A recent legal case highlights the issues set forth in So Much for Asset-Backed Film Financing (August 10, 2007). It provides an interesting take on just what is a “security” under Federal law. It also illustrates the juxtaposition of Western concepts of financing versus those found in Muslim and Islamic countries. The defendants in the action are the New York financier Basem Y. Zakariya and his companies Structured Capital Group and Structured Funding Group.
According to the complaint Zakariya claimed he had devised a proprietary method of “structured film financing.” For a portfolio of films he would assemble various collateral items such as foreign pre-sales; the anticipated value of a domestic distribution agreement; syndicated tax benefits; a bank loan; producer participations; vendor participations; a small third-party equity component; and the like. Altogether the value of these collateral items would add up to 100% of each film’s budget plus a modest reserve for post-production interest.
Zakariya then would organize these collateral items in a hierarchy of risk. The bank loan (which might comprise some 35% of each film’s budget) was lowest risk in that it would be repaid first. The equity component was highest risk in that it would be repaid last.
He then would aggregate all of these various collateral items for each individual film; assemble them into a package; and then re-syndicate the package to institutional investors such as insurance companies. The institutional investor would not own an entitlement to proceeds from a specific movie. It would own a tier or a “tranche” of the portfolio with a specified risk-return characteristic. The lower the priority of repayment (the greater the default risk), the higher the interest rate.
This financing technique is not unique to Zakariya. Structured asset-based financing using collateralized debt obligations is common in many industries including everything from mortgages to receivables to credit card debt. As set forth in a recent article in the Wall Street Journal, “A CDO most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security. The CDO issues a new set of securities, each bearing a different degree of risk. The highest-risk pieces of a CDO pay their investors higher returns. Pieces with lower risk, and higher credit ratings, pay less,” Mollenkamp, C. & Ng., S. (2008, December 28). How ‘Norma’ begat crisis.” Wall Street Journal. The value of the over-all portfolio is sensitive to the performance of the collateral and prevailing interest rates in the credit markets generally.
An important component of such a package is residual value insurance. Residual value insurance insures that the value of all of the collateral components equals or exceeds the negative cost. It assumes all collateral items are in place equal to the the total negative cost. With an RVI policy in place each slate could obtain a rating from Moody’s or Standard & Poors, which in turn would induce institutional investors to participate. Residual value insurance is fundamentally unlike “gap insurance,” the now-discredited engine that powered a previous wave of film financing in the 1990s. The purpose of gap insurance was to provide funding for the differential between each film’s negative cost and the total cost of its collateral elements. RVI insures against default risk of the underlying portfolio, more like true insurance conventionally understood.
By way of background there always has been a clean split in the motion picture business between producing a movie and financing it. They are two completely different disciplines. The job of the producer is to find material, cast and financing. The job of the financier is to provide the money. These are separate tasks with separate objectives and responsibilities.
There is a lengthy history behind this of this division of labor. Since the demise of the studio system the main problem facing motion picture producers is securing financing for their projects. Long gone are the days when an “investor” simply would hold a “long” position in a film – finance it, subject to the risk it might not be commercially demanded in the volatile and fickle pop-culture marketplace. In place of this a variety of strategies have arisen to cushion or mitigate this risk. Recently these have included: issuing securities to the public, as did the now-defunct Cannon and Carolco; foreign bank financing, such as that formerly supplied by Crédit Lyonnais, which financed Giancarlo Parretti’s takeover of MGM in 1990 for $1.25 billion, ultimately losing over $5 billion; Japanese financing, culminating in Matsushita acquiring Universal and Sony acquiring Columbia; bank financing backed with gap insurance, which resulted in myriad and complex litigation between banks and insurers over which would bear the resulting losses; and financing from Germany’s Neuer Market and state-sponsored tax shelter funds. See Moore, S. (2001, July 30). “The Next Wave Of Film Financing.” Los Angeles Business Journal.
To this list now might be added investment in film “slates” by so called “hedge funds” such as that proposed by Zakariya. Relativity Media, for example, has successfully deployed this technique to raise several billion dollars for film production. Relativity’s principal is Ryan Kavanaugh. The key to Relativity’s success has been not so much the quality of the motion pictures it has financed, which has been mixed. Motion pictures that are credible candidates for financing are plentiful and many of Relativity’s pictures actually may have lost money. The critical ingredient is contacts within the financing community to obtain funding. One can have all of the fully-collateralized projects in the world but without a financing “relationship” there will be no movement.
This same separation between production and financing also is illustrated by the disparate tax treatment accorded to film producers as opposed to film financers. In the independent film business the film production vehicle typically is a special-purpose entity (“SPE”). The SPE typically is a limited liability company (“LLC”). One of the key features of an LLC is that it is taxed as a partnership – all income and losses flow through to the Members. It is impossible for a producer to have a tax basis in the LLC because the producer makes no capital contribution. The producer is not entitled to participate in LLC income or losses. Only the financer can participate in losses, which are passed through to the financer and then can be set off against other financer income. If the producer were to become a Member of the LLC without making a capital contribution then the producer would have attributed ordinary income equal to the financer’s contribution. It still is possible for the producer to participate in Net Proceeds but this distribution occurs before pass-through allocation of profit or loss at the LLC membership level.
The complaint in the case alleges that for some time Zakariya was a constant presence in the Hollywood independent film community. He offered to finance film slates assembled by independent producers. Zakariya was not interested in individual films. He only was interested in multiple-picture packages, which were amenable to internal cross-collateralization and diversification of risk. Zakariya’s colleague was Gerald I. Wolff, formerly associated with a now-defunct film company called Five Points Entertainment, Inc. Zakariya and Wolff arrived at an ingenious division of labor. Wolff’s function primarily was to solicit interest from producers with completed film packages comprising script and cast attachments. He then would direct them into meetings with Zakariya. Those meetings (predominantly) were conducted at the Peninsula Hotel in Beverly Hills.
The complaint goes on to allege that Zakariya not only undertook to organize and syndicate the financing package, he also undertook to secure distribution; various tax benefits; and the third-party equity component. He represented he previously had deployed this method with success for several other film slates. He represented he had contacts in the financing community to conclude the contemplated facility with ease. He solicited up-front fees, allegedly to procure a residual value insurance policy. He represented he would sequester this money in a separate interest-bearing trust account and not commingle it with his general corporate or personal funds. One now-defunct company – Franchise Pictures, Inc. founded by Elie Samaha and Andrew Stevens – allegedly paid him thousands of dollars in up-front fees for financing packages that never existed. The complaint goes on to allege that Zakariya represented he had an RVI policy in place from Hagedorn & Co., an insurance brokerage firm, and also one with Marsh & McLennan. No such insurance was in place. The complaint concludes by alleging that Zakariya offered a structure that was inherently plausible. He represented he had the structure in place – the contacts, the relationships, and all other necessary elements – when in fact they did not exist.
So, is it a security? Under 9th Circuit and U.S. Supreme Court decisions, a security doesn’t have to be denominated as such. It can be an “investment contract,” which Zakariya’s offering was. The process Zakariya said he would undertake actually is referred to as “securitization” of the underlying assets. The initial holder of the underlying assets – the collateral – is not the “issuer” of the security. Rather, it supplies the component elements to the issuer, which then assembles those elements and comprises them into “virtual” tiers or tranches as set forth above. The issuer sells a security to the holder of the collateral, which is a participation in the value of the overall portfolio. The consideration for that interest is the producer’s transfer of the underlying assets. The issuer also sells a security to the investors in the portfolio, which is a participation in a defined risk-return characteristic. The proceeds from that sale in turn are used to fund the actual production of the films.
It will be interesting to see how the case turns out, should Zakariya elect to proceed further.