I. Basics of LLCs
Independent filmmakers are busy people and often wear many hats. The producer of an independent film is often the person organizing the numerous tasks and people doing them to put a film together. To make sure he is not the one holding the bag for everything at the end of the production, the filmmaker needs a business organization that spells out who does what, who is responsible for paying for things, how those people are to work together, and under what circumstances they are to break up. The creative rush of working on a film sometimes has the effect of putting the business organization on the back burner, but this can have dire consequences. Like any group of people forming to do business, a film should have a formal business form, or the principals will be liable for all the debts of the project personally. If there is no business form registered, the participants will be treated and taxed as a partnership, with each partner liable for his or her divided share of the debts. A single person making a film will be treated and taxed as a sole proprietor, and will report film income and debts as his own, on his personal income tax form. The organization form which is the easiest and most suited for a film production involving a group of people is the Limited Liability Company, or LLC governed in Ohio by Ohio Revised Code Chapter 1705.
An LLC can consist of a single owner or many members; it can be managed by the members themselves, or by an outside managing company that is not part of the LLC. This is all spelled out in the LLC’s operating agreement, the part of the Articles of Organization which sets out not only the people who will be members of the LLC and what their role will be, but the contributions they will make to the company. It is essential to detail every aspect of the company and how it will be run in the operating agreement. This will help to avoid the necessity of the disagreeing members hashing out what they meant in a court setting, which can be very expensive. There are several helpful checklists in Blackford Business Organizations on Limited Liability Companies which will make sure the owner(s) do all that is required by law in the formation of the company. It sets out mandatory provisions of the Articles of Organization, such as the name of the company; its purpose; its duration, unless it is to be perpetual; its address, and statutory agent. A film LLC may be formed for the production of a single film, and thus may have a limited duration with more detailed provisions in the event of the termination of the company. An LLC formed by a group of members to produce a number of films may have a perpetual duration and have more detailed rules for allocating profits and losses from the operation. One caveat for the formation of multiple LLCs for individual movies is that the companies must remain separate, with separate offices, bank accounts, recordkeeping, and expenditures. Any commingling of funds between multiple LLCs with the same or similar members may result in the voiding of the business form as a `sham’ or `shell’ company, which may allow creditors to go after the assets of the solvent LLC or even the alter ego of the company, the principal members. It may be tempting to share funds between solvent and insolvent films if one movie produced by the same group of people makes money and another does not, but in exchange for limiting the liability of the principals for debts of the company, strict recordkeeping and separate books are required to use the LLC form. If the company is sued for a personal injury or contract breach, the principals may end up being liable to the injured party if there is no real evidence that the LLC form has been complied with. To avoid being sued, the members or principals of an LLC comprising the film production itself should make sure all contracts with the participants, vendors, licensors and members are solid, clear, and not capable of being interpreted more than one way. Address all issues – make sure there are provisions for enforcement, recordkeeping and auditing. The contract elements of offer, acceptance, and consideration (some value or benefit given) should be clear in your releases for performers and crew. All the intellectual property used in your film (sounds and images) should be licensed or permission obtained for their use from the copyright or trademark holders. Copyright clearinghouses and music licensing companies and websites can be utilized to help with the clearances. This allows the filmmaker to obtain distribution and errors and omissions insurance as well. Also, possible tax liens and penalties could accrue if the LLC does not pay employment or other taxes incurred by the company’s activities. If there are employees paid salaries or wages, the filmmaker must deduct employment taxes, social security and disability insurance from their pay. The Screen Actors Guild contracts require such deductions, as well as payments to the SAG-Producers Pension and Health Plans. Another checklist gives provisions that could be included in the Operating Agreement, but are not mandatory, such as management form; rights to transfer membership interests, allocation of profits, losses, gain and credits; voting requirements; dispute resolution procedures; specification of events that will cause dissolution of the company; adoption of compliance, sexual harassment, non-discrimination and other policies, and a code of ethics; setting up of bank accounts; compensation plans; and what is to be done when a member dies or becomes incompetent.
Records of the stated contributions are required to be kept by the company and are usually provided in an attachment to the Operating Agreement. Each member’s contribution may be either in cash, property, services rendered, a promissory note, or any other binding obligation to contribute cash or property or to perform services; by providing any other benefit to the limited liability company; or by any combination of these. A promise by a member to contribute to the limited liability company is not enforceable unless it is in writing signed by the member. After promising to contribute to the LLC, the member is liable for that contribution even if the member is unable to perform the promise because of death, disability, or other reason. If the member is unable to contribute the promised property or services, the LLC has the option of compelling the member to contribute the cash value equal to the portion of the stated value of the contribution the member has failed to make. Provisions about the contributions of members can include buy and sell arrangements and self-dealing rules for the members; establishment of a capital account for each member, and the method of accounting to be used to determine additions or subtractions from the capital account; and determination of the fair market value by members or managers if property other than cash is received. The LLC also has other rights under Ohio law against the member who has failed to contribute what he promised to the LLC. However, by the consent of all the members, the failure of a member to make a promised contribution or to return money or other property paid or distributed in violation of the LLC laws may be compromised, unless otherwise stated in the operating agreement. Filmmakers are creative people, who gather together with other friends and artists to make a movie, but things can get decidedly unfriendly if the duties and responsibilities of each participant are not spelled out. Filmmaking can be an expensive proposition, and even a small independent film can easily cost upwards of $100,000. The least amount of production expenditures spent in Ohio that will qualify the producers for the Ohio Film Tax Credit consideration is $300,000. Rather than subjecting your house or other property to a lien for a film debt, a filmmaker should take the time to comply with the statutory and practical requirements of the Limited Liability Company form. It will be well worth it in the long run in making sure that debts or even the splitting of profits do not become an unnecessary concern.
II. Comparison of LLCs with other Business Entities: Financing and Securities Laws
Obtaining financing for your film is a daunting task, especially in this rough economy. If you do find an `angel’ to invest in your film, the type of business organization form you select will make a difference in how you receive the funds. Partnerships are the most common business form, and other forms, such as an LLC, with more than one member will revert to this model if statutory requirements are not met. The classic investor model for a Broadway production is a Limited Partnership, which allows for general (managing) partners and limited (non-managing investor) partners. In this form, the promoters are in charge, the limited partners are entirely passive. Promoters hire and organize things; limited partners give in their percentage of the funds and sit down! Of course, the tax treatment is different from an incorporated company, with each Partner being taxed on the individual level by his percentage of participation in the profits. The entity itself is not taxed as is the case with a corporation. A Limited Liability Partnership has general partners and limited partners who are liable for partnership debts and torts, but not for those of the individual partners not done in the name of the partnership or not caused by the Limited Liability Partnership. The Limited Liability Partnership can be held liable for torts, injuries to persons or property caused by the partnership, and that includes civil rights violations and copyright and trademark infringement. Determining the type of organization you want for your film venture will depend on what kind of association the parties desire. A limited partnership may be suited to an investor who wishes to avoid the greater potential liability of a general partner and is willing to pay the price of giving up a say in management. A limited liability company may be best suited to a group of people who are pooling their labor and resources to make one or more movies, but do not want to put their individual residences and assets at risk.
Limited Liability Companies are a good form to use for films as long as you are diligent about your recordkeeping. Raising money for your film as part of an LLC has some extra concerns, since selling interests or memberships in an LLC or even in a Limited Liability Partnership most likely are going to be “securities” within the scope of both state and federal securities laws. Any “offer to sell” (not just a completed purchase) of LLC memberships can put the transaction into the securities realm, which requires compliance with state and federal laws and regulations. Even if membership in a small member-managed LLC ought not to be seen as a security, any LLC membership interest that is solely for the purpose of investment is classified as a security. Ohio law explicitly mentions LLC memberships as securities in its definition of them. Although Ohio Securities laws provide for exemptions to full compliance for offerings of LLC memberships, some exemptions must still be claimed in a filing with the Ohio Division of Securities, which must find by rule that registration is not necessary or appropriate in the public interest or for the protection of investors. The most common reasons for exemption of an LLC membership as a security by issuers include a number of provisions involving smaller numbers of investors. The first under Ohio law allows an offering to ten or fewer purchasers. This exemption requires that the total number of purchasers (or members, in the case of an LLC) in this state in one year does not exceed ten. It also requires that no advertisement, article, notice, or other communication be published in any newspaper, magazine or similar medium or broadcast over television or radio in connection with the sale, but the use of offering circulars delivered by the issuer to select individuals is allowed. The issuer must also reasonably believe after investigation that the purchaser is purchasing for investment. The exemption also limits any commission or other remuneration for sales, and that such commission is paid only to registered dealers or salespersons of securities registered under state law. This exemption does not require a filing to perfect it, but an issuer should memorialize reliance of the LLC on this exemption in its company records.
Another reason for exemption refers to the federal securities law, providing that section 5 of the Securities Act of 1933 do not apply to the sale by reason of an exemption under section 4 (2) of that act. These are so-called “private offerings” under O.R.C. 1707.03(X) and the federal act, not involving a “public offering”, which thus prohibits any advertising or general solicitation, and also requires investment intent. A Form 3-Q must be filed with the Division within sixty days of the date of sale for this exemption to be valid, and the Ohio Administrative Code section 1301:6-3-03(B)(6) defines the date of sale. The offering must also comply with the conditions of Securities and Exchange Commission Rule 506, which among other things prohibits advertising and general solicitation, and limits the number of purchasers to thirty five “accredited” investors, which under SEC Rule 501, are directors, executive officers, or general partners of the issuer, or has a very high net worth of over 1 million dollars. Non-accredited investors, which the rule allows in unlimited numbers, are required to be “sophisticated”, and disclosure documents must be delivered to them. Out of state issuers have additional filing requirements under Ohio law. Private offerings under O.R.C. 1707.03(W) have the same investor requirements as that of section (X), and are limited to $5 million under SEC Rule 505. A filing fee of $100.00 must be included with form 3-W and sent to the Division of Securities within five business days prior to the first use of an offering document or the first sale in Ohio. This exemption also has a “Bad Boy” provision, which disqualifies any issuer or broker-dealer which would be prohibited from using the exemption because of convictions for fraud or securities violations. Lastly, under O.R.C. 1707.02(G), private offerings of commercial paper and promissory notes that are not offered directly or indirectly to the public are exempt from registration. O.A.C. 1301:6-3-02 defines private offering and details other exempt securities, including those of commercial paper and promissory notes. You can see from the requirements of the private offerings exemption that the purpose of the securities laws is to safeguard smaller investors who do not have a lot of money to lose, as an `accredited’ investor does. They are also designed to allow an exemption for an investor who is `accredited’ because of being a director, executive officer or general partners of the issuer, because he or she has a hand in the management of the LLC and its assets personally.
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, you could run into some real trouble. 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,  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.
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., distinguishing between companies that seek the “passive investor” and situations where there is a reasonable expectation of “significant investor control.” 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 would be unnecessary.
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.” 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 the 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.
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. 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. 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.
© 2011 Mary Ellen Tomazic
 Ohio Revised Code 1705.01 – 1705.61 , Lawriter Ohio Laws and Rules, codes.ohio.gov/orc/17
 O.R.C. 1705.04.
 Jason C. Blackford, Baldwin’s Ohio Practice, Blackford Business Organizations 1, Ch. 14 (West 2009).
 Screen Actors Guild Basic Agreement 34, 34 (2005).
 O.R.C. 1705.43(A)(2).
 Blackford, supra note 6.
 O.R.C. 1705.28.
 O.R.C. 1705.09(A).
 O.R.C. 1705.09(B).
 O.R.C. 1705.09(C).
 Blackford supra note 6.
 O.R.C. 1705.09(D)
 O.R.C. 122.85 (C)(1)(b)
 Thomas Swisher, Partnerships KP 8.01, Ohio Forms & Transactions (2005).
 O.R.C. 1707.01 -99(2007), Ohio Administrative Code 1301:6-1-01 to 03. (2009); Securities Act of 1933, 15 U.S.C. §§77a -77aa (2010).
 O.R.C. 1707.01(B).
 O.R.C. 1707.03(V).
 O.R.C. 1707.03(O).
 Thomas E. Geyer, Basics of Ohio Securities Law, September 16, 2003 (Bailey Cavalieri LLC, Attorneys at Law pdf).
 O.R.C. 1707.03(Q).
 O.R.C. 1707.11.
 Geyer, Basics of Ohio Securities Law.
 O.R.C. 1707.03(W) (2) (a).
 O.A.C. 1301:6-3-02(D).
 529 F.3d 83 (2d Cir. 2008).
 Id. at 86.
 687 F.2d 577, 582 (2d Cir. 1982).
 Id. at 585.
 Securities Act of 1933, 15 U.S.C. §§77a -77aa (2010).
 Leonard, at 89.
Id. at 93.
 SEC v. W.J. Howey Co., 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100, 1103 (1946).
 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).