Hastings Communications and Entertainment Law Journal

Volume 5 | Number 1 Article 4

1-1-1982

Feature Film Secured Financing: A TransactionalApproach for Lender's CounselRobert G. Weiss

Alan G. Benjamin

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Recommended CitationRobert G. Weiss and Alan G. Benjamin, Feature Film Secured Financing: A Transactional Approach for Lender's Counsel, 5 HastingsComm. & Ent. L.J. 75 (1982).Available at: https://repository.uchastings.edu/hastings_comm_ent_law_journal/vol5/iss1/4

Feature Film Secured Financing: ATransactional Approach for Lender's

Counsel*

By ROBERT G. WEIss**ALAN G. BENJAMIN***

IIntroduction

As an increasing number of banks, financial institutions andother lenders become involved in the financing of the produc-tion and distribution of feature films (i.e., full-length movies),it is increasingly important for counsel to become familiar withthe mechanisms that have developed to protect the position ofthe secured lender in such transactions. Much of the lendingthat occurs in this area is quite similar to standard loan trans-actions. For example, an unsecured loan to a major studiobased on its balance sheet, or a loan to an independent produc-tion company secured by collateral, such as real estate, is en-tirely unrelated to the feature film being financed. However, asubstantial number of loan transactions occur in which the fea-ture film being financed, and the contract payments and otherproceeds derived from it, are the sole or the principal collateraland source of repayment. In such cases, the successful com-pletion, on budget and on time, and distribution of the featurefilm are of primary concern to the lender.

Within the universe of such lending transactions, there are agreat variety of financing arrangements. For example, thereare loans to finance the making of several movies at once, loansbased in part on non-movie collateral or guaranties, and loansin which the distributor plays a variety of financing roles. Thisarticle will focus on one particular and typical kind of financingtransaction often undertaken by a bank or other lender: an in-

* Copyright 1982 Robert G. Weiss and Alan G. Benjamin. All rights reserved.

** A.B., Princeton University, 1975; J.D., Yale University, 1978. Attorney in theLos Angeles office of Morrison & Foerster.

*** A.B., University of California, Los Angeles, 1974;, J.D., University of California,Los Angeles, 1977. Attorney in the Los Angeles office of Morrison & Foerster.

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terim loan to an independent production company to financethe production of a single feature film, in which principal pho-tography has not begun at the time the loan is made.

An interim loan supports the production of the feature filmuntil such time as the fim is delivered to the distributor. Atthat point, the original lender is to be "taken out" by advancepayments made under the distribution agreement and pre-sales of various rights in the fim. These advance payments, orpre-sales,' are assigned to the lender and are the principalsource of repayment for the lender. The existence of pre-saleagreements with committed non-returnable advances inamounts sufficient to cover repayment of the loan dramaticallyreduces the lender's risk. The lender then becomes analogousto an interim financier in a construction project, providing themoney for completion of the project and is, in effect, "takenout" by receiving payments from the permanent lenders, thedomestic distributor and the purchasers of various pre-soldrights. Again, the principal distinguishing aspect of this kindof loan is that the lender will look to the feature fim itself, andall rights arising from it, to assure repayment.

It is conceivable that a lender undertaking such a transactionwould be satisfied simply with the unmade feature film as col-lateral and would not insist on any firm indication that themovie would ever be distributed, or if distributed that it wouldever generate enough money to pay back all or part of theloan.' Indeed, equity investors often invest in a film on thisbasis. However, from the perspective of a bank or other lend-ing institution that enjoys no substantial upside return pos-sibilities, such a transaction normally would be an unwisegamble because a large proportion of all films that are com-pleted are never distributed, and a great majority of those thatare distributed never return their original production cost. It istherefore typical for a lending institution whose sole source ofrepayment is the proceeds of the feature film to insist, as amatter of business judgment, that the independent productioncompany sell certain rights in the feature film (such as domes-tic and foreign distribution rights, and broadcast and cable tel-evision rights) before making the loan.

From a business point of view, the independent production

1. See infra section M-I.A-3.2. P. BAUMGARTEN & D. FARBER, PRODUCING, FINANCING AND DISmTrUrING FilM 61-

2 (1973) [hereinafter cited as P. BAUMGARTEN & D. FARBER].

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company will often resist pre-sales, preferring to retain asmany rights in the feature film as possible until it is com-pleted.3 The reason is that the independent production com-pany will be in a much better bargaining position if it can sellthe rights to a completed film which can be shown to potentialbuyers as a successful product rather than by seeking to obtainpayment for rights to a feature film which has not yet beenphotographed, and may in fact be little more than a script or anidea. This tension between the requirement of the lender thatthe borrower obtain a domestic distribution agreement andvarious pre-sales prior to the making of the loan, and the op-posing desire of the production company to retain as manyrights as possible for as long as possible, shapes many of thekey elements of the business transaction.

IIThe Underlying Transaction

The independent production company that is our hypotheti-cal borrower is typically a small, lightly capitalized corporationthat produces the film from start to finish and then turns it overto a major studio or to a "mini-major" distributor for distribu-tion. The independent production company will acquire all ofthe necessary rights in the underlying literary property onwhich the film is based; engage a director, producer, screen-writer, and actors (the talent); develop a preliminary and afinal shooting script and budget; and supervise and oversee allaspects of the actual principal photography phase of the fea-ture, as well as post-production, which includes editing anddubbing. The role of the domestic distributor during thesestages will vary depending on the deal that has been struckand the identity of the persons involved in making the film.When it is completed, the film will be turned over to one ormore distributors, who will make arrangements for its releasethrough theaters (exhibitors) and often other media outlets.4

For the purposes of our example, it will be assumed that atthe time of the making of the loan, the independent productioncompany has signed a domestic distribution agreement (which

. 3. ZIFFREN, The Structure and Negotiation of Distribution Agreements in THESELLING OF MOTION PICTURES IN THE 80's: NEW PRODUCER/DISTRIBUTOR/EXHIBITOR RE-LATIONSHIP 184, 188-190 (Dec. 5-6, 1980) (available in UCLA Law School Library).[hereinafter cited as ZIFFREN].

4. P. BAUMGARTEN & D. FARBER, supra note 2, at 1-29.

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generally covers the United States and Canada) under whichthe company will receive from the distributor a large percent-age of the cost of the production of the movie upon delivery ofthe movie to the distributor in accordance with the terms con-tained in the distribution agreement. This non-returnable ad-vance payment is made against anticipated profits. It is notcontingent upon the film's success and must be made whetheror not the film is ever released by the distributor. The distribu-tor will then finance the substantial costs of distribution, in-cluding advertising and production of prints. These costs willgenerally be recouped by the distributor from ticket sales andother forms of exhibition when the movie is released. Theamount of the advance payment and the method for financingthe distribution of the movie will be established in the distribu-tion agreement, which will also set forth the economic splitamong the distributor, the independent production companyand others participating in the gross or net proceeds of thefilm.

It is further assumed that the independent production com-pany will have pre-sold certain other rights. This may includeforeign pre-sales, i.e., the right to distribute the film in one ormore foreign countries (territories); the right to exhibit themovie on network, syndicated or cable television; the rights tothe soundtrack; and the merchandising rights, such as the rightto use characters and images from the feature film to maketoys, dolls and teeshirts. As in the case of the domestic distri-bution agreement, other pre-sale contracts will often providefor a fixed minimum non-returnable advance, plus additionalmonies contingent in some way on the film's success. Thesevarious pre-loan agreements will enable the independent pro-duction company to present for assignment to the lender, atthe time the loan is made, a package consisting of a domesticdistribution agreement and various pre-sales6 that will providenon-returnable minimum advances sufficient to take out andrepay the loan. These monies may be payable in whole or inpart at various times. In this example it is assumed that theyare payable at the time the feature film is delivered to the dis-

5. See generally ZIFFREN, supra note 3, at 184.6. For purposes of convenience, the non-returnable minimum advance payments

to be made to the production company under both the domestic distribution agree-ment and the pre-sales, if any, of additional rights will often be referred to in this arti-cle as the "pre-sale advances."

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tributor, but they could be payable upon general theatrical re-lease, at some fixed point after theatrical release, or on anotherschedule.

At the time the independent production company receivesthe loan proceeds, it will also have arranged to acquire allrights to the story, executed deal memos or contracts with thetalent, and prepared a final shooting script, a budget and shoot-ing schedule for the film.

III

Focus of Lender's Counsel

Because the .receipt of pre-sale advances is the principalsource of repayment for the lender and is the means of effect-ing the take-out of the lender's interim position, the focus ofthe lender's counsel will be to assure that the advances are infact made. From a functional point of view this process hasseveral steps. First, the collateral itself must be properly de-fined, the security interest in it properly perfected, and the col-lateral protected from various perils commonly arising in themotion picture industry.

Second, the film must be completed, hopefully, on time andwithin budget. This involves minimizing the risks of budgetoverruns and runaway productions, and limiting, to the extentpossible, arbitrary action by any person involved in the pro-duction of the fim. In addition, insurance should generally beobtained to offset the effect of death of principal talent, de-struction of the negative, special effects materials and sets, andother risks.

Third, it must be assured that upon delivery of the com-pleted fim, the distributor and purchasers of the various pre-sale rights will honor their contractual commitments to makethe advance payments due under their agreements. In this re-gard, counsel for the lender will generally wish to review thedistribution agreement with an eye toward minimizing the riskthat the distributor could avoid making the advance paymentsunder the distribution agreement if the film looks to be, uponcompletion, a probable failure, or if the distributor's financialposition changes. The same may well apply to pre-sale pur-chasers of other rights.

The remainder of this article will focus on the means by

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which counsel for the lender can successfully accomplish thesethree inter-related tasks.

A. Definition of Collateral

The collateral description in the security agreement, and re-lated documentation, will normally be a blanket collateraldescription covering all of the independent production com-pany's present and future assets. Special attention, however,should be given to three items of collateral that are unique to afeature-financing transaction: (1) the copyright in the featurefilm and in the literary property that forms the basis of the fea-ture film; (2) the film negatives and positives; and (3) therights to payment under the distribution agreement, the vari-ous pre-sale agreements and other proceeds of the film.

1. The Copyright

The creation, perfection and enforcement of security inter-ests in the copyright to a feature film and in the literary prop-erty on which the film is based are governed by a complexinterplay of federal and state law.' As a result of certain ambi-guities in the law, it is advisable that the drafting of the docu-ment granting the security interest be done in a manner that issufficient under both the federal Copyright Act and state law.'This latter requirement will generally mean compliance withthe provisions of section 9-2031 of the Uniform CommercialCode (UCC) in effect in the state in question.10 The document

7. 3 M. NUIMER, NIMMER ON COPYRIGHT § 10.05[A] (1982) [hereinafter cited asNIMMER]. Article 9 does not apply "to a security interest subject to any statute of theUnited States, to the extent that such statute governs the rights of parties to and thirdparties affected by transactions in particular types of property." U.C.C. § 9-104(a) (em-phasis added). The Copyright Act covers copyright mortgages and recordation of as-signments of copyright; however, the Copyright Act does not contain "sufficientprovisions regulating the rights of the parties and third parties to exclude security in-terests in copyrights" from the provisions of article 9, comment 1 to U.C.C. § 9-104.

8. NIMMER § 10.05[A], supra note 7, at 10-44 n.12.9. Section 9-203(1) provides in relevant part:[A] security interest is not enforceable against the debtor or third parties withrespect to the collateral and does not attach unless:

(a) [t]he debtor has signed a security agreement which contains a descrip-tion of the collateral.., and

(b) value has been given; and(c) the debtor has rights in the collateral.

10. This article discusses the state law of those states which have adopted article 9of the U.C.C. (all states except Louisiana). References are to the 1972 version of theU.C.C.

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creating the security interest (because of tradition more thanany other reason) is often called a Mortgage of Copyright.

The enforcement or foreclosure of the security interest afterdefault is generally a matter of state law, although questionsrelating to infringement of copyright are generally federalquestions." Division 5 of article 9 of the UCC, and particularlyUCC section 9-50412 are relevant in this context. The caselawprovides no decisive answer as to whether the perfection of thesecurity interest in a copyright is covered solely by federal law,or by a combination of federal and state law, although the morewell-reasoned authority is that this matter is strictly a federalone.

13

With respect to the federal law, the security interest in thecopyright to a feature film, and in the underlying literary prop-erty, is perfected by recording the instrument creating the se-curity interest with the Copyright Office in Washington, D.C.' 4

Counsel should also advise a lender client that UCC-1 financ-ing statements be filed in the appropriate jurisdictions since,as alluded to above, the question of whether perfection issolely a federal question is not free from doubt.

The perfection of a security interest in the copyright to a fea-ture fim raises a number of significant timing issues. The se-curity interest cannot be perfected until the copyright in theunderlying work exists and is registered with the CopyrightOffice; and as a preliminary matter, the feature film itself can-not be copyrighted until and unless it has been completed.However, a book, song or other literary property on which themovie is based can and should be registered with the Copy-right Office as soon as possible. The security interest in therights of the independent production company in these itemsshould be perfected at the same time. Furthermore, a screen-play can and should be registered, and the mortgage thereonrecorded, with the Copyright Office.

As with perfection of a security interest in any type of prop-erty, the question of priority is of paramount importance. Inother words, counsel for the lender must not only assure thatthe security interest is perfected, but also that it is in first posi-

11. NIMMER § 10.05[A], supra note 7, at 10-44 n.12.12. Section 9-504 deals with Secured Party's Right to Dispose' of Collateral after

Default.13. ND4MER § 10.05 [A], supra, note 7, at 10-43.14. 17 U.S.C. app. § 205(a) (1976).

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tion. The first step for the lender's attorney in assuring thatthe security interest in the copyright will be a first and priorsecurity interest is to undertake a copyright title search. Oneof several services in Washington, D.C. that specialize in thispractice usually conducts the search, although technically, it ispossible for anyone to undertake the task.15 This search willnot only determine whether any other person has a securityinterest in the copyright but also serves two other importantpurposes. First, the search will establish if the underlying lit-erary property on which the movie is based (for example, abook, a play, a screenplay, or in some cases a song) is in factcopyrighted and registered with the Copyright Office. Second,the search will determine if the independent production com-pany that plans to make the feature film has acquired sufficientrights in the literary property necessary to produce, distributeand otherwise exploit the film (the so-called "movie rights").This will include a determination of the chain of title, a deter-mination that the grantor of the rights to the independent pro-duction company did in fact possess them.

A copyright title search involves certain peculiar problemswhich arise from the fact that a book or a screenplay's titlemay easily be changed and therefore mortgaged under a differ-ent title. 6 Hence, difficult questions of priority may be raised.Although there is no foolproof means of avoiding this problem,the risk is minimized by the nature of the search normally un-dertaken by the firms that specialize in this procedure. In ad-dition to a search of the Copyright Office records under thenames known, a search is made of certain other files, princi-pally clippings from entertainment trade publications that re-fer to sales, possible sales, and other potential or actualdispositions of intellectual property.

The second step is to make sure that the appropriate "wait-ing period" has run. Under the new Copyright Act, in a situa-tion involving conflicting transfers of the same copyright, theprior transferee will have priority over the subsequent trans-feree if the prior transferee records within thirty (30) days ofthe execution of the transfer of copyright, or within sixty (60)days, if a foreign transaction is involved. Therefore, until sixty(60) days after the execution and recordation of the mortgage,

15. P. BAUMGARTEN & D. FARBER, supra note 2, at 2-3.16. Notes, Transfers of Copyright for Security Under the New Copyright Act, 88

YALE L.J. 125, 131 n.31 (1978).

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the lender cannot be certain that it holds a first lien on thecopyright, and may wish to delay the disbursement of loan pro-ceeds accordingly. 7

2. The Tangible Film

The description of collateral should include each and everypiece of exposed film made in conjunction with the feature. 18

Of particular importance is the negative, because generallyonly a single negative is made from which prints are derivedfor exhibition.' 9 Needless to say, appropriate insurance mustbe in effect to protect the tangible film at all times.20

During principal photography, the exposed film is deliveredfrom time to time to a film laboratory for processing and thelaboratory retains actual possession of the negative. 21 It istherefore critical to structure the relationship of the lender, theindependent production company and the laboratory in such away as to protect the lender's collateral and to minimize theability of the laboratory to interfere with the lender's right toenforce its security interest.

This relationship is generally set forth in an agreement, com-monly called a laboratory pledgeholder agreement, betweenthe three parties. This agreement serves several functions.First, it establishes that the laboratory holds the film not in itsown right, but as trustee for the lender. This can help establishthat the lender's security interest in the negative is perfectedvis a vis creditors of the independent production company byvirtue of UCC section 9-30522 and is free from attack by credi-tors of the laboratory. In connection with potential attacks by

17. NIMMER § 10.07 [A], supra note 7, at 10-52.18. It is important to note that under the copyright laws, the acquisition of an own-

ership or a security interest in tangible property, such as the negatives of a film, givesno interest in the intangible property inhering therein, including the copyright, unlesssuch a grant of rights is spelled out in the agreement. 17 U.S.C. § 202 (1976).

1119. Concoff, Motion Picture Secured Transactions Under the Uniform CommercialCode: Problems in Perfection, 13 U.C.L.A. L. REV. 1214, 1224-25 (1966) [hereinafter citedas Concoff].

20. See infra section II-B-3.21. Concoff, supra note 19, at 1223.22. U.C.C. § 9-305 states: A security interest in ... goods ... may be perfected by

the secured party's taking possession of the collateral. If such collateral other thangoods covered by a negotiable document is held by a bailee, the secured party isdeemed to have possession from the time the bailee receives notification of the se-cured party's interest.

U.C.C. § 9-105(1) (h) defines "goods" as all things which are movable at the time thesecurity interest attaches. Therefore, the film would be considered as goods.

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creditors of the laboratory, it may be advisable in certain cir-cumstances to also file a UCC-1 financing statement againstthe laboratory if counsel concludes that UCC section 2-326might be applicable.23

Second, the laboratory pledgeholder agreement allows thelender, acting through the laboratory, to regulate access to thenegative. For example, the laboratory pledgeholder agreementmay provide that in the event the independent productioncompany breaches its agreement with the lender, the lendermay block the independent production company's access tothe negative in the laboratory. This gives the lender substan-tial leverage.

Third, the laboratory pledgeholder agreement will arrangefor the limitation or waiver, to the extent legally possible, ofthe laboratory's statutory or common law lien in the negative.Absent agreement to the contrary, the statutory lien might wellextend to claims arising not only from the costs of processingthe film in question, but also to claims arising from other filmsthat the laboratory may be handling for the same independentproduction company.

3. Proceeds of Domestic Distribution Agreement and Pre-Sales

The collateral description should specify the pre-sale ad-vances and other payments to be made under the distributionand pre-sale agreements executed or contemplated at the timethe loan is made. The distributor and the purchasers of pre-sales should be notified to make the payments directly to thelender. If possible, agreements not to assert defenses againstthe lender pursuant to UCC section 9-20624 should also be ob-tained. The lender may also wish to obtain letters of credit tofurther assure such payments.

Of course, counsel should make certain that the lender's se-curity interest in the tangible film and the pre-sale advanceswill be in first position. In order to ensure priority, a UCC

23. Creditors of the laboratory might contend that delivery of the film to the labo-ratory is a consignment. In order to perfect the collateral in this situation, U.C.C. § 2-326 mandates compliance with the filing provisions of article 9 among otherrequirements.

24. "[An agreement by a buyer or lessee that he will not assert against an as-signee any claim in defense which he may have against the seller or lessor is enforcea-ble by an assignee who takes his assignment for value in good faith and without noticeof a claim or defense . . . ." § 9-206(1).

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search should be conducted in the same manner as any otherpersonal property secured transaction search.25

B. Assuring Timely and On-Budget Delivery of the Feature Film

Recurring Hollywood nightmares include the runaway pro-duction in which the director or producer makes lavish altera-tions to the final shooting script in the course of principalphotography, or arbitrary behavior of actors or others associ-ated with the film which causes expensive delays in produc-tion. Minimizing the chances of either of these scenarios is oneof the key roles of counsel for the lender in a feature financingtransaction.

The problems of delay and added expense are generallyclosely related because the most frequent cause of added ex-pense is delay in production. Further, timely completion anddelivery of the film to the distributor are crucial because, aspreviously discussed2 6 delivery of the film by a specified dateis generally a condition to the payment of the non-returnableminimum advance in the distribution agreement. Remainingwithin budget is critical because if the film runs out of fundsbefore completion, the lender may be forced to provide addi-tional funds to assure that the film can be completed on time.

There are numerous ways to help assure proper completionof the film, a number of which will be discussed herein. Thesingle most important assurance that proper production of thefilm will be accomplished, however, is the past record of theproducer, the director, and the independent production com-pany. Having said this, we now turn to what counsel for thelender should focus on to assure timely and within-budgetcompletion of the film.

1. Contractual Incentives and Disincentives

Among the steps which lender's counsel can take to maxi-mize the chance of on-time and on-budget completion is reviewof the employment contracts for the producer and the director,the two persons most responsible for adherence to or depar-ture from the final shooting script and budget. Counsel shoulddetermine if the contracts contain monetary disincentives for

25. A review of the law that governs the proper place for filing of UCC financingstatements on films and related collateral is beyond the scope of this article. For adiscussion of this problem see Concoff, supra note 19, at 1214.

26. See note 6 and accompanying text, supra.

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late or over-budget completion, and possibly monetary incen-tives for proper completion of the film.27 If they do not, counselmay wish to request appropriate modification.

One typical contract clause which provides an on-budget in-centive is the so-called double add-back. The double add-backis effective in situations in which the director or producer en-joys a net profit participation in the film. Under the doubleadd-back, the amount by which the ifim exceeds budget iscounted twice in the total cost figure which must be recoveredbefore the break-even point is reached and the profit partici-pant sees "first dollar. '28

Often, because of the identity of the participants, or becausethe lender's involvement begins after the producer and direc-tor employment agreements have already been signed, or forother reasons, the lender's counsel will be unable to influencethe terms of the producer's or director's contracts. However, insome situations, such as when the lender agrees with the pro-duction company to finance a series of films, it may be practica-ble to insist upon the incorporation of appropriate incentivesand disincentives relating to proper completion of the film inthese contracts.

2. The Completion Guaranty

Even assuming the reliability or good track record of the par-ticipants in the feature film venture, and even if appropriatecontract provisions exist to incline those participants towardsproper completion of the film, the risk remains that the filmwill run over-budget or face the prospect of late delivery. Mis-takenly low budget estimates, changed circumstances, and theoccasional arbitrariness of human nature are just a few causesof late delivery of feature films. One protection the lender willgenerally request, and on which lender's counsel should focus,is the completion guaranty. Like a performance bond in con-struction lending, the completion guaranty is an undertakingby an entity distinct from the independent production com-pany to assure the completion of the film on time and withinbudget.

The completion guarantor will, from a functional perspective,evaluate the film's budget and insurance coverage to ascertain

27. P. BAUMGARTEN & D. FARBER, supra note 2, at 87-90.28. P. BAUMGARTEN & D. FARBER, supra note 2, at 87-90.

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that they are realistic, and will also consider the past perform-ance record of the participants. He will have to assure himselfthat, given those facts, the movie can and will be completedwithin the proposed budget. If this cannot be done, the com-pletion guarantor would have to either step in and completethe picture, footing any additional expense, or abandon theproduction and pay the lender the amount of the completionguaranty, or the amount of the loan, whichever is less. Thisfinancial obligation generally is, and should always be, backedby appropriate insurance.29

The completion guarantor provides a number of ancillary butextremely valuable services to the lender" in addition to theperformance or payment obligation. As noted above, the com-pletion guarantor undertakes a detailed review, and must ap-prove, the final shooting budget. Because the completionguarantor will only profit if the film is completed within budget,it is in his interest to challenge and force modification of un-realistically low budget estimates. The completion guarantormay also serve in a role analogous to a general contractor in aconstruction project, supervising day-to-day expenditures,countersigning all checks disbursing funds from the loan ac-count, and reviewing on-going budget and shooting reports fre-quently (often daily during the course of principalphotography). In addition, the completion guarantor will typi-cally have a representative physically present during principalphotography. For all of these services, the completion guaran-tor generally receives a sum which is approximately six per-cent of the film's budget.

The completion guaranty generally provides that the comple-tion guarantor is not obligated to pay expenses over budget in-curred because of changes in the shooting script. It isimportant for lender's counsel to consider the two potentialmotivations for such changes: those within the control of theproducer and the director, such as artistic decisions made dur-ing the course of filming to add certain special effects or to re-write or add several scenes, and those which are forced by

29. Regardless of how carefully a completion guarantee is drafted, if the comple-tion guarantor, or the insurance company backing up the guarantee, can make a color-able claim of fraud on the part of the independent production company (such as indrawing up the budget), then there is a substantial likelihood that no payment will bemade on the completion guarantee, or that it will be sharply contested.

30. P. BAUMGARTEN & D. FARBER, supra note 2, at 91.

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circumstances beyond the control of the producer and director.The completion guaranty should take reasonable account ofthese two different kinds of script changes, including, if possi-ble, preserving the guarantor's obligations in the event ofscript changes caused by non-insured events beyond the pro-ducer's or director's control. Additionally, the lender may wishto put restrictions in the loan agreement on the ability of theproducer or director to make script changes.

Another issue which counsel for the lender must address re-lates to the circumstances under which the completion guaran-tor can step in and take over the filmmaking. The criteria aregenerally either objective or subjective, or both. A typical ob'jective standard will allow the completion guarantor to takeover the film if the shooting costs are running 10% above thefinal shooting budget, or photography is running more than tendays behind the final shooting schedule1.3 A subjective stan-dard might be patterned after the concept of insecurity, whichwould allow the completion guarantor to step in whenever hebelieves in good faith that the film, as it is progressing, will notbe completed on budget or on time. Inclusion of this subjectivestandard is generally advisable from the lender's point of view.

A final note with respect to the drafting of the completionguaranty is that it should be designed so that if the completionguarantor exercises his option to abandon a runaway produc-tion rather than complete it, he is obligated to reimburse thelender not only for the outstanding principal, but also for ac-crued interest and other costs. This apparently simple point isoften ignored in the negotiation of completion guaranties.

Despite the above precautions, the lender may neverthelessbe confronted someday with a substantial cost overrun situa-tion. The first line of defense for such an eventuality is that a10% overrun contingency is generally built into the finalbudget. However, if the overruns exceed 10%, appropriate ac-tions will have to be taken by the completion guarantor and thelender.

There exist a number of options which may prove more ad-vantageous than take-over by the completion guarantor, orcommitment of added funds by the original lender. For exam-ple, if the overruns occur after substantial principal photogra-

31. An additional triggering event of take-over may be the material breach by theindependent production company of any agreement relating to the film.

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phy has been undertaken, the production company may have aproduct to show to additional exhibitors, enabling the companyto raise additional funds through presales it was not in a posi-tion to make at the time the original loan was made. An addi-tional alternative is to attract funds from other sources inexchange for the lender's agreement for pro-rata or othersharing.

Lender's counsel should be aware that in a cost overrun situ-ation, all parties should be brought together to approve any re-medial steps that alter the original transaction. Thecompletion guaranty, the distribution agreement, the variouspre-sale agreements, and the agreements with talent are allclosely interrelated and interdependent. It may be necessaryto achieve an agreement of all such parties to any remedial ac-tion, or some party may be inadvertently released fromfinancial obligations or other commitments that may be vital tothe protection of the lender's security. This is especially truewith respect to any remedial action which might affect the obli-gation of the distributor to accept delivery and make paymentunder the distribution agreement.

3. Insurance

The completion guaranty deals primarily with barriers to theproper completion of the film caused by voluntary acts or er-rors of judgment of participants in the feature film project (al-though certain involuntary acts may also be covered). Thereare, of course, a number of involuntary or accidental contin-gencies which may seriously impair or destroy the possibilityof completing and delivering the feature as contemplated. Forexample, the death or disability of a principal actor during thecourse of filming can either make completion impossible, com-mercially impracticable, or vastly more expensive. The de-struction of sets or of special effects material, or the theft ordestruction of the negative could also prove disastrous. Virtu-ally all of these contingencies can be, and from the lender'spoint of view must be, covered by appropriate insurance. Sev-eral insurance companies offer a standard entertainment pack-age, and lender's counsel should make certain that the packageobtained fulfills the ordinary standards of industry coverage,and in addition, takes into account any unusually great risksentailed in a production of the particular feature being

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financed.32

Generally speaking, the insurance companies that write thistype of insurance will refuse to cover pre-existing medical con-ditions. Additionally, certain talent, because of the state oftheir health or serious pre-existing conditions, are uninsur-able. The lender's counsel should insist that all major talent befully insurable, or at the very least, make certain that his clientfully appreciates the serious risks presented by uninsured pre-existing medical conditions.

A feature film must also be protected by adequate "errorsand omissions" insurance to guard against the multiplyingnumber of statutory and common-law actions that may bebrought against those connected with the film. These actionsinclude copyright infringement, invasion of privacy, violationof publicity rights, breach of confidence, and violation of moralrights.33 Notably, errors and omissions policies generally donot cover an injunction against the showing of a film basedupon copyright infringement (although damage awards arisingfrom copyright infringement are generally covered). This ex-clusion presents an arguably minor, but potentially significant,and probably unavoidable risk to the lender. In this regard,many courts have adopted an extremely liberal view of theavailability of preliminary injunctions in the copyrightcontext.

34

C. Assuring Take-out Upon Completion and Delivery of the Film

The protective steps described in the previous sections re-late to assurance that the lender's collateral, the film, will beproperly defined and protected, and that the film itself will becompleted and delivered on time to the distributor. Assumingthat these steps have been effective, and that the independentproduction company will therefore deliver a completed film,

32. An insurance company will generally require that the major talent who areinsured by the cast insurance allow a reasonable period of time after the scheduledfinal shooting date, to continue to work on the feature, in the event that delays arecaused. This is generally referred to as the "stop date."

33. The text focuses only on certain aspects of insurance which are peculiar to theentertainment industry, and is not intended to be exhaustive.

34. A good example of the relaxed standards under which some courts considerrequests for injunctive relief in the copyright area is American Metropolitan Enter-prises of New York v. Warner Bros. Records, 389 F.2d 903, 905 (2d Cir. 1968), in whichthe court, although affirming the denial of a preliminary injunction, stated that irrepa-rable harm may generally be presumed upon a showing of copyright infringement.

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subject to the lender's fully perfected and protected securityinterest, to the distributor on time and within budget, thelender must nevertheless make proper arrangements to assurethat it will actually receive the promised pre-sale advances.This difficult problem requires taking into account the practi-cal economic interplay of distributor and producer.

Generally speaking, the distributor will seek to avoid pay-ment of its "guaranteed" minimum advance by a variety ofmeans if: the independent production company breaches itsagreement with the distributor; the completed film seems likeit will be a failure; or, the distributor's economic status or planshave changed since the signing of the distribution agreement.35

The distributor's obligation to make payment of the "guaran-teed" minimum advance is contained in the distribution agree-ment to which this article has referred many times. Thedistribution agreement will normally contain a number of con-ditions and other contractual terms which relate to the natureof the film and the actions of the production company. Theagreement may include, for example, a provision that certainpersons will direct, produce, or star; that the film will be of acertain length or even of a certain quality; and that the film willsubstantially conform to the original script as shown to the dis-tributor. Because the distribution agreement is simply a con-tract, the distributor might refuse to make its "guaranteed"advance payments under the contract on the basis of an actualor claimed breach of, or failure to meet, any of the specifiedconditions. Repayment of the loan will obviously be imperiledif the distributor repudiates its obligation to accept deliveryand pay for the fim. In addition, there is the simple risk thatthe distributor might be financially unable to meet its paymentobligation.

The risk of non-payment by the distributor is one that theindependent production company is generally willing to under-take. This may be because the production company lacks bar-gaining power vis-a-vis a major studio, because the productioncompany has confidence in itself to produce a film that the dis-tributor will gladly accept, or because the production companyassumes that another distributor can be found if the originaldistributor repudiates the contract. However, for the lender

35. The standard distribution agreement will generally not require the distributorto spend even the minimum amount that may be necessary for effective distribution ofthe film. P. BAUMGARTEN & D. FARBmt, supra note 2, at 100-103.

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who looks principally to the "guaranteed" minimum advanceof the domestic distributor (and other purchasers of pre-sales)as the source of repayment, the risk of non-payment is one thatmust be seriously considered. Occasionally, the lender will as-sume the risk of non-payment by the distributor on the basis ofan overall evaluation of the track record of the distributor andthe production company, and appropriate discounting of thecontract rights in question.

More often, however, the lender is not willing to assume therisk of non-payment by the distributor. In that event, there areat least two ways to address this risk. First, the risk can bevirtually eliminated through the issuance of a letter of credit.3"The letter of credit is issued directly to the lender by the dis-tributor's bank and normally can be drawn upon when the lab-oratory issues its certificate containing pre-arranged languageto the effect that the laboratory has in its possession a filmmeeting certain technical specifications and that it has issuedto the distributor a "laboratory access letter" giving the distrib-utor access to the film for purposes of making copies. Insistingon a letter of credit minimizes both the risk that the distributorwill intentionally withhold payment because of a breach of orfailure to comply with the distribution agreement, and the riskof financial inability to pay.

The requirements for delivery of the certificate by the labo-ratory are set forth in what is sometimes called a laboratoryletter. The laboratory letter must be drafted in such a way asto eliminate ambiguous language and opportunities for subjec-tive judgments so that the lender can be assured that the quali-ty or likelihood of success of the film will not affect paymentunder the letter of credit. For example, many such laboratoryletters (and letters of credit) call for payment upon receipt of afim that "substantially conforms to the script." Such languageis ambiguous, calls for an essentially artistic conclusion, andshould be avoided if at all possible. The laboratory letter alsocontains a description of the physical elements which mustcompose the fim, such as a 35 millimeter negative, an in-

36. The effectiveness of a letter of credit as a guarantee of the pre-sale advances tothe lender is subject to various legal defenses and practical problems, such as, argua-bly, the ability of the account party to convince the issuing bank of fraud in the under-lying transaction. U.C.C. § 5-114. To minimize this possibility, it is generally advisablefor the lender to be named directly as beneficiary, rather than for the production com-pany to be the beneficiary with an assignment of its interest to the lender.

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terpositive, etc. The terms used to describe the material thatthe laboratory must receive should be strictly limited to thetechnical quality of the film.

The second approach to handling the risk of non-paymentaddresses the risk of intentional repudiation of the obligationto pay by the distributor, but does not address the risk that thedistributor will be financially unable to pay. This approach isto insist that the distribution agreement contain waivers of de-fenses against the lender whereby the distributor agrees tomake payment to the lender even if he has a separate actionfor breach of contract against the independent production com-pany. The UCC specifically validates such waivers"' and coun-sel should review the relevant cases interpreting that sectionunder applicable state law.

IVEquity Kickers

An increasingly common business practice is for thosefinancing the production of a feature film to take an equity in-terest in that film. Equity participation by the lender opens upthe wide and complicated world of the net profits definition. Asubstantial amount of the time spent in negotiating entertain-ment-related contracts centers around the precise terms of thenet profits clause. Indeed, there may be ten separate net prof-its definitions for ten different profit participants in the samefilm, which will vary with the bargaining power and skill of theparticular profit participants. Counsel for a lender taking anequity kicker will want to familiarize himself with the relevantconcepts affecting net profits definitions, or to finesse the en-tire problem if possible by taking a percentage based on grossor "modified-gross" profits.3 8

37. U.C.C. § 9-206 provides, in part, that "an agreement by a buyer or lessee that hewill not assert against an assignee any claim or defense which he may have against theseller or lessor is enforceable by an assignee who takes his assignment for value, ingood faith and without notice of a claim or defense."

38. Although beyond the scope of this article, the arrangements between the dis-tributor, the production company, and the exhibitors may be a matter of concern to alender if such arrangements are not at arm's length. If this is the case, the possibilityexists for unfair bargains in which an excessively large amount of the gross revenuesis awarded to the exhibitors and thereby eliminated from the distributor's gross reve-nues and, by extension, from the net profit participants unrelated to the exhibitors. Inappropriate circumstances, this problem can be avoided by requiring in advance cer-tain standard exhibition contracts, or by the lender's retaining certain approval rightsover these agreements.

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There may of course be particular regulatory restrictions onthe ability of a lender to take an equity participation, and coun-sel for the lender must determine that the equity interest canlegally be taken. For example, for a national banking associa-tion, the operative rule of the Comptroller of the Currency is asfollows:

A national bank may take as consideration for a loan a sharein the profit, income or earnings from a business enterprise of aborrower. Such share may be in addition to or in lieu of inter-est. The borrower's obligation to repay principal, however,shall not be conditioned upon the profit, income or earnings ofthe business enterprise.39

Thus, a national bank can accept a percentage profit partici-pation in exchange for part or all of its interest repayment, butnot for its principal.

VConclusion

The interim financing of feature films is subject to certain un-usual risks that are inherent in motion picture production anddistribution. By use of the legal techniques that have been de-veloped in this area and discussed in this article, however,lender's counsel can reduce those risks to a level which hope-fully can make this type of lending profitable for his client.

39. Comptroller of Currency, Dept. of Treasury Interpretative Rulings, 12 C.F.R.§ 7.7312 (1982).

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