald v. Paramount Pictures Corp. and the Future of Net Profit.” Adam J. Marcus. Cardoza Arts and Entertainment Law Journal 9, no. 2 (1991). Budget Book for Film and Television. Robert J. Koster. Focal Press, 2004. “Business Law Update: The Texas Limited Liability Company and the Registered Limited Liability Partnership.” Edgardo E. Colon. Texas Bar Journal, October 1993, 908. “The Business of Show Business: Legal Affairs for the Independent Producer” (half-day workshop at ShowBiz Expo). Produced by Bruce Kassman. Beverly Hills Bar Association, Entertainment Law Section, 1992. “Cable Investors on Roll, Study Says.” David Kelly. Hollywood Reporter, July 12, 1991. “California Bows Web Portal for Filmmakers: Site Meant to Ease Applications for Reimbursement.” Dave McNary. Variety, January 15, 2001. http://www.variety.com/index.asp?layout=upsell_article&articleID= VR1117791815&cs=1. California Corporate Practice Guide. 2nd ed. Morgan D. King. Lawpress, 1989. California Corporation: How to Form Your Own. Anthony Mancuso. Nolo Press, 1988. California Corporations Code and Corporate Securities Rules. Matthew Bender, 1991. California Corporations Code Section 25102(n) and the MAIE: A Guide for Entrepreneurs. William D. Evers. Foley and Lardner Handbook Series for Startups and Emerging Companies, 2002. California Corporation Start-up Package and Minute Book. Kevin W. Finck. Oasis Press, 1987. “California Taxation of the Entertainment Industry.” Schuyler M. Moore. California Tax Lawyer, July 1991. “Campus Screenings Helped—So Did Mom’s Cooking.” Robin J. Schwartz. New York Times, Aug. 27, 1995 (East Coast edition). Canadian Audio-Visual Certification Office. http://www.pch.gc.ca/progs/ ac-ca/progs/bcpac-cavco/index_e.cfm. “Can Sacramento Help Hollywood?” James Bates. Los Angeles Times, October 20, 2003. 333


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“Contingent Compensation for Talent.” Schuyler M. Moore. Entertainment Law and Finance 13, no. 6 (September 1997) and no. 7 (October 1997). “Contingent Compensation for Theatrical Motion Pictures.” David Nochimson and Leon Brachman. Entertainment and Sports Lawyer 5, no. 1 (Summer 1986). “Contracts through the Looking-Glass.” Structured Finance International, June 2, 2003, 1 (film finance section–newsletter). “A Cookbook for Achieving Optimal Tax Results for the Buyer and Seller of a Film or Television Enterprise.” M. S. Appel. Major Tax Plan 51, no. 2 (1999): 13.1–52. Copyright Registration Practice. James E. Hawes. Clark Boardman Callaghan, 1990. Corporate Forms I: Under the Securities Act of 1933. http://www.aspenpublishers.com/SECRULES/crpfmttI.pdf. “Could Lender Bender Land Bank in Tank?” Judy Brennan. Variety, January 11, 1993. “Creative Financing for Films: The Role of Tax Shelters in the European Audiovisual Industry—Opening the Debate.” Alessandra Priante. Entertainment Law Review 15, no. 4 (2004): 114–20. “Current Issues in International Tax Planning for Motion Picture Production and Distribution.” J. DeCarlo Jr. and M. J. Mazitto. Major Tax Plan 49, no. 2 (1997), 18.1–54. “Current State Filing Requirements for SEC Rule 506 Offerings” (memorandum of Joseph J. Kornblum). http://www.sec.gov/news/studies/uniformy. htm. Dark Victory (Ronald Reagan, MCA, and the Mob). Dan E. Moldea. Penguin Books, 1987. Dealmaking in the Film and Television Industry from Negotiations to Final Contracts. Mark Litwak. Silman-James Press, 1994. “Defining Net Profits, Shares for a Motion Picture Deal.” Edward E. Colton, New York Law Journal, September 30, 1988. Dictionary of Film Finance and Distribution: A Guide for Independent Producers. John W. Cones. Marquette Books, 2007. Dictionary of Finance and Investment Terms. 2nd ed. John Downes and Jordan Elliot Goodman. Baron’s Financial Guides, 1987. Directory of Grants in the Humanities. Oryx Press. (annual) Directory of Research Grants. Oryx Press. (annual) Directory of Venture Capital. Catherine E. Lister and Thomas D. Harnish. John Wiley and Sons, 1996. “Disney Will Film Baseball Movie Here.” Stewart Yerton. New Orleans TimesPicayune, April 25, 2003. 335


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“Tax Issues in Movie Transactions.” Schuyler M. Moore and Matthew C. Thompson. Entertainment Law and Finance 12, no. 9 (December 1996), no. 10 (January 1997), and no. 11 (February 1997). The Tax Prophet. http://www.taxprophet.com/foreign/forgift.html. Tax Shelters: The Basics. Arthur Andersen. Harper and Row, 1982. “Tax Tips.” Katja Hofmann. Variety (at the Cannes Film Festival), May 10, 2004. “Teamsters Uproot Cheapo Shoots.” Michael Fleming. Variety, October 5, 1992. Texas Film Commission. http://www.governor.state.tx.us/film/. “There’s Hope for German Film Yet.” DW–World.DE.Culture&Lifestyle. April 4, 2003. http://www.dw-world.de/english/0,,1441_A_824274_1_A,00.html. They Can Kill You but They Can’t Eat You . . . and Other Lessons from the Front. Dawn Steel. Simon and Schuster, 1993. “337 Reported Business Practices of the Major Studio/Distributors.” John W. Cones. 1992. http://www.homevideo.net/FIRM/dist1a.htm. “Throwing Cash at Movieland.” Letter to the Editor from Jack De Govia. Sacramento Bee, April 23, 1999. “Tobacco Product Placement Becomes Illegal.” Reality Check. http://www. realitycheck-dutchess.org/pages/hollywd_illplmt.html. “To Incorporate or Not to Incorporate? That Is the Question.” Robert A. Cohen. Texas Review of Entertainment and Sports Law 2, no. 1 (Spring 2001): 113. “Too Many Hoorays for Hollywood.” William Cash. Spectator, October 1992. “Trading Angels and Blue Skies for Straight Capitalism.” Michael Barnes and Kevin Morris. Filmmaker, Spring 1993. “Transition in the Motion Picture Industry: Financing and Distribution.” Peter Dekom. In Counseling Clients in the Entertainment Industry. Practicing Law Institute, 1984. Tribes: How Race, Religion and Identity Determine Success in the New Global Economy. Joel Kotkin. Random House, 1993. UK Film Council. http://www.ukfilmcouncil.org.uk/funding/features/ncf/. Understanding the Antitrust Laws. 9th ed. Jerrold G. Van Cise, William T. Lifland, and Laurence T. Sorkin. Practicing Law Institute, 1986. Understanding the Securities Laws. Larry D. Soderquist. Practicing Law Institute, 1990. University Film and Video Association. http://www.ufva.org. “U.S. Film.” Screen Finance, January 26, 2005. “U.S. Filmers Find Angels Overseas: Indies, in a Conservative Mode, Gather Coin from Afar and Tighten Their Belts.” Christian Moerk. Variety, October 12, 1992. “U.S./Foreign Film Funding (Co-production Tips).” Nigel Sinclair. Entertainment Law and Finance 6, no. 12 (March 1991). 355


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356


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“Why Savvy Independents Are ‘Cocooning’ with the Major Studios” (entertainment finance special report). Robert Marich. Hollywood Reporter, January 1991. “William Morris to Set Up Film Finance Firm.” Claudia Eller and James Bates. Los Angeles Times, May 17, 2003. “Will Mega-Media Mergers Destroy Hollywood and Democracy?” James Talbott. Entertainment and Sports Lawyer 18, no. 1 (Spring 2000). Women and Film: A Sight and Sound Reader. Edited by Pam Cook and Phillip Dodd. Temple University Press, 1993. The Writer Got Screwed (but Didn’t Have to): A Guide to the Legal and Business Practices of Writing for the Entertainment Industry. B. Wharton. HarperCollins, 1996. You’ll Never Eat Lunch in This Town Again. Julia Phillips. Penguin Books, 1991.

357


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12/20/07 1:54:37 PM

Index aggregate offering price, 100, 106, 109, 110, 118, 120, 132 allocation, 56, 57, 238, 252 American Film Marketing Association (AFMA), 3, 178, 207, 330, 344 American Stock Exchange, 143, 144, 145 ancillary markets, 225 ancillary rights, 158, 174 annual: financial statements, 84; meeting, 60; report, 15, 93, 143; shareholder meeting, 45, 84; statement, 93 antifraud: provisions, 70, 100, 101, 107, 109, 121; rule, 68, 83, 97, 100–103, 107–10, 113, 125, 325 “A” picture, 175 approval right, 56, 171, 199, 213 approved script, 158, 160 arbitration, 57 Article 20, 164 articles: of incorporation, 80, 81, 84; of organization, 60, 64, 71, 72, 77 artificial pickup, 147, 164–65 artistic control, 164 arts, 13, 15, 26, 243, 263, 269 asset, 11, 45, 46, 51, 52, 123, 142, 149–51, 155, 156, 161, 163, 175, 185, 186, 188, 189, 191 assignee, 76 Association of Film Commissioners International (AFCI), 33–34, 276, 281, 283, 289 assumed name, 44, 45 attach, 17, 41, 47, 61, 89, 175, 182, 195, 199, 215, 216, 234, 239, 259, 260, 299, 300, 325 attorney: entertainment, 36, 71, 75, 154, 155, 196, 199, 202, 293, 318, 367; fees, 77, 81, 82, 108, 111, 123, 136, 138, 160, 154, 186, 188; international, 255, 279;

accountant, 11, 13, 57, 60, 65, 68, 71, 74, 87, 93, 143, 231, 273, 274, 290 accounting fee, 77, 82, 137, 140 accredited investor, 67, 68, 70, 73, 99–102, 108, 109, 111–13, 115, 116, 119, 122–27, 316, 324, 325, 328 acquisition, 4, 40, 50, 63, 81, 124, 145, 152, 157, 161, 163, 195, 197, 199, 200, 208, 263; cost of, 197 acquisition/distribution agreement, 157, 161, 163, 208 active investor, 7, 39, 40, 42, 43, 46, 47–48, 59–51, 52, 54, 55, 59–63, 64, 66, 67, 78, 89, 133, 299, 301–3, 329 active partner, 58, 282 actor, 22, 36, 41, 55, 159, 170, 171, 176, 195, 200, 211, 215–20, 248, 262, 271, 287, 292, 294, 301 actor financing, 217–19 actor replacements, 159 actor suites, 211 actress, 171, 200, 217, 292 ADR, 213 advance, 158, 160–62, 166, 169, 171, 174, 175, 178–80, 201, 291 advertising, 25, 32, 35, 36, 43, 99, 100, 106, 108, 116, 119, 123, 125, 127, 131–33, 136, 140, 158, 174, 222, 224, 228, 236, 241, 308, 310, 323, 324, 329 AFCI. See Association of Film Commissioners International AFMA. See American Film Marketing Association agency project, 198 agent, 36, 114, 168, 170, 178, 199, 200, 202, 214, 216, 218, 242, 254, 270, 309, 310, 311, 315, 319, 320, 338, 341 359

Cones Index.indd 359

1/8/08 2:30:29 PM

Index

attorney (continued) securities, 65, 68, 78, 89, 107, 108, 111, 113, 136, 138, 140, 154; tax, 87, 273, 290 attorney’s opinion, 129, 130, 136, 139 audience, 3, 19, 202, 208, 221–24, 226, 234, 240, 241, 294 audit committees, 144 Australia, 172, 190, 240–42, 244, 247, 250–51, 252, 257, 262–66 back-end participation, 154, 170 backside of a picture, 229 bank, 65, 72, 83, 149, 151–53, 156, 157, 159, 160, 163, 166, 167, 169, 175, 177–87, 189, 190, 202, 251, 268, 270, 272, 275, 276, 287, 289, 300, 301, 332, 333, 343, 349, 354; account, 36, 56, 72, 80, 261, 371; legal fees, 155, 169; loan, 150, 151, 158, 163, 166, 172, 177, 178, 184, 202, 268; notes, 265, 279 bankruptcy, 66, 181, 187, 189 bargaining position, 229 base territory, 225 below-market interest rate, 150, 156 below-the-line, 31, 55, 211, 242, 244, 252, 253, 276, 281, 282; facilities deals, 215, 281; union crews, 164 bidding war, 163 binding, 77, 82, 130, 133, 137, 140 blind pool, 116, 121, 128 blocked: currencies, 275, 276; funds, 275–78 blue-sky laws, 67, 99, 108, 111, 113, 114, 128, 144 board: of directors, 45, 60–63, 73, 80–82, 84, 91, 241; resolutions, 45, 75 bond, 81, 160, 163, 173, 178, 184, 188–91, 222 booking, 209 borrower, 150–52, 154, 156 box office, 168, 173, 187, 201, 207, 257, 284–86; gross, 201, 209, 218 Britain, 172, 235, 242, 249, 250 British Columbia, 260 broker/dealer, 77, 82, 129, 137, 140–44, 307–22; commission, 82, 140, 313 budget overrun, 156 bureaucracy, 94, 243

bureaucratic system, 280 business plan, 42, 49, 50, 59, 60, 68, 89, 124, 133, 180, 210, 293, 299–7, 329 buyer, 141, 152, 168, 169, 170, 173–75, 182, 267, 306, 320, 321; default, 170 bylaws, 61, 80, 81, 83, 84 cable company, 166, 174, 205, 225 calendar year, 12, 85 camera ready, 82 capital, 22, 26, 30, 44, 47, 53, 54, 57, 61, 62, 70, 71, 75, 77, 81, 83, 84, 86, 88–92, 101, 128, 142, 175, 186, 188, 189, 191, 256, 258, 259, 271, 321; contributions, 75; gain, 57, 70, 84, 86, 242, 256; loss, 77, 83 case law, 96, 99, 320, 321 cast, 30, 31, 159, 160, 179, 183, 212, 215, 227, 223, 235, 248, 250, 251, 254, 263, 266, 269, 278, 281, 282, 298 casting director, 217 C corporation, 6, 7, 42, 78, 80, 84, 86, 87 censorship, 170 certificate, 25, 32, 74–76, 80, 93, 94, 234, 248, 249, 259, 260, 263, 264, 266, 269; Brazilian audiovisual investment, 267; of British nature, 248, 249; for Canadian film or video, 259; of exemption, 25, 32; of Good Standing, 93; of incorporation, 80; insurance, 159; of limited partnership, 74; of nationality, 248; of registration, 94; share, 80, 81; theatrical and video release, 235 chain of title, 179 chattel paper, 150 Civil War, 278, 282 class of stock (securities), 65, 85, 86, 87, 97, 100, 124, 253, 314, 328 clearance, 159 closely held corporations, 83, 335, 349 cofinancing, 207, 241, 264, 265 cold calls, 133, 322 collaborative process, 7, 197 collateral, 145, 149–52, 155, 156, 163, 166, 169, 172, 173, 175, 177–79, 181, 185, 190 collection, 24, 31, 173, 188, 190, 191, 195, 209, 242, 270 collections, 201, 290

360


1/8/08 2:30:30 PM

Index

201, 204, 213, 216, 219, 221, 224, 233, 236–38, 240, 243–47, 251, 254, 265, 256, 282, 294, 303; control, 44, 55, 56, 58, 66, 73, 78, 150, 155, 164, 165, 173, 201, 219, 243, 254, 303; decision, 173, 244; department, 195; executive, 195 credit, 15, 25, 26–32, 49, 56, 152, 153, 168–70, 179, 181, 185, 186, 188–90, 196, 214, 242, 258–60, 268, 272, 328; card, 153, 328 creditor, 13, 53, 154 crew, 28, 30, 31, 164, 211, 212, 223, 251, 254, 263, 266, 268, 269, 278, 281, 282, 298 cross-collateralization, 168 currency, 35, 181, 243, 275–77, 279, 280, 289; conversion, 279; restrictions, 275, 276

commercial: appeal, 202, 226; bank, 152, 276; film, 170, 217; quality, 160 commissaries, 210 commissions, 24, 34, 77, 82, 129, 137, 140, 196, 210, 253, 291, 292, 313, 316, 318 common stock, 85, 86, 128, 143 completion: bond, 160, 163, 173, 179–81, 200, 237, 242, 270, 300; company, 181; fund, 41, 227–30, 232; guarantee, 162; guarantor, 156, 163, 165, 171, 173, 180, 181; services, 214 concept, 50, 102, 113, 115, 182, 184, 195, 197, 207 conflict of interest, 5, 144, 202, 216, 223 consideration, 11, 16, 59, 81, 89, 117, 121, 125, 155, 158, 224 contingency, 158, 159, 169, 173 continuity, 76 contract rights, 150 contractual quagmire, 175 control, 11, 13, 23, 36, 43, 52, 60, 63, 75, 78, 80, 82, 90, 92, 99, 104, 137, 140–42, 150, 155, 164, 198, 200, 201, 218, 219, 225, 231, 301, 309 convertible debt security, 142 coproducer, 17, 170, 234, 250, 254, 265, 273, 283, 286, 287 coproduction: agreement, 235, 244–47, 249, 253, 261, 265; treaties, 244, 250–252, 254, 262, 281 copyright, 25, 56, 159, 188, 189, 191, 198, 203, 243, 253, 258–60, 263, 265, 270, 271, 273; ownership, 203, 273 corporate: borrowers, 154; debt, 81, 85, 189; formalities, 84; kits, 81; maintenance, 66; powers, 93; production company, 59, 138, 151, 156, 233; rates, 45; seal, 80, 81; stock, 6, 7, 59, 60, 80, 82, 105, 132; vehicle, 84, 154 corporation, 6, 7, 19, 29, 42, 45, 46, 57, 59–66, 69, 71, 76, 78, 80–89, 93, 94, 116, 117, 128, 131, 135, 136, 137, 139, 140, 144, 151, 155, 188, 240, 246, 250, 258–60, 265, 273, 277, 289, 308, 310 cost of capital, 175, 186 cover shots, 171, 172 creative, 39, 44, 55, 56, 58, 66, 73, 78, 88, 91, 150, 155, 162, 164, 165, 172, 173, 195,

dailies, 213 deal: memo, 196; points, 196 death, 57, 66 debentures, 81 debt, 45, 53, 75, 80, 81, 83, 85, 86, 91, 142, 149, 150, 153, 154, 177, 188, 189, 289, 290, 307; capitalization programs, 289, 290; security, 142 debt-for-development, 290, 356 deductions, 12, 21–24, 32, 45, 56, 86, 219, 248, 251, 256, 265, 266, 271, 306 default, 150, 151, 170, 175; disaster, 170, 184, 189 deferral, 77, 169, 218, 219; of income, 256 deferred basis, 214 delivery, 11, 14, 40, 41, 77, 100, 109, 117, 149, 157–60, 162, 168–70, 172, 178, 184, 202, 211, 225, 227, 237, 245, 308, 310, 311, 325, 326; requirements, 100, 159, 162, 237, 326; schedule, 160, 171 depreciation, 22, 57, 256 devaluation, 279, 280 development, 2, 4, 7, 8, 13, 14, 19, 28–32, 40–44, 47, 50, 59, 63, 65, 66, 81, 89–91, 123, 124, 132, 147, 149–51, 153, 155, 162, 182, 190, 195–200, 204–7, 209–11, 236, 238, 249, 251, 252, 263, 267, 284, 285, 290; costs, 151, 153, 199; deal, 41, 162, 195–200, 207; financing, 89, 195, 197; hell, 198; loan, 150, 251; money, 50, 89, 15; offering, 40; phase, 4, 195, 199; scam, 206

361


1/8/08 2:30:31 PM

Index

editorial cutting rooms, 213 electronic: editing, 214; price quotations, 143 employee, 26, 27, 29, 46, 76, 83, 90, 136, 140, 145, 164, 198, 200, 272, 328 employment, 28–30, 54, 215, 319 end user financing, 225–26 entertainment: attorney, 36, 69, 71, 75, 154–55, 196, 202, 293, 318; lenders, 157, 208 equipment, 14, 25, 28, 45, 204, 211, 212, 214, 269, 271, 280 equity investment, 88, 149, 150, 233, 236, 246, 255, 269, 277; participation, 149, 228, 233, 242; percentage participation, 225; transaction, 149 escrow account, 160 exchange, 71, 35, 49, 60, 68, 70, 91, 141, 143–46, 196, 199, 221, 222, 224, 225, 233, 246, 251, 267, 275, 277, 293–81, 289, 303, 315, 316; rate, 277, 279; trading, 141 Exchange Act, 70, 315, 316 executive producer, 1, 7, 170, 196, 239, 248 exempt offering, 43, 67, 69, 70, 95, 102, 107 exemptions, 2, 5, 43, 46, 54, 68, 77, 83, 95, 96, 97, 99–101, 103–7, 112, 115, 117, 119, 121, 123, 125, 127, 128, 266, 308, 313, 318–20, 323, 324, 327 exhibit, 68, 159 exhibition, 8, 164, 237, 241, 270 expanded entertainment, 207

director, 29–31, 55, 62, 88, 124, 159, 160, 170–72, 179, 195, 196, 197, 199, 200, 202, 216, 217, 223, 235, 239, 248, 249, 298, 301, 310 director’s agreement, 196 directory, 90, 204, 205, 210, 234, 276, 281, 283, 289 disability, 57 disbursing agent, 214 disclosure document, 57, 60, 62, 65, 68, 70, 73, 75, 77, 82, 89, 97, 99, 100, 107, 109, 110, 112, 117, 120, 125, 126, 129, 130–32, 135, 138, 139, 180, 300–303, 308, 325–27, 329; guidelines, 107–11, 304, 318; obligations, 70, 102, 109, 110, 315, 329; requirements, 88, 102, 106, 109, 111, 117, 125, 139, 135, 139 discountable, 209 discounted: monies, 277; value, 172 discounting, 169 Disney, 204 disputes, 56, 58, 159 dissolution, 57, 66, 76 distribution: advance, 160; agreement, 26, 146, 149, 157–64, 167, 168, 171, 172, 208; company, 175, 189, 213, 225; costs, 174, 194, 202, 203, 208; expenses, 147, 172, 202, 203, 208; fee, 190, 194, 202, 203, 208; rights, 157, 167, 168, 178, 189, 190, 272, 281; subsidiary, 210 distributor: approval, 158; commitment, 161, 162; gross receipts, 213, 218; rentals, 201, 209 dividends, 62, 83, 84, 86, 225 domestic: exhibitors, 209; marketplace, 4, 168; producer, 243; release, 208; releasing costs, 167; rights, 167; studio production facilities, 211; television rights, 167; theatrical advertising, 158; theatrical distributor, 174; theatrical marketplace, 166, 167, 201, 209; theatrical release, 174, 190; video, 167 double taxation, 76, 83, 87 downside risk, 161, 169, 227 draft, 171, 195, 196, 236 due diligence, 77, 82, 137, 180, 313, 314, 318

facilities, 25, 55, 145, 210–12, 215, 244, 252, 253, 268, 269, 285, 272, 278, 281, 282, 287; deal, 281–82 family, 12, 59, 170, 197, 205; income, 87 fax, 18, 77, 205, 326 feature film production, 88, 92, 108, 111, 128, 137, 156, 184, 230, 235 fictitious business name, 44 filing fee, 81, 118, 119 film commission, 24, 210, 211, 231, 241, 242, 251, 270, 276, 281, 283, 286, 287; laboratory, 159; processing, 213; product, 222, 225; projection, 213 financial: guarantee, 168, 169; institution, 28, 85, 179; obligations, 209;

362


1/8/08 2:30:33 PM

Index

general: corporate finance, 62; partner, 42, 51, 52–55, 65, 74–76, 315, 316, 319, 322; partnership, 42, 47, 49, 52–54, 57, 58, 64, 66, 67; solicitation, 59, 60, 84, 98, 99, 106, 115, 120, 127, 133, 136, 140, 297, 299, 308, 309, 310, 311, 324, 327 genre, 170, 179, 255, 260 Germany, 172, 242, 244, 247, 250, 257, 262 government: grants, 283; loans, 244; notes, 279; subsidies, 21, 23, 25, 27, 29, 31, 33–35, 37, 169, 215, 253, 283, 285, 287 governmental bureaucracy, 243 green light, 197, 198, 206 grip package, 214 gross receipts, 32, 66, 160, 203, 213, 218 guarantee, 75, 83, 149, 151, 153, 157–63, 168, 169, 172, 173, 175, 211, 225, 237, 242, 270 guarantor, 151, 156, 163, 165, 169, 171, 173, 180, 181 guild, 215, 220

projections, 77, 82, 136, 139, 180, 304–6; resources, 207, 209, 246, 310; statements, 77, 82, 84, 131, 135, 139, 143 financiers, 2, 61, 182, 216, 227, 229 financing: agreement, 6, 44, 47, 49–51, 54, 55, 59, 89, 133, 299, 303; source, 169, 180, 197, 226, 229, 242, 293, 300 finder, 129, 279, 293, 307, 317–22 finder’s fees, 129, 313 first: draft, 195, 196; look, 196, 204, 205; position, 213 fiscal year, 85 fixed repayment date, 150 flat fee, 77, 82, 180 Florida, 24–25, 211, 228 flow-through tax vehicle, 65, 78, 83, 86 foreign: buyer, 169; coproduction, 276, 281; corporations, 84, 93; currency, 243, 279, 280, 289; debt capitalization, 289, 290; distribution, 26, 207; entities, 115, 225; equity financing, 233; equity investment, 233, 246; facility deal, 211; government subsidies, 23, 215, 283, 285, 289; governments, 23, 177, 244, 256, 281, 283, 287; investors, 256; paper, 169; presales, 7, 147, 166, 168, 172, 176, 181, 182, 300; rights, 245; sales agent, 168, 178, 183; shareholders, 85; tax, 256, 257, 259, 261, 263, 265, 267, 269, 271, 273; territories, 166, 168, 172, 174, 176, 178 forfeiture, 93 Form D, 25, 81, 106, 114, 129, 318 Form S-1, 136, 138–40 Form U-7, 128–30, 132 founding shareholders, 59, 63, 81, 82, 299 fractionalized, 168, 174 fractured-rights deal, 167 France, 172, 244, 245, 247, 250–52, 257, 262, 268, 285 franchise tax, 29, 66, 77, 81, 84, 93 fraud, 45, 70, 107, 108, 113, 120, 124, 192, 321, 323 free television, 171 friends of family, 205 fringe benefits, 76, 83

hard: assets, 149, 163; currency, 275, 279, 280 high budget, 200 Hollywood Creative Directory, 204 home video, 166, 190, 225 housekeeping deals, 204, 205 housing, 211, 212, 254, 278, 282 hybrid: exemptions, 2, 43, 46, 67–69, 95, 115, 117, 121, 123, 125, 137; offerings, 69, 324 hype, 170 IATSE (International Alliance of Theatrical and Stage Employees), 164 IFEX, 207 imputed interest, 150 income tax, 13, 25, 26, 27, 29–32, 58, 65, 76, 84, 86, 87, 244, 259, 260, 262, 267, 270, 271, 273 indemnification, 57, 322 independent: distributor, 157, 182, 207, 209; film, 3–5, 7, 36, 39, 40–43, 51, 68, 69, 70, 72, 91, 98, 127, 147, 155, 157, 163, 177, 178, 188, 191, 207, 216, 219, 228, 264, 272, 279, 297, 302, 303, 307, 323; producer, 43, 44, 61, 62, 94, 150, 154, 164,

363


1/8/08 2:30:34 PM

Index

independent (continued) 198–201, 203, 205, 206–8, 218, 219, 228, 275, 291, 293; production company, 207; video companies, 167 individual rates, 45 industry: funding source, 200; insider, 204; sources, 41, 299, 300 informational tax return, 56 inheritance, 13, 45 in-house production, 164, 177, 195–98 initial: incorporation, 47, 49, 59–63, 81, 89, 133, 299, 307; incorporation strategy, 60, 63; public offering (IPO), 136, 137, 140 insider, 99, 137, 140, 197, 204, 231, 243 insider’s game, 198, 294 institutional investors, 88, 301, 302 insurance, 83, 85, 88, 159, 164, 178, 184–87, 188, 233, 237, 300, 301; certificates, 159; company, 99, 187 integration: product, 221, 222, 223; securities, 106 interest rate, 150, 153, 154, 156, 189, 202 Internal Revenue Code, U.S., 11, 14 Internal Revenue Service (IRS), U.S., 22, 57, 76, 80, 83, 85–86, 150, 246, 254 international: attorney, 255, 279; coproduction, 6, 41, 54, 89, 215, 231, 233, 235, 240, 244–55, 265, 271, 276, 280, 281, 286; currency traders, 279; law firms, 276; rights, 167–68; tax, 7, 273, 274, 298 intrastate offering, 67, 103–4, 119 investment: company, 116, 121, 320, 328; contract, 155; funds, 6, 266; tax credit, 25, 26, 28, 30–31; vehicle, 42–44, 48, 54, 66, 67, 72–74, 78, 89, 128, 227, 229, 205, 302–4 investor: financing agreement, 6, 44, 47, 49–51, 54, 55, 59, 89, 133, 299, 303; offering, 7, 41, 304 IPO. See under initial Ireland: and coproductions, 247, 250–52, 276; and tax shelters, 257, 262, 268, 269; and U.S. films, 172 irrevocable letter of credit, 169 IRS. See Internal Revenue Service issuer of securities, 69, 70, 77, 82, 96–98, 100–108, 109, 110–12, 114, 116–25,

131–33, 135, 138, 139, 142, 143, 190, 305, 307–12, 315–24, 326–29; disqualifiers, 107, 110, 112; sales, 307, 315–16, 319–20, 322–23; sales rule, 316, 322, 323 issuing entity, 97, 106, 108, 111, 113, 136, 138, 137 Italy, 172, 244, 247, 250, 252, 257, 262 Japan, 172, 244, 247, 257 joint: income, 109; net worth, 109; venture, 6, 41, 42, 47, 49, 52–58, 60, 89, 133, 149, 246, 254, 271, 299, 303; venture agreement, 6, 56, 57, 299, 303; venture partner, 57, 58, 60, 299 “joint and several,” 55 laboratory, 159, 160, 178, 199, 213, 214, 227, 229, 252, 268; fees, 227, 229; letter, 160 language barriers, 278, 282 lead actors, 200, 301 lendable contracts, 173 lender, 163–66, 169, 170, 171, 176, 177, 182, 183, 186, 191, 199, 213, 239, 314; financing, 2, 3, 6, 41, 83, 84 147, 149–58, 160, 162, 164, 166, 168, 170, 172, 174, 176–80, 182, 184, 186, 190, 294, 300 lending source, 163 letter: of credit, 152, 153, 168, 169, 170, 179, 242; of intent, 171, 180 leverage, 159, 201, 208, 209, 257, 277, 280, 290 liability: criminal, 54, 70, 102; limited, 2, 6, 22, 27, 29, 47, 50, 55, 57, 58, 64, 65, 71, 74, 75, 78, 88, 90, 235, 301, 302, 303; personal, 45, 53, 156; partnership, 53; tax, 26, 27, 29, 76, 256, 268 library asset values, 175 license, 157, 166, 168, 170, 173, 178, 179, 321, 322 licensee, 173, 175 licensor, 152 lighting, 214, 281 limitations on resale, 106 limited: liability (see under liability); liability company, 2, 6, 22, 27, 29, 47, 64, 188, 235, 302, 303; offering exemption, 105, 106, 319–21; partner, 75, 76; partnership (L.P.), 6, 22, 29, 42, 44,

364


1/8/08 2:30:35 PM

Index

Motion Picture Association of America (MPAA), 34, 160, 171, 200, 209, 235, 347 movie-of-the-week, 27 MPAA. See Motion Picture Association of America; MPAA rating MPAA rating, 160, 171, 200 music, 25, 27, 32, 188, 189, 191, 222, 237, 248, 249

54, 55, 57, 61, 64, 65, 69, 72, 74–78, 86, 88, 90, 95, 105, 116, 130, 132, 136, 139, 161, 173, 188, 233, 254, 272, 277, 290, 302, 307, 309, 312, 314–16, 309, 329; partnership agreement, 74, 75, 76; partnership certificate, 75, 76 listing requirements, 144, 145 literary property, 55, 56, 179 litigation, 187, 188 loan, 14, 39, 44, 147, 149–52, 154–56, 160, 163, 166, 169, 172, 175, 177–81, 184–86, 188, 205, 229, 241, 242, 246, 251, 252, 286; fees, 169, 180 local: casting, 211; company, 104; economy, 35, 211, 275, 283, 290, 298; film production, 33, 94, 257; law, 275; sales tax, 33, 47 location, 31, 32, 35, 40, 118, 141, 171, 182, 200, 210, 211, 212, 252, 253, 254, 259, 265, 266, 270, 276, 277, 280, 281, 287, 289, 326 long-form distribution agreement, 172 losses, 45, 52, 56, 77, 86, 176, 181 low budget, 9, 36, 50, 62, 71, 100, 134, 151, 155, 202, 207, 223, 228, 229, 300, 303 L.P. See under limited

narrative biographies, 171, 300 NASAA. See North American Securities Administrators Association NASD. See National Association of Securities Dealers NASDAQ (National Association of Securities Dealers Automated Quotations), 7, 68, 141, 142–43, 145 National Association of Securities Dealers (NASD), 77, 82, 142, 143, 312–15, 318 nationality, 245, 248, 250 natural persons, 109, 117 negative: cost, 158, 202, 203; cutting, 213; developing, 213; perception, 78; pickup, 7, 147, 157–65, 166, 167, 168, 173, 184, 200, 202, 208; raw stock, 213 nepotism, 197, 205 net proceeds, 49, 136, 139, 155, 202, 218, 219; profit participation, 219; profits, 49, 93, 155, 158, 160, 161, 167, 168, 202, 205, 208, 209, 213, 214, 218, 219; worth, 109, 123, 325 New York Stock Exchange, 144 nonpublic offering, 96, 98–100, 105, 106, 108, 111, 113 nonrecourse loan, 150 nonresident alien, 85 nontaxable entity, 246 nonunion movie, 164 nonvoting stock, 82 North American Securities Administrators Association (NASAA), 62, 108, 119, 122, 123, 126, 128, 292, 316, 323, 324 notice of sale, 81, 106

macroeconomics, 176 maintenance, 45, 56, 66, 78, 84 major motion picture, 197 makeup artists, 164 manager, 54, 55, 64, 65, 66, 71–74, 219, 227, 228, 262, 293, 310, 315, 316, 319, 322 manager-managed limited-liability company, 2, 6, 42, 44, 54, 55, 57, 64, 65, 66, 69, 71, 72, 73, 74, 76, 81, 86, 95, 105, 129, 135, 161, 173, 227, 229, 233, 192, 302, 307, 309, 315, 317, 329 managing underwriter, 142 manner of offering, 104, 106, 307–9 marketing costs, 77, 82, 137, 140 market makers, 141–43 market share, 4, 172, 201, 207, 286 meal penalties, 164 media rights, 159 member companies, 207 minimum guarantee, 168, 170, 175, 178, 179 mismanagement, 45

objective: delivery, 171; grounds, 159 offering: circular, 129, 131, 132, 133, 303; costs, 77, 82; memorandum, 77, 82, 96, 97, 99, 107, 109, 110, 129, 132, 154, 180,

365


1/8/08 2:30:37 PM

Index

offering (continued) 293, 303, 310, 311, 325, 329; proceeds, 65, 77, 103, 104; statement, 131, 132 office on-the-lot, 196, 205 officers, 60, 61, 63, 80–83, 99, 124, 135, 139, 276, 316 omissions, 53, 83, 237 ordinary: income, 76, 256; loss, 76 organizational minutes, 84 organized exchange, 141 OTC market. See over-the-counter market outline, 42, 195–97, 237–39 out-of-pocket, 44, 171, 281 outside directors, 144 outsiders, 35, 75, 83, 198, 204 overages, 168 over-budget costs, 160 overhead, 203, 263 over-the-counter market, 7, 68, 141–46 overtime, 164 owners, 2, 7, 44–46, 57, 64–66, 75, 82, 116, 124, 151, 188, 197, 209, 256, 259, 265, 271 ownership, 43, 81, 82, 83, 84, 91, 92, 179, 195, 198, 203, 206, 211, 233, 250, 271, 273, 289; interest, 81, 84, 92, 206, 211, 233 packaged project, 40, 41, 55, 149, 162, 163, 167, 170, 171, 175, 181, 184, 185, 195, 196, 198, 199, 202, 214–16, 299, 300 packaging, 7, 40, 81, 89, 170, 199, 202, 215 216 P&A fund, 228 para-passu, 213 participation, 22, 49, 52, 149, 155, 158, 160, 161, 170, 186, 196, 198, 202, 211, 213, 214, 218, 219, 220, 225, 228, 233, 241, 242, 247, 249, 250, 265, 267, 270, 306, 311–15 partnership, 6, 22, 27, 29, 42, 44, 47, 49, 52–58, 62, 64, 65, 75, 76, 78, 83, 85, 86, 88, 105, 116, 117, 129, 130, 132, 135, 163, 223, 246, 254, 261, 264, 265, 271, 272, 297, 307, 315; agreement, 52, 53, 74–76 passive: income, 45, 86; investor, 7, 39, 40, 42, 43, 46, 46, 48, 50, 51, 55, 59, 60, 65–67, 69, 71–74, 80, 89, 95, 105, 149, 155, 227, 229, 245, 293, 299–7, 329

pay cable, 225 pension, 45, 83, 88, 164, 301 percentage participation, 49, 158, 160, 196, 213, 218–20, 225, 306 perpetual existence, 83 personal: guarantees, 83; income, 25, 45; liability, 45, 53, 156 photos, 171 pick-up price, 157, 158, 162 pitching, 195, 199, 204 polishing, 195 politics, 15, 197 postproduction, 14, 33, 40, 41, 210, 211, 214, 227–29, 235, 236, 269, 271 predividend profits, 83 preexisting relationship, 43, 98, 100, 106, 108, 111–13, 115, 123, 299, 308, 311, 316 preferred stock, 88, 91, 233 prefiling, 131, 133 preliminary notes, 107 preproduction, 28, 40, 41, 81, 149, 210, 285 presale, 7, 114, 147, 162, 163, 166–78, 181, 182, 184, 208, 209, 215, 225, 246, 269, 270, 300; agreement, 167, 168, 169–73, 175, 269; contract, 168, 169, 172–74, 181; financing, 147, 153, 166–76, 177; purchasing entity, 169, 170, 173 presold: film, 176, 246; rights, 172, 175 press: clippings, 171; releases, 145 price ceilings, 170 principal, 141, 142, 151, 152, 311, 312, 315, 317; cast, 159, 235, 248, 269; office, 76; photography, 26, 40, 41, 72, 167, 227–29, 236, 272; shareholders, 83 printing, 77, 82, 133, 136, 140 prints and advertising, 228 private: offering, 43, 67, 69–70, 81, 82, 96–98, 115, 299, 303, 308, 310–16, 331; placement, 60, 62, 69, 70, 77, 82, 83, 96, 99, 105–8, 110–14, 119, 127, 139, 121, 137, 138, 140, 154, 180, 299, 303, 307–14, 316–18, 322, 324, 327, 329; placement offering memorandum (PPM), 154, 303 producer advance, 160, 201 producer’s: package, 171, 299, 300; representative, 229, 278; share, 49, 155, 167, 219

366


1/8/08 2:30:38 PM

Index

records, 15, 25, 56, 76, 82, 84, 226, 308, 315 recoupment, 33, 39, 40, 160, 161, 172, 174–76, 181, 202, 208, 213, 219, 227, 228, 237, 238, 240, 242, 268, 272 recourse, 150, 151 regular C corporation, 6, 7, 42, 78, 80, 83, 84, 87 Regulation A, 68, 109, 131–34, 137, 138, 140, 324 Regulation D, 5, 68, 73, 99, 101, 102, 105–14, 116, 117, 119, 120, 123, 126, 128, 129, 307, 309–12, 317–19, 322–28, 336 Regulation S-B, 68, 109, 111, 135–37, 138, 304 regulatory: approval, 107; authorities, 60, 69, 105, 107, 303 relationship, 6, 12, 43, 50, 54, 98, 101, 106, 108, 111, 112, 113, 115, 123, 150, 163, 165, 178, 185, 197, 198, 204–6, 214, 216, 244, 299, 305, 308–11, 316 relationship-driven business, 197 release: prints, 213; slots, 198 rent-a-distributor, 41, 208 reports to shareholders, 84 reputation, 92, 169, 170, 204, 211, 246 resale, 103, 104, 106, 121, 123, 124 reserve account, 169 residence, 103, 104, 271 resolution, 45, 75, 84 resolving disputes, 56 restricted currencies, 275, 276 retained rights, 159 revenue: source, 167; stream, 49, 83, 153, 158, 167, 189, 191, 213, 217, 218, 225, 306 reversion rights, 175 revolving credit, 152, 190 riots, 278, 282 risk factors, 135, 139, 329 Rule 504, 68, 106–11, 119, 123, 126, 128, 129, 308, 324 Rule 505, 68, 107–11 Rule 506, 68, 101, 110–14, 317, 322, 324, 325, 327, 335 running time, 160, 172, 200

producing entity, 76, 83 product flow, 225 production: account, 169; activities, 25, 35, 40, 283, 289, 292; budget, 17, 50, 138, 156, 172, 177, 178, 181, 197, 217, 228, 236–39, 251, 258, 272, 286, 287, 289; community, 23, 211; division, 207; dollars, 280; elements, 159, 229; entity, 43, 199, 219, 233, 235, 256; equipment, 25, 211, 214; financing, 4, 40, 41, 47, 56, 89, 152, 161–63, 164, 166, 172, 173, 185, 186, 195, 199, 203, 208, 209, 215, 216, 227, 244, 246, 293; loan, 160, 163, 166, 167, 169, 180, 182, 187; money, 41, 61, 154, 156, 173, 187, 188, 199, 201, 202, 207, 208, 225; offering, 41; office, 29, 211; personnel, 22, 205; schedule, 200, 269 production-financing/distribution (P-F/ D) agreement, 161, 162, 163, 168, 173, 177, 186, 199–202, 203, 207, 209 profit: margin, 176; participation, 155, 158, 202, 211, 213, 214, 219, 223; participation auditors, 202 profits, 34, 49, 52, 54, 56, 76, 83, 84, 86, 87, 91, 93, 150, 155, 158, 160, 161, 167, 168, 188, 196, 202, 208, 209, 213, 214, 218, 219, 245, 246, 261 profit-sharing, 46, 76, 83, 301 project financing, 6, 71, 76, 81, 83, 90, 246 projections, 77, 82, 136, 139, 179, 180, 301, 304–6 promotional expenditures, 158 prop departments, 210 prospective purchaser, 102, 117, 118, 120, 125, 129, 318, 320, 321 prospectus, 82, 97, 129, 132, 135, 138, 139, 180, 303 public: announcements, 129; company, 142; offering, 68, 69, 77, 82, 90, 92, 96–98, 100, 105, 107, 109, 110, 112, 115, 127, 128, 131, 133, 136–40, 144, 312, 313 publicists, 170 publicity, 144, 263, 283 publicly: held corporation, 7, 84, 136, 137, 140, 141, 143; trading partnership, 76 purchaser representative, 112, 325 pure acquisition, 4, 157, 208

salary, 27, 29, 196, 217, 218, 220 sale-and-leaseback, 261, 272

367


1/8/08 2:30:39 PM

Index

settlement transaction, 201, 202, 209 share certificate, 80, 81 shareholder, 59, 60, 62, 63, 66, 80–87, 93, 144, 240, 299; agreement, 82, 83 shares, 7, 57, 59, 61, 68, 69, 80–84, 95, 121, 137, 140, 143, 233, 271, 299, 301, 307, 328 shooting schedule, 199, 237, 238 single active investor, 49, 54, 59, 60, 299 single-picture financing, 78 Small Corporate Offering Registration (SCOR), 68, 128–30, 132, 137, 138, 140, 324 sole proprietorship, 6, 42–47 sound: re-recording, 213; transfers, 213 soundstage, 25, 31, 176, 210, 211, 272 Spain, 172, 247, 257, 262, 286 specialist, 141, 144, 145, 185, 210, 276, 278 split rights, 167, 168, 174 spreading risk, 7, 40, 98, 181, 184, 227, 244, 303 stagehands, 164 standards and practices department, 172 star, 23, 181, 197, 199, 204, 221–24 start date, 200 start-up costs, 45, 93 state law, 31, 52, 56, 64, 67, 75–77, 80, 106, 108, 111, 113, 114, 119, 122, 133, 317, 318, 321 step deal, 195 stock, 6, 7, 59, 60, 65, 80–82, 85, 86–88, 90, 91, 105, 128, 132, 137, 141–145, 202, 213, 233, 281, 289; exchange, 7, 68, 141–45; transfer log, 80, 81 stockholder, 85, 202 studio: affiliated distributor, 202; approvals, 200; deal, 204, 205, 212; development deal, 162, 195, 197; employee, 198, 200; executive, 34, 36, 196–98, 202, 204, 205, 233, 294; facilities, 25, 210–12, 269, 281; financing, 47, 198, 202, 205, 233; in-house production, 164, 177, 195–98, 199; insiders, 197; lot, 196, 204, 205, 210; studio/distributor, 4, 8, 23, 36, 47, 140, 154, 157, 162, 164, 167, 168, 177, 182, 188, 193, 195, 197, 198–203, 204, 207, 208, 209, 210–12, 215, 217, 222, 231, 291, 292, 294

sales: agent, 168, 169, 170, 171, 175, 177–79, 181, 183, 237, 238, 241, 270; fees, 169; tax, 24, 25, 28–30, 32, 33 SCOR. See Small Corporate Offering Registration S corp, 6, 7, 42, 65, 80, 83, 84, 85, 86, 87 Screen Actors Guild, 215, 220 screen credit, 15, 49, 57, 196, 252 screenplay, 81, 89, 149, 170, 171, 176, 195, 196, 199, 200, 206, 235, 280, 294, 300 screenwriters, 1, 14, 36, 294 script, 27, 40, 41, 55, 59, 62, 81, 89, 158–59, 160, 171, 179, 182, 195–97, 199, 206, 213, 217, 221, 227, 236, 238, 239, 245, 278, 282, 284, 298, 299, 301; approval, 171; changes, 157, 159, 171; stage, 213, 227 SEC. See Securities and Exchange Commission secretary of state, 45, 57, 60, 64, 65, 71, 72, 74, 75, 77, 80, 81, 93, 94, 303 Section 3(a)(11), 67, 103, 119 Section 4(2), 96–101, 113, 327 Section 4(6), 99–102 secured loan, 149, 150 Securities Act of 1933, 67, 96–102, 103, 105, 113, 120, 121, 122, 124, 128, 136, 139 Securities and Exchange Commission (SEC), 60, 303; attorney, 65, 68, 78, 79, 107, 108, 111, 113, 136, 137, 138, 140, 154; compliance, 73, 95, 96, 103, 105, 115, 128, 131, 135, 138, 141, 149; disclosure document, 57, 62, 68, 70, 73, 75, 77, 89, 97, 125, 131, 132, 180, 300, 301, 302, 303, 325; and Exchange Act of 1934, 70, 315, 316; filings, 84, 142; fraud, 107, 108, 321; offering, 6, 40, 59, 60, 62, 63, 67–72, 81, 89, 97, 119, 108, 109, 111, 113, 117, 118, 129, 133, 135, 136–38, 140, 293, 299, 302–4, 317, 322, 329; registration, 40, 69, 96, 98, 103, 105, 116, 128, 129, 131, 138, 144, 309, 320, 323, 324; review, 136, 139 securitization, 2, 147, 184, 188–91 security interest, 56, 67, 150 selling: agent, 129, 310, 311, 312; materials, 129 separate entity, 55

368


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Index

title: film, 26, 27, 179, 182, 185; to literary property, 56; personnel, 205; of security, 117, 118, 132 track record, 163, 169, 179, 197, 226, 277, 285 transactional exemption, 105, 108, 111, 318 transferee, 76, 104 treatment: favorable, 145, 201, 209; film, 195, 197, 235, 238; tax, 74, 86, 246 turnaround, 198 TV/cable network, 205

subchapter S, 84, 85 subcontract, 208 subjective grounds, 159 submissions, 29, 30, 31, 195, 197, 199, 228, 239 subordination, 150 subsidiary, 4, 8, 27, 65, 135, 182, 201, 210 subsidies, 2, 3, 6, 7, 9, 11–37, 169, 215, 244, 245, 253, 257, 266, 274, 283–88 Sweden, 172, 247, 257, 262, 272 syndicated television, 225 synopsis, 29, 171, 195, 197, 236, 300 take-it-or-leave-it, 202, 291 takeover rights, 200 talent, 23, 28, 55, 62, 200, 202, 205, 215, 216, 219, 234, 235, 284–86; agency, 198, 199, 216; agent, 202 Taurus Releasing, 207 tax: advantages, 13, 34, 78, 274; attorney, 87, 273, 290; benefits, 36, 65, 244, 256, 265, 266, 272–74; consequences, 11, 57, 58, 84, 149, 156, 289; credits, 25–32, 56, 247, 256, 258–60, 282, 286; investment credit, 25, 26, 28, 30, 31; law, 12, 23, 34, 45, 76, 257, 273, 274; liability, 26, 27, 29, 76, 256, 268; services credit, 26, 27, 258, 260; shelter, 34, 256–74; status, 17, 246; taxable entity, 56, 80, 246, 254; year, 22, 26, 29, 30, 56, 57, 85 taxation, 25, 36, 45, 76, 83–87, 94, 262 tax-driven motion picture financing, 257 technicians, 271, 287 television rights, 167, 168, 172 termination, 57, 86, 87 133 territorial rights, 177, 246 territory, 158, 159, 166–68, 169, 170, 172–78, 181, 225, 233, 242, 243, 244, 245, 248, 253, 267, 270 test-the-waters, 133 Texas, 33, 211 theatre, 174, 207–10, 228, 267, 278, 285, 292 theft, 198, 204 third: party, 51, 53, 56, 150, 152, 157, 160, 168, 177, 261; world, 289, 290 time schedules, 196

ultra-low-budget film, 9, 155, 228, 300 unconscionable agreement, 161, 201, 208 underlying property, 55, 89, 159, 195, 286 underwriting, financial, 145, 182, 241 unincorporated production company, 44, 45, 59 union, 164, 165, 220, 252, 253, 301 unregistered security, 54, 102, 110, 149, 319 unsecured loans, 149 unstable government, 278, 282 upper-level management, 106, 111, 113, 115, 127, 135, 139, 311, 312, 315, 322, 323 upside potentia1, 173–75, 198, 201 U.S-made film, 21, 166, 172, 225 use of proceeds, 136, 139, 300 usury laws, 149, 154 video, 2, 25, 27–30, 33, 41, 166–68, 172, 174, 190, 210, 213, 225, 227, 235, 258–60, 263, 267, 315, 317, 319; rights, 167, 168, 174 voting: rights, 85, 144; trust, 82 wardrobe, 164, 248 warranties, 187 warrants, 143 weight analysis, 169 welfare, 38, 224 withholding, 47, 254, 267 word-of-mouth, 211 worldwide: negative pickup, 167, 168; revenues, 225 writer, 1, 14, 17, 69, 170, 195–98, 204, 215, 216, 228 writer’s agreement, 196

369


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John W. Cones is a securities and entertainment attorney who has practiced in Los Angeles for nearly twenty years, advising independent feature film producers and others on investor financing of entertainment projects. The author of fifteen books and a member of the California and Texas bar associations, Cones also hosts a Q&A Internet site on investor financing at http://www.mecfilms.com/coneslaw/finforum.htm.


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Cones

FILM

“[Cones provides] valuable pointers and insights to the burgeoning producer.” —Boxoffice

JOHN W. CONES, a securities and entertainment attorney based in California, is the author of The Feature Film Distribution Deal (available from Southern Illinois University Press). He has extensive experience in the financing of feature films, television pilots, documentaries, infomercials, live stage plays, and Internet companies.

Printed in the United States of America

Cones cvr mech.indd 1

43Ways to

Finance Your Feature Film A Comprehensive Analysis of Film Finance

Third Edition

John W. Cones

ISBN 0-8093-2693-0 ISBN 978-0-8093-2693-8

Southern Illinois University Press

Southern Illinois University Press 1915 University Press Drive Mail Code 6806 Carbondale, IL 62901 www.siu.edu/~siupress

A Comprehensive Analysis of Film Finance Third Edition

This reorganized and expanded third edition of 43 Ways to Finance Your Feature Film answers the question that every filmmaker and producer ultimately faces, the issue that can make or break any venture into the film industry: How do I finance my film? This guide covers the options for film financing in rich detail so that even first-time producers and filmmakers will be able to make informed decisions about the best approaches to financing their films. An extensive bibliography refers readers to additional information about each form of film finance. In addition, author John W. Cones counters much of the bad advice of pseudoprofessional film finance consultants and points out scams that may separate unwary film producers from their money. Although 43 Ways focuses on financing feature films, much of its information is relevant to the financing of other kinds of projects, such as short films, documentaries, videos, and multimedia and theatrical endeavors. Anyone considering making or investing in a feature film will be well served by this practical and helpful guide.


“[43 Ways to Finance Your Feature Film] is well suited for independent filmmakers who wish to learn how film financing occurs throughout the industry and how to converse with their attorneys about legal arrangements when they discover potential investors for their film projects.” —Entertainment and Sports Lawyer

1/9/08 2:10:29 PM

43 Ways to Finance your Feature Film

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