How to Acquire a Film Library

The acquisition of a film library requires balancing a number of competing considerations, including assignability of licenses and allocation of liabilities, as well as bankruptcy, tax, accounting and securities issues.

This article presents a summary of some of the more important issues that arise. Some issues set the selling company (the "Seller") and the purchaser (the "Buyer") at odds, but the most perplexing issues are those that put the Buyer at odds with itself -- or, more precisely, put the Buyer's lawyers at odds with one another.

Assignability of licenses
The acquisition of any film library typically involves the transfer of numerous pre-existing licenses to the Seller, including rights under copyright, trademark and right of publicity. These licenses can relate to completed films or to underlying rights, all of which will be necessary for the Buyer to exploit the film library.

A number of cases have held that unless the license of intangible rights expressly permits assignment, the licensee may not assign it, e.g., Gardner v. Nike, Inc., 279 F.3d 774 (9th Cir. 2002). Most licenses do not expressly permit assignment and, indeed, many expressly prohibit assignment except in certain narrow circumstances. It is often difficult to obtain consent from all the various licensors of intangible rights, so structuring the sale of a film library as an asset sale is often challenging.

The best way to avoid the problem, if possible, is to acquire 100% of the Seller's ownership interests (for simplicity, this article will assume that the Seller is a corporation, so the ownership interests are represented by stock) from its owners (the "Shareholders") rather than acquiring the assets from the Seller.

Unlike the assignment of a license, the sale of stock does not require the consent of licensors to the Seller unless the licenses expressly require the consent of the licensors to a change of control of the Seller, which is rare.

Liabilities
Although the sale of stock may solve the problem of assignability of licenses, it runs headlong into the countervailing desire of the Buyer to shed the Seller's liabilities. If the Seller's stock is acquired, the known and unknown liabilities of the Seller follow it after the sale.

While it may be possible for the Buyer to obtain an indemnity from the Shareholders, third parties will be able to sue the Seller directly (now owned by the Buyer), and the Buyer will have to seek an indemnity from the Shareholders.

Viewed strictly from a liability point of view, it is far preferable to the Buyer to structure the acquisition as a purchase of assets from the Seller, with an express disclaimer of assumption of any liabilities of the Seller. Even then, however, the Buyer will take the assets subject to any liabilities that are secured by the purchased assets (if those liabilities are not repaid as part of the sale) and to contractual liabilities to third parties under any contracts that are acquired.

For these reasons, if the transaction is structured as an asset sale, the Buyer may prefer to have the assets purchased by an entity with limited liability, such as a limited liability company or corporation, that is wholly owned by the Buyer.

Contractual Issues
The purchase contract must be carefully drafted to deal with a number of issues, including the following:

?Contracts should clearly delineate what assets are being acquired and left behind. For example, the acquisition may include (a) the right to make derivative works, such as sequels, of the Seller's existing film library; (b) receivables; (c) cash received by the Seller between the date the contract is signed and the closing; and (d) the trademarks or trade name of the Seller. If the Seller's stock is being acquired, then its Shareholders will want to strip-out any retained assets before the sale.

?There typically will be extensive provisions dealing with the allocation of liabilities, including representations and warranties, indemnities and possibly guarantees by the Shareholders and escrows or holdbacks for part of the consideration.

?There often will be closing adjustments based on expenditures or receipts that occur between the date of signing the contract and the date of closing. These closing adjustments can become remarkably complex, based on any number of accounting adjustments that may require a full-blown post-closing audit.

Whenever the purchase price adjustments are based on accounting concepts, it is critical to have a full understanding of how the final numbers actually are determined (e.g., often management has significant discretion in calculating certain amounts unless the contract provides otherwise).

?There may be non-solicitation or noncompete provisions imposed on the Seller or the Shareholders. It is important to make sure that these provisions do not run afoul of any state law prohibitions on noncompetition agreements. For example, California generally does not permit noncompete provisions, except in connection with the sale of goodwill, in which case a noncompete provision may be imposed in the geographic area that the Seller engaged in business.

The requirement that the sale include goodwill has important tax considerations discussed below. It is important not to overreach with a noncompete provision; a recent California case held that an over-reaching provision was entirely unenforceable. Strategix v. Infocrossing West, Inc., 142 Cal.App.4th 1068 (2006).

Securities
As discussed above in connection with the transfer of licenses, it is often preferable to structure the transaction as a sale of the Seller's stock.

One commonly overlooked fact in connection with this structure is that a sale of stock triggers application of securities laws. While these transactions typically are exempt from the registration requirements of securities laws, they remain subject to the anti-fraud provisions of the 1933 Securities Act, including SEC Rule 10b-5, which essentially requires the accurate disclosure of all material facts in connection with the sale of securities.

Thus, even apart from the provisions in the purchase contract, the Buyer may possess the potent weapon of being able to sue the Shareholders for misrepresentations or failure to make the requisite disclosures required under Rule 10b-5, and this protection is not waivable by contract.

Accounting
The Buyer, particularly if it is a public entity, will have an eye on the accounting treatment of the transaction and will want to minimize any current or future deductions associated with the purchase because such deductions will depress the Buyer's earnings.

For accounting purposes, it will not matter whether the transaction is structured as (a) a direct acquisition of assets by the Buyer; (b) an acquisition of assets by an entity owned by the Buyer; or (c) the acquisition of the Seller's stock since the latter two situations are treated identically to the first by accounting rules that consolidate the Buyer and all of its controlled affiliates.

For accounting purposes, the purchase price is first allocated up to the market value of all specifically identifiable assets, such as receivables, film rights, etc., and the balance is allocated to goodwill.

The amount allocated to specifically identifiable assets is subject to depreciation or amortization, typically using income forecast amortization for film rights (discussed below).

But the balance that is allocated to goodwill is not deducted unless and until some later event occurs that impairs the value of that goodwill, such as abandonment of an acquired trademark. This accounting treatment can be extraordinarily beneficial since it avoids any deduction for the amount of the purchase price allocated to goodwill.

To the extent that the purchase price is allocated to particular film rights, the film rights are amortized using income forecast amortization, which, in the case of acquisition of a film library, requires the purchase price to be amortized pro rata against the income expected from the library over the first 20 years after the date of acquisition.

This approach often results in most of the purchase price for particular films being deducted over the first several years since most films earn the bulk of their income in the early years.

Taxation
For tax purposes, the Buyer will have motivations diametrically opposed to the accounting treatment since the Buyer typically will want to maximize its deductions. In most cases, the Buyer will want to avoid IRC section 197, which requires 15-year straight-line amortization of the cost of acquiring a film library if it constitutes the acquisition of a trade or business.

A film library will constitute a trade or business for this purpose if, in the hands of either the Seller or the Buyer, goodwill or going concern value could under any circumstances attach to the assets. In general, the acquisition of a trade or business will be indicated if, in connection with the acquisition of assets, (a) there are any covenants not to compete, management contracts, or continuing employees or (b) the assets constitute a trade or business in the hands of the Seller.

The acquisition of any trademark automatically constitutes the acquisition of a trade or business, unless the trademark is part of a film (like the title) and is used only in connection with exploitation of that film.

If the Buyer attempts to avoid Section 197 by not acquiring goodwill, it will run into two competing considerations: (a) it will not be able to impose an enforceable covenant not to compete under California law (since such covenants only are enforceable in connection with the sale of goodwill); and (b) it will lose the ability to allocate a portion of the purchase price to goodwill for accounting purposes.

If Section 197 is avoided, then the Buyer may use the income forecast method for tax purposes, which permits the cost of each film right to be amortized in proportion to the income expected to be earned over the first 11 years after the date of acquisition. This approach generally will result in a substantial acceleration of the deduction of the purchase price since most film income is earned early in a film's life.

If the transaction is structured as the acquisition of ownership of the Seller, the tax consequences depend on what type of entity the Seller is:

?If the Seller is treated as a partnership (including a limited liability company, unless it has elected to be treated as a corporation), then the tax treatment is identical to the treatment of the acquisition of assets, described above.

?If the Seller is a corporation, then in most cases the Buyer must capitalize the entire purchase price to the stock purchased, for which Buyer is not entitled to any deductions at all. However, if the Buyer is itself a corporation and if the Seller is either an S corporation or a member of a consolidated corporate group, then the Buyer and the Shareholders may jointly make an election to treat the transaction identically to an asset sale.

Bankruptcy
Often, the Seller may be financially strapped or teetering on the brink of bankruptcy. Whenever the Seller is in dire financial straights, the Buyer typically does not want to acquire stock because the Seller's liabilities may cause it to be worthless.

In this case, the Buyer will want to structure the transaction as an asset sale, but there is a significant risk that an asset sale may be set aside as a "fraudulent conveyance" if the Seller subsequently goes into bankruptcy and if a court finds that the sale price was less than the market value of the assets sold. There are several ways to deal with this concern:

?Obtain an appraisal from a qualified third party. However, this appraisal may take time -- typically in short supply if the Seller is on the brink of bankruptcy -- and the appraisal will not be binding in court.

?Have the Seller declare bankruptcy prior to the sale, and petition the court for a sale of the assets under Bankruptcy Code Section 363(g). The problem with this approach is that it opens the sale up to an auction process monitored by the bankruptcy court, which typically is not acceptable to the Buyer.

?Have the Seller make an "assignment for the benefit of creditors." Under this approach, the Seller transfers all its assets to a trustee, which sells the assets to the Buyer, distributing the proceeds to the creditors of the Seller. While technically this approach does not prevent the Seller's creditors from bringing an involuntary bankruptcy petition to force the process into bankruptcy court, in many cases the creditors are mollified by the perception of an impartial trustee administering the liquidation process, so they acquiesce in this non-bankruptcy liquidation procedure.

Conclusion
There are often competing considerations on the fundamental question of whether the film library purchase should be structured as the acquisition of assets or stock, and there are competing considerations between the treatment for accounting (where the desire is to minimize deductions) and tax (where the desire is to maximize deductions).

So not only must the Buyer deal with all the obvious conflicting issues with the Seller, it must also resolve its own internal conflicts (often waged between lawyers with different specialties), which makes acquiring film libraries challenging -- and fun.