[NEohioPAL] Limited Liability Companies for Films - Installment #3

[Mary Ellen Tomazic]

Please disregard my previous duplicative post of Installment #2, here is the
latest installment, #3:

*Limited Liability Companies for Films*

*By Mary Ellen Tomazic*





III. LLC Financing and Securities Fraud – a Case Study



If somehow your film LLC membership offerings still do not come under any
state or federal exemption, or you do not want to go through the filings and
notifications required for the exemptions. A recent case involving the
selling of film company LLC memberships outlines the tests that courts use
to determine whether an offering is a security, aside from any possible
exemptions. *United States v. Leonard,
[1]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn1>
* held that in determining whether LLC memberships were `securities’
requiring registration under state and federal securities laws, a “totality
of the circumstances” test should be used, rather than a literal reading of
the LLC’s organizational documents. A “case-by-case” analysis of the
“economic realities” of the transaction underlying the transfer of the LLC
interests was required. In the *Leonard* case, sellers of interests in
companies formed to finance the production and distribution of motion
pictures were convicted of criminal conspiracy, mail fraud and securities
fraud. Their independent sales office (ISO) contacted investors by phone and
sent them offerings by mail which included a brochure, operating agreement,
subscription agreement, risk disclosure sheet, and instruction sheet. The
information contained in the offerings was ruled to be material
misrepresentations of fact under the federal securities law. The sellers
were found to have intended to deceive the investor “members” that their
money would be spent on pre-production, rather than on sales commissions.
The offering materials did not reflect the hefty commissions of 45% taken by
the ISO, but seemed to indicate that the commissions would be no more than
20% of the unit
price.[2]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn2>

         The sellers’ appeal turned on the issue of whether the LLC
memberships offered by the sellers were “securities”. Their argument was
based on the organizational documents of the LLC, which would by a literal
reading lead the court to believe that the members were expected to play an
active role in the management of the film companies. In the organization
documents, the members’ managerial and voting rights, did not accrue until
the LLCs were “fully organized”, and so-called “interim managers” initially
held legal control rights, deciding almost every single significant issue
prior to the completion of fundraising – the script, the director, the
casting and crew, the scoring, and even the editing of the picture. The vast
majority of the investor “members” did not actively participate in the
ventures, exercising almost no control. In fact, the members solicited to
invest in the film venture had no particular experience in film or
entertainment, and would have had difficulty taking over their formal
managerial rights in the companies after they were fully organized. The
court found that the managerial rights recited in the organization documents
were hollow and illusory. The court cited the case of *SEC v. Aqua-Sonic
Prods. Corp.,[3]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn3>
* distinguishing between companies that seek the “passive investor” and
situations where there is a reasonable expectation of “significant investor
control.”[4]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn4>The
court in
*Aqua Sonic *stated that the securities laws were enacted for the benefit of
the passive investor, and that where there was a reasonable expectation of
investor control, the protection of the 1933 and 1934
Acts[5]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn5>would
be unnecessary.
[6]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn6>

        Witnesses testified in the Leonard case that the LLCs were
structured to minimize the possibility that the memberships would be seen as
securities, with the summary sheet sent to potential investors reciting that
the memberships were not passive investments, and that although motion
picture expertise was not required, members should have such general
business, financial, and investment experience as to intelligently exercise
their managerial and voting rights. In actuality the 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.”[7]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn7>The
members did not appear to have negotiated any terms of the LLC
agreements, but rather were presented with the subscription agreements on a
“take-it-or-leave-it” basis. The court concluded that despite the
organizational documents drafted to suggest active participation by members,
the defendants sought and expected passive investors for their movie
companies, and therefore the interests they marketed constituted securities.
The Second Circuit Court of Appeals affirmed the convictions of the sellers
for fraud under the federal securities laws for their material
misrepresentations to the investors. Although they deferred to toe District
Court’s determination that the investors would not have purchased the
investment had they known that 45% of the sales price went to commissions,
they remanded the case for recalculation of the value of the securities for
restitution purposes, reasoning that the investment may not have been
entirely without
value.[8]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn8>
**

         The *Leonard *case is the latest in a line of cases which have
attempted to define what kind of interests constitute securities, and
especially the relatively new type of interest in an LLC. The key in most of
the cases hinges on the control actually exercised by the members, and not
just what is purported by the offering and organizational documents. An
investment contract constituting a security under the Securities Act is one
in which a person invests his money in a common enterprise and is led to
expect profits solely from the efforts of the promoter or a third
party.[9]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn9>
There are at least two cases in which LLC interests were not found to be
securities because of the control retained over the enterprise by the
members.[10]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftn10>With
a small film LLC where the members all exercise managerial control and
help form the bylaws and organizational documents of the company, there
should not be any question that the membership interests are not securities.
It is when outside investors are solicited and buy into the company that the
elements of a security are present; in that case, the several exemptions for
small or private offerings in an LLC mentioned earlier should be claimed by
the promoters of the movie venture.





















 Mary Ellen Tomazic is an attorney in Cleveland specializing in
entertainment
issue such as copyright, trademarks, contracts and licenses for musical
groups and filmmakers.



------------------------------

[1]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref1>529
F.3d 83 (2d Cir. 2008).

[2]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref2>
*Id.* at 86.

[3]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref3>687
F.2d 577, 582 (2d Cir. 1982).

[4]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref4>
*Id.* at 585.

[5]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref5>Securities
Act of 1933, 15 U.S.C. §§77a -77aa (2010).

[6]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref6>
*Id.*

[7]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref7>
*Leonard, *at 89.

[8]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref8>
*Id.* at 93.

[9]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref9>
 *SEC v. W.J. Howey Co.,* 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100, 1103
(1946).

[10]<file:///C:/Users/Maryellen/Documents/Limited%20Liability%20Companies%20for%20Film%20-%20Installment%20III.docx#_ftnref10>See
*Great Lakes Chemical Corp. v. Monsanto Co.,* 96 F.Supp.2d 376 (D.Del. 2000)
and *Keith v. Black Diamond Advisors, Inc.,* 48 F.Supp. 2d 326 (S.D.N.Y.
1999).
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