Source: http://www.filmfinanceattorney.com/page/423203570
Timestamp: 2019-04-24 20:51:56+00:00

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Contingent Promissory Notes as a Film Finance Method – Are Filmmakers Being Misled?
Some entertainment attorneys recommend that independent producers seeking to finance the production costs of an independent film, raise the money through use of contingent promissory notes. These attorneys suggest that such notes are considered “debt” and therefore are not securities. Thus, according to these attorneys, compliance with the securities laws is not required. In other words, their advice appears to be partly motivated by either the attorney or the client’s desire to avoid what they consider to be the burdensome and potentially costly task of complying with the federal and state securities laws. Such promissory notes are typically either not collateralized, not adequately collateralized, not guaranteed, not insured or otherwise secured. The repayment of such notes is dependent upon the financed film earning sufficient revenues to repay the note or notes.
Unfortunately, this advice is extremely risky and overlooks most of a significant body of both federal and state statutory and case-made law regarding the question of whether promissory notes are securities. And, of course, if the promissory notes being offered by an independent film producer are securities, he or she would need to comply with the federal and state securities laws, including the antifraud rule, in order to avoid potential criminal or civil liability.
Part of the problem for the practitioner, however, is knowing in advance which interpretation of the law will apply to a particular client’s situation, and the standard used does vary, with at least three distinctive tests being applied. It is particularly problematic because independent film producers from other states commonly do seek entertainment law advice from Los Angeles-based attorneys. The problem becomes even more complicated when one relaizes that this issue can be raised, in federal or state court, civil or criminal proceedings.
3. the “risk capital” test.
The “family resemblance” test is used uniformly in Federal law situations.1 The “family resemblance” test is also the primary test used in state civil and administrative cases.2 The “Howey” test is primarily used in state criminal cases.3 The “risk capital” test is purportedly the primary test being used in the state of California for both civil and criminal proceedings,4 although the actual language of the courts in certain of those cases (as discussed below) appears to mix the “risk capital” test with the “Howey” test.
At the federal level, the 1933 Securities Act definition of a security,5 specifically includes “notes,” “bonds,” “debentures” and “evidences of indebtedness”. Thus, at first blush it would appear that all notes are securities, although the ‘33 Act also excludes from the securities registration requirement some notes with maturities no longer than nine months.6 On the other hand, a promissory note with a maturity date of less than nine months is of little use in the production financing of a feature film, although such short-term notes may be helpful for the bridge financing associated with the development and packaging of a film project.
The leading federal case (Reves v. Ernst & Young), dealt with uncollateralized, uninsured demand notes. The Court held that the 1933 Act creates a presumption that any note in excess of nine months is a security.8 The Court, however, did not suggest that notes less than nine months were not securities. In point of fact, earlier case law has rather uniformly held that short-term notes are securities, as well, if they have investment characteristics. As an example, in the Briggs v. Sterner case,9 short-term demand notes, offered to obtain risk capital, were held to be securities. Thus, it would appear that even the short-term promissory note being used to raise funds for the development and packaging of a feature film may also have to be considered to be a security.
Readers should note carefully that the contingent promissory note typically used by independent film producers to finance the production costs of their films are not listed, and therefore, once again, must be considered to be a security. Thus, compliance with the federal and state securities laws is required for the issuance of such promissory notes.
1. Motivations of the Buyer and Seller – If the purpose of the seller of the notes (i.e., the film producer) is to raise money for the general use of a business enterprise or to finance substantial investments (e.g., the production costs of a feature film), and the buyer of the note is interested primarily in the profit the note is expected to generate, the instrument is very likely to be considered a security. On the other hand, if the money is used to acquire a minor asset or consumer good, to correct the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, the note is less likely to be a security.
2. Plan of Distribution – If there is general, widespread distribution of the instrument, it is more likely to be a security.
3. Reasonable Expectations of the Investing Public – The Court will consider instruments to be “securities” on the basis of the reasonable expectation of the investing public.
Once again, however, it is highly likely that a contingent promissory note used to provide the financing the substantial costs associated with the production of a feature or documentary film, without the presence of significant risk-reducing factors, would be considered a security using this test, regardless of what the investor’s expectations were or whether there was widespread distribution of the instrument. Thus, pursuant to the “family resemblance” test, it is not likely that such notes would be added to the list of instruments that are not considered securities.
As noted earlier, many state court decisions on this issue, based on definitions of securities that mirror the federal definition, have been consistent with the Supreme Court’s view (applying the “family resemblance” test), while others, including California, have not. In an effort to bring about more uniformity amongst the states with respect to the regulation of securities generally, Congress enacted the National Securities Markets Improvement Act (“NSMIA”) in 1996.14 NSMIA however, allowed states to continue to rely on their own definitions of what notes should be considered securities. Thus, state law is still the final authority on state law questions.15 Although, as seen below, the state courts often look to federal case law for guidance.
Unfortunately, the court did not distinguish between the parents (the actual investors) and the children who cannot, by any stretch of the imagination, be considered to be active in the sense that they are involved in management in any meaningful way. Also, even though the parents accompanied the children to their rehearsals, they were not permitted in the rehearsal studio, much less given any say with regard to management of the project.
Further, California courts have supported the securities regulators’ view that an active investor must have some level of knowledge and understanding of the field in which he or she is investing. In the case of Consolidated Management Group, LLC versus the California Department of Corporations49 a California appellate court ruled that “the investor’s inexperience and dependence on a managing venturer served to establish that the joint venture interests were in fact securities.” The court further stated that these business promoters (selling investments in oil well drilling equipment using a joint venture as the investment vehicle) “were soliciting investments from people who would, as a practical matter, lack the knowledge to effectively exercise the managerial powers conferred by the joint venture agreements . . .” The court went on to say that “the success of the particular projects marketed was uniquely dependent on the efforts of the . . . managing venturer, and that investors would be relying on those efforts in making their investments.” Ultimately, the court observed that the “investments were solicited from persons with no experience in the oil and gas industry”.
Thus, if the circumstances of the 1951 People v. Syde case were revisited today, it is very unlikely that the decision would be the same. Because of the subsequent refinements created with respect to who may be considered to be an active investor in an investment transaction, it is clear that neither the parents, nor the children in People v. Syde would qualify pursuant to the standards established in Williamson v. Tucker or Consolidated Management.
Consequently, a film producer issuing one or more promissory notes to finance the production of a motion picture when the maturities for such notes exceed nine months, would have to presume that such notes are securities. And, even in situations where the notes are short-term demand notes, if they are offered to obtain risk capital (which is typically the case in independent film finance), those notes would also be securities.
If the transaction is questioned and the federal “family resemblance” test applies, the producer may seek to rebut the presumption that the note he or she is issuing bears a strong “family resemblance” to one or more of the notes listed by the courts as not being securities. But that does not appear to be likely. Further, the producer may also seek to convince a court that a new category of note not considered a security, needs to be created. But, once again, it appears that the contingent promissory note could not meet its burden of persuasion to be added to the list of excluded instruments. It would appear that such transactions are motivated for the purpose of raising money to finance substantial investments (i.e., the production of a feature film), that the reasonable expectation of the investing public is that the transaction is a security and there are no risk-reducing factors such as collateral or insurance. So, even if the transaction is limited in its distribution (sold to only a few investors), for all practical purposes, such notes would very likely still be recognized as securities.
1. “Is a Note a ‘Security’? Current Tests Under State Law”, Kenneth L. MacRitchie, South Dakota Law Review, Vol. 46, at 409, Summer 2001.
4. Id at 396 & 409.
5. §2(1), 1933 Act, 15 USC §77b(1).
6. §3(a)(3), 1933 Act, 15 USC §77c(a)(3).
7. Securities Counseling for New and Developing Companies, Stuart R. Cohn, Clark Boardman Callaghan, Chapter 3, at 6, 2000.
9. Briggs v. Sterner, 529 F Supp 1155 (SD Iowa 1981).
10. Notes 1-6 were listed in Exchange Nat. Bank of Chicago v. Touche Ross & Co., 544 F2d 1126, 1138 (CA2 1976). Note 7 was added by Chemical Bank v. Arthur Andersen & Co., 726 F2d 930 (CA2 1984), cert den 469 US 884 (1984).
11. Marine Bank v. Weaver, 455 US 551, 71 L Ed 2d 409, 102 S Ct 1220 (1982).
12. Reves Revisited, Janer Kerr and Karen M. Eisenhour, 19 Pepp. L. Rev. 1123, 1153-62 (1992).
13. Securities Counseling for New and Developing Companies, Stuart R. Cohn, Clark Boardman Callaghan, Chapter 3, at 9, 2000.
14. National Securities Markets Improvement Act, Pub. L. No. 104-290, 110 Stat. 3416 (1996).
15. Erie R. Co. v. Tompkins, 304 US 64, (1938).
16. Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811, 361 P.2d 906 (Cal. 1961).
17. People v. Davenport 13 Cal. 2d 681 at 686; 91 P.2d 892, 1939.
18. Domestic & Foreign Petr. Co., Ltd. v. Long, 4 Cal.2d 547, 555; 51 P.2d 73; Oil Lease Service, Inc. v. Stephenson, 162 Cal. App.2d 100, 107-108; 327 P.2d 628; Securities & Exchange Com. v. Howey (W.J.) Co., 328 US 293, 298; 66 S.Ct. 1100, 90 L Ed 1244, 163 ALR 1043.
19. People v. Figueroa, 715 P.2d 680 (Cal. 1986).
20. Tcherepnin v. Knight 389 US 332, 336 (1967) and United Housing Foundation, Inc. v. Forman 421 US 837, 848-852 (1975).
21. People v. Figueroa, supra.
22. Landreth Timber Co. v. Landreth 471 US 681, 686-687; 105 S.Ct. 2297, 2302, 2306, 1985.
23. Citing People v. Syde, 37 Cal.2d 765, 768; 235 P.2d 601, 1951.
24. Silver Hills Country Club, supra.
25. Silver Hills Country Club, supra.
26. Silver Hills Country Club, supra.
27. People v. Leach 106 Cal. App 442; 290 P. 131, 1930.
28. In re Leach 215 Cal. 536, at 536; 12 P. 2d 3, 1932.
29. People v. Leach, supra at 450.
30. People v. Walberg 263 Cal. App. 2d 286; 69 Cal. Rptr. 457, 1968.
32. People v. Syde, supra.
33. Corp. Code, Section 2500 et seq.
34. S.E.C. v. Howey, supra at 1251.
35. S.E.C. v. Howey, supra.
36. United Housing Foundation, Inc. v. Forman, 421 US at 852; 44 L Ed 2d at 632, 1975.
37. People v. Figueroa, supra at 697.
38. People v. Schock 152 Cal. App.3d 379, 384-385; 199 Cal. Rptr. 327, 1984, and citing People v. Davenport, supra, at 690.
39. Hamilton Jewelers v. Department of Corporations, 37 Cal. App.3d 330, 333; 112 Cal. Rptr. 387, 1974.
40. People v. Schock, supra.
41. Citing People v. Leach, supra.
42. Silver Hills Country Club, supra.
43. Dahlquist, Tom, Regulation and Civil Liability Under the California Securities Act, 33 Cal.L.Rev. 343, at 360, 1945.
44. People v. Syde, supra.
45. People v. Syde, supra.
46. People v. Syde, supra.
47. Fundamentals of Securities Regulation, 4th Edition, Louis Loss and Joel Seligman, Aspen Publishers, 2007.
48. Williamson v. Tucker, 645 F.2d 404, 5th Cir. 1981.
49. Consolidated Management Group, LLC versus the California Department of Corporations, 162 CA4th 598, 75 CR3d 795, 2008.
50. S.E.C. v. Merchant Capital, LLC, 483 F.3d 747, 11th Cir. 2007; Holden v. Hagopian, 978 F2d. 1115, 9th Cir. 1992 and the Williamson case cited above.
51. For a discussion of various film finance methods see Forty-Three Ways to Finance Your Feature Film, Third Edition, John W. Cones, Southern Illinois University Press, 2007.

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