Filmmakers, Crowdfunding, and Securities Law: A Cautionary Tale

Most filmmakers are surprised to learn that securities law may apply to the production of their film. It seems counterintuitive to think that securities law, something we normally associate with stocks and Wall Street financial firms, can apply to a small budget film funded by family or close friends or from crowdfunding sources. But in many cases, securities laws may apply, and one recent New York case underscores this fact.

The Case

Two defendants (the Sellers) were selling $10,000 “units” or interests in limited liability companies to produce the film Carlo’s Wake and The Amati Girls. The sellers solicited investments over the phone. If the people they called expressed interest, then the sellers would send them several items including a brochure and risk disclosure document. The sellers received a commission on every investment they sold that amounted to almost %50 of the size of the investment. The defendants raised $520,000 for one film and over $90,000 for the other.

The government brought charges against the two defendant sellers on the ground that they had not disclosed the size of their commission in the materials they sent to potential investors. One defendant was sentenced to three years and seven months in prison, while the other defendant received a prison sentence of six months. Both defendants appealed because they claimed the LLC membership interests they were selling were not “securities.”

What is a Security?

The Securities Act of 1933 defines security as being, among other things, an “investment contract.” 15 U.S.C.A. 77(b)(1). The Supreme Court defined “investment contract” in SEC v. W.J. Howey Co., 328 U.S. 293. The court stated that:

an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby [1] a person invests his money [2]  in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.

The Defendant Sellers’ Counter-Argument

The defendant’s argued that the LLC membership interests were not securities because the investors did not expect to make a profit solely from the efforts of others.

The court rightly noted that because LLC membership interests can take a variety of forms, the interests “resist categorical classification.” Instead, the court will take a case by case approach to determine the “economic reality” underlying the transaction.

The court also noted that the word solely is not a literal limitation. Instead, the court considers whether there was an investment, or “a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.”

The defendant sellers had prepared ahead of time to make this argument. They included statements in their LLC operating agreement that required the participation of all of the investors so that they would not be making a profit solely from the efforts of others. There were statements such as “Each Member is required to participate in the management of the Company” and “The purchase of interests in the Company is not a passive investment.”

But when it comes to securities matters, the court will look to the “economic reality” of the transaction, not what the sellers choose to call their investments. The court disregarded these provisions of the operating agreements. The court reasoned that:

• In actuality, the [LLC's] members played an extremely passive role in the management and operation of the companies. At trial, members testified that they voted, at most, “a couple of times.”
• Although the organizational documents provided for the formation of a number of committees, only two committees were formed for each of [the LLCs]…. the vast majority of investors in both companies did not actively participate in the venture, exercising almost no control.
• members’ managerial rights and obligations did not accrue until the LLCs were “fully organized,” meaning there was little control until the film was fully produced.
• the members appear not to have negotiated any terms of the LLC agreements.
• The members were not experienced in the entertainment industry and thus could not exercise any meaningful control.

Under New York Law, “investors may be so lacking in requisite expertise, so numerous, or so dispersed that they become utterly dependent on centralized management, counteracting a legal right of control.”

In the end the court declined to reverse the defendants’ convictions on the ground that the LLC membership interests were not a security.

United States v. Leonard, 529 F.3d 83 (2nd Cir. 2008).

Conclusion

No matter how counter-intuitive it may seem, one should always consult with an attorney before soliciting investments for a film. There are several exceptions to the securities registration laws, and some of them may be applicable.

Another option is not to seek investments at all, but rather to seek funds from donations and the sale of merchandise, as many films using the crowdfunding model do.