Crowdfunding: The Brave New World in Project Financing

by  Victoria Burke

Remember in the movie Field of Dreams when Ray Kinsella hears a voice whispering to him, “If you build it, he will come?”  For the entrepreneur, the concept of crowdfunding is built on a similar premise:  If you dream it, they will fund it.  Raising capital is not easy for any venture.  This is especially true in today’s market, where securing investors for a project can be downright impossible.  Furthermore, some people just feel that dealing with banks or pitching to sophisticated investors isn’t their cup of tea.  Perhaps they fear making a Faust-like contract to finance a dream.  For all of these reasons and more, innovative funding can often be the defibrillator needed to resurrect a dying project.

Crowdfunding involves raising a delineated amount of money from a large pool of investors (often via small increments) for a common effort.  The idea relies on the “it takes a village” approach to succeeding at fundraising for a project, cause, or business enterprise.  The fundraising takes place through an internet campaign hosted by a funding portal.  The campaign has a set deadline, and ideally donors pledge money.  Crowdfunding web sites charge the principal an administrative fee based on a percentage of the money raised.

But crowdfunding can be tricky – avoiding Securities and Exchange Commission (SEC) entanglements while crowdfunding is like navigating around the Minotaur in the labyrinth.  Where there is profit on investment, there is likely a security.  And where there is a security, a ton of SEC regulations always follow.  Section 2(1) of the Securities Act of 1933 includes an “investment contract” within its definition of a security.  To determine if an investment contract exists, the United States Supreme Court developed the Howey Test.  SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946).  Under this test, an investment contract exists when “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.”  What exactly equals a “profit” is not always clear.

Several varieties of crowdfunding exist.  One type utilizes debt capital.  The crowd of investors extends money that will ultimately be paid back.  Business owners who feel it is better to be indebted than owned often prefer this method.  However, one possible issue is “crowdfunding sites organized on the lending model probably are offering securities if the lender is promised interest.” C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 31 (2012).  In these situations, interest acts as profit.

Another popular crowdfunding format is raising donations for projects or causes. Many users implement the donor/reward model to attract funding.  Under this methodology, the donor will get something of value as consideration for his or her funding donation.  Principals utilizing this format are typically indie filmmakers, musicians, fashion designers, inventors, artists, and humanitarians.  They might draw from a pool of investors comprised of film buffs, fans, philanthropists, techies, etc.  In exchange for the funding donations, they often reward donors with a copy of the finished product (film DVD/band CD/invention itself), a mention in the credits, having a character named for them, receiving a personal phone call, a simple t-shirt, etc.  Yet, in these situations, the reward itself may prove to be a liability.

Speculation continues as to whether this kind of reward system constitutes an investment contract.  This concern mainly arises when a reward is not necessarily nominal.  Notably, many jurisdictions have adopted the “Hawaii Market Test” to determine if an investment contract exists.  State v. Hawaii Mkt Ctr, Inc., 485 P.2d 105, 109 (Haw. 1971).  This test is similar to the Howey Test, however, under the language of this test, the donor/reward relationship could be open to interpretation as to whether it constitutes an investment contract.  The waters turn murky in the third prong where the test states “the furnishing of the initial value is induced by the offeror’s promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise.”  Does a reward constitute a “valuable benefit of some kind” when it is “above the initial value?”  For example, let’s say a person donates $100 for the development of a gadget.  As a reward, the person is guaranteed one of these gadgets.  If the gadget receives a market value of $500, is this now an investment contract because the benefit rises above the initial value?

The final crowdfunding format is one in which an Average Joe gains an equity stake in a start-up business or project by connecting with the issuer through a third-party funding portal.  Currently, this method is illegal.  However, on April 5, 2012, the President signed into law the Jumpstart Our Business Startup Act (the “JOBS Act”).  This law contains the important Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (the “CROWDFUND Act”).  The CROWDFUND Act contains exemptions to current federal securities laws.  Additionally, as per this new law, funding portals dealing with the sale of securities must register with the SEC.

Some of the significant CROWDFUND Act exemptions are:

(1)              Issuer can offer or sell securities to raise up to $1,000,000 over twelve months.

(2)             If an investor’s annual income or net worth is less than $100,000, he or she can invest the greater of $2,000 or 5% of his or her annual income or net worth.

(3)            If an investor’s annual income is equal to or more than $100,000, then he or she can invest 10% of his or her annual income or net worth, not to exceed a maximum investment of $100,000.

It’s best to proceed with caution and keep in mind that the ink is very wet on these changes.  The SEC has 270 days from the time the law has been enacted to establish new governing rules and standards.  Perhaps these rules will further address the public policy concern of protecting the unsophisticated buyer (such as retirees).  Moreover, the SEC has emphasized that until these new rules are set, “any offers or sale of securities purporting to rely on the crowdfunding exemption would be unlawful under federal securities laws.”

Victoria Burke attained her juris doctor degree from Southwestern Law School and is admitted to practice in California.  Her area of interest is intellectual property with an emphasis on trademarks, copyrights, and fashion law.  She is a member of the executive committee of the Beverly Hills Bar Association IP/Internet & New Media Section.

Roll Trademark, Roll: The University of Alabama’s Battle for Trademark Protection

by Jordan S. Paul

On June 11, 2012, artist Daniel Moore finally prevailed in his 10-year battle for the right to create paintings and prints of the University of Alabama’s “Crimson Tide” football team.

Since 1979, Daniel Moore has been painting celebrated moments from the Crimson Tide’s storied history.  Many of these paintings depict realistic portrayals of action scenes and often include the University of Alabama’s iconic crimson and white helmets and uniforms.  Moore has also created derivative works of these paintings on mugs, mini-prints, cups, flags, towels, and t-shirts.

 Mr. Moore’s work did not go unnoticed by the University of Alabama.  In fact, the University of Alabama had been commissioning, purchasing, and reselling Moore’s work since 1991 and continued to do so through 1999.  As part of this arrangement, Moore and the University of Alabama entered into numerous licensing agreements that permitted Moore to use additional University trademarks and granted permission to Moore to say that his art was “officially licensed.”  However, during this period, Moore also created numerous unlicensed prints, paintings, and related products depicting University of Alabama football players and scenes.  Some of these were  sold by the University of Alabama in its campus store and one unlicensed painting even adorned the University’s athletic department office.

Despite the University of Alabama’s knowledge that Moore was creating numerous unlicensed works, it did not demand royalties until 2002, eventually commencing litigation in 2005, in which it accused Moore of breach of contract, trademark infringement, and unfair competition.

In 2009, the Northern District of Alabama held that (1) the prior licensing agreements did not require that Moore receive permission to portray the University’s uniforms because the uniforms were not included in the agreements’ definition of “licensed indicia”; (2) the University’s colors had some secondary meaning but were not especially strong marks on the trademark spectrum; (3) Moore’s depiction of the uniforms in paintings and prints was protected by the First Amendment and also was a fair use; and (4) Moore’s depiction of the uniforms on mugs, calendars, and other “mundane products” was not protected by the First Amendment, was not a fair use, and would likely result in consumer confusion.  In its decision last week, the Eleventh Circuit affirmed and reversed the District Court’s ruling.

With respect to the prior licensing agreements entered into by Moore and the University of Alabama, the Eleventh Circuit agreed that there was ambiguity as to whether Moore was allowed to depict Alabama uniforms in unlicensed products.  To resolve this ambiguity, the Eleventh Circuit agreed that it was proper to examine the course of conduct between the parties, noting that Moore’s continued unrestricted use of Crimson Tide uniforms and helmets was known, tolerated, and even monetized by the University of Alabama.  Therefore, the Eleventh Circuit affirmed the district court’s ruling that the parties’ course of conduct indicated that neither Moore nor the University of Alabama had any expectation that the licensing agreement would prohibit Moore from engaging in unlicensed work that incorporated Crimson Tide uniforms or helmets:

The parties’ course of conduct clearly indicates that they did not intend that Moore would need permission every time he sought to portray the university’s uniforms in the content of his paintings, prints and calendars.

Nor was the University of Alabama any more successful on its trademark infringement claims.  Ultimately, the Eleventh Circuit agreed that Moore’s First Amendment Rights outweighed any likelihood of confusion that may flow from his incorporation of Crimson Tide helmets, uniforms, or associated colors, holding:

An artistically expressive use of a trademark will not violate the Lanham Act unless the use of the mark has no artistic relevance to the underlying work whatsoever, or, if it has some artistic relevance, unless it explicitly misleads as to the source or the content of the work.

Even if some members of the public would draw the incorrect inference that [the University] had some involvement with [Moore’s paintings, prints, and calendars,] . . . that risk of misunderstanding, not engendered by any overt [or in this case even implicit] claim . . . is so outweighed by the interest in artistic expression as to preclude” any violation of the Lanham Act.

But, with respect to the mini-prints, cups, flags, towels and t-shirts, the Eleventh Circuit rejected the district court’s ruling that these products were covered by the licensing agreements and could only be created by Moore subject to those agreements.  In so doing, the Eleventh Circuit remanded the case on this issue and ordered the District Court to more fully develop the record with regard to Moore’s First Amendment and fair use defenses.

Of course, this decision is a decisive win for Moore.  And, in a larger sense, it is another step closer to greater clarity and resolution of the longstanding tension between trademark and First Amendment Rights, first explored in depth in by the Second Circuit in Rogers v. Grimaldi, 875 F.2d 994 (2d Cir. 1989) and by the Sixth Circuit in ETW Corp. v. Jireh Pub., Inc., 332 F.3d 915, 925 (6th Cir. 2003).  For trademark owners, the takeaway could not be clearer:  develop and institute a focused and comprehensive IP management policy that vigilantly “polices” your marks, or risk diminution of their value – or, worse, lose the right to control them completely.  For content owners, this case is an ostensible win, but it should caution those who stray too far from First Amendment expression and into intellectual property misappropriation.

Jordan Paul is an attorney with Robins, Kaplan, Miller & Ciresi L.L.P. where his practice focuses on intellectual property and complex commercial matters, with an emphasis on copyright infringement and contract disputes in the entertainment industry.

Supreme Court Provides Patent Litigators with a Retooled Argument in Prometheus

by Elizabeth Swanson

The United States Supreme Court recently provided litigators with a retooled weapon for invalidating patents in its Mayo Medical Labs et al v Prometheus et al (Supreme Court, 20 March 2012) (“Prometheus”) decision.  35 USC § 101 states: “Whoever invents or discovers any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, may obtain a patent therefore, subject to the conditions and requirements of this title.”

Typically, in litigation, patents are invalidated because the claimed matter is not patent-able based on §§ 102 and 103 (anticipation and obviousness, respectively) due to conflicting prior art, not because they are patent-ineligible based on §101.  In fact, §101 is relatively rarely used by courts to invalidate patents.

The patent at issue in Prometheus claimed a patent in a method of finding the optimal level of a drug whose levels varied widely from patient to patient.  The patent claimed the steps of (1) “administering a drug” to a patient and (2) “determining the [resulting metabolite] level”.

The first time that Prometheus was before the Federal Circuit, the Court applied the “machine or transformation test” to the matter and found the patent valid under that test.  The case then went up to the Supreme Court, which determined in June 2010 that the “machine or transformation test” was not the sole test available, but that there were other available tests based on the plain language of §101. The case then was remanded to the Federal Circuit, which again found the patent at issue to be valid. When the case arrived before the Supreme Court for a second time in March 2012, the Court issued more language regarding invalidation under §101.

The Supreme Court disagreed with the Federal Circuit:  “The question before us is whether the [patent] claims do significantly more than simply describe these natural relations.  To put the matter more precisely, do the patent claims add enough to their statements of the correlations to allow the processes they describe to qualify as patent-eligible processes that apply natural laws?  We believe that the answer to this question is no.”

After examining each of the Prometheus claims individually, the  Supreme Court summarized: “The upshot is that the three steps simply tell doctors to gather data from which they may draw an inference in light of the correlations.  To put the matter more succinctly, the claims inform a relevant audience about certain laws of nature; any additional steps consist of well understood, routine, conventional activity already engaged in by the scientific community; and those steps, when viewed as a whole, add nothing significant beyond the sum of their parts taken separately.  For these reasons we believe that the steps are not sufficient to transform unpatentable natural correlations into patentable applications of those regularities.”

Since Prometheus, there have been several decisions issued in patent cases that draw on or reference Prometheus.  The district court in Washington, D.C. followed the Prometheus guidelines step for step and invalidated a method patent that used a computer to guide the selection of therapy for patients.  In contrast, the Northern District of California validated a patent, stating that it did not run afoul of §101 because it did “more than recite an abstract idea and say ‘apply it’” (language quoted directly from the Supreme Court’s second Prometheus opinion).

So, litigators take note:  Even if a method patent can be argued to satisfy the “machine or transformation test,” it still may be found invalid and ineligible for patent protection under §101 if the patent does little more than – in the Court’s opinion – restate a natural law.

Elizabeth Swanson’s Century City practice includes all aspects of patent, trademark and copyright prosecution, trade secret management, and also includes infringement matters and litigation.  Ms. Swanson has been practicing only IP law for over 22 years.

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