Clear Your Mind: Episode IV - Managing Risk and Deal Finance
Continuing our countdown to the release of Star Wars Episode IX, sports and media lawyer and lifelong Star Wars fan, John Devine, looks at what the saga can teach us about financing a deal. We don’t want to run into any bounty hunters do we?
“Do, or do not, there is no try.” Yoda, Episode V: The Empire Strikes Back
Deciding whether or not it’s a good idea to invest your own money in a project you care passionately about is an interesting dilemma; just ask any football club owner.
Don't lower your defences
Having created a global phenomenon with the original film and reaped the financial rewards of the realisation of his vision, Star Wars creator George Lucas almost immediately turned his attention to the much anticipated sequel. He chose to set up a special purpose vehicle (SPV) subsidiary company, The Chapter II Company, to undertake the production.
Lucasfilm’s treasurer, Richard Tong said: “It was established because you wanted to isolate the financial and operating risks of a new production, and to limit the potential liabilities that may arise out of a new production”.
A sister company, Chapter II Productions Limited, was also incorporated in England, subject to English law, since much of the principal photography and visual effects would take place at Elstree Studios.
Creating a group corporate structure where, under English law, a new SPV company is formed to be the ‘subsidiary undertaking’ (as defined in s1159 Companies Act 2006) of the existing business (its ‘parent’) is a common approach adopted by many businesses embarking on a major new project.
This helps to manage risk, especially where the new venture is related to but needs to be kept separate from (and not endanger) the core business. It is also important to consider the SPV’s legal registration and jurisdiction to optimise its tax efficiency.
Independence - there will be no bargain
From the position of strength he now commanded from both the success of Episode IV: A New Hope and the rights he’d already retained, Lucas began negotiations with Fox, making it abundantly clear he would be revising the profit split between Lucasfilm and Fox and that any deal would have to include the remaining licensing rights to both his movies and his characters.
Fox director, Warren Hellman recalled: “We had a bunch of lawyers who said, ‘you can’t simply give away property rights’! We voted and I think it was a six to five vote, because someone made the point you can’t own his children”. 
Lucas also held firm on the sequel rights he had managed to secure to Lucasfilm on the first movie. If Fox wanted in, it would be on his terms. Realising that a smaller share of something was better than arguing over a bigger share of nothing if Lucas walked, Fox agreed to distribute the movie only.
Diversify income streams
“The thing Fox did not expect was that I would pay for it and that was what shifted everything,” Lucas said. He financed the movie with Bank of America and signed the sequel contract with Fox in September 1977, with gross receipts being split between producer (Lucasfilm) and distributor (Fox) on a banded sliding scale in favour of Lucas; rising to a potentially lucrative 77.5% (Lucasfilm): 22.5% (Fox) for anything over $100 Million.
The better the movie did, the more Lucas could consolidate his position as an independent filmmaker. He backed himself, the strength of the story he wanted to tell and the audience’s willingness to come along for the ride.
Crucially, the producer would also get ‘final cut’; so Fox could not compel him to edit the movie if it did not think Empire’s brilliant ‘twist’ was one the public would accept and ultimately want to see.
The management of licensing, marketing and merchandising would revert to another Lucasfilm subsidiary, Black Falcon Ltd, on an initial 80/20 profit split with Fox in Lucas’ favour, rising to 90/10 from 1981. Lucas was no longer solely reliant on just the box office numbers to generate revenue from his creations.
While the diversification of income streams was key to the group’s success, the power shift in the cinema had also changed markedly in a relatively short period. The Chicago Tribune noted that, on Episode IV; A New Hope, Lucasfilm had made just 17 cents from every $4 ticket sold, while Fox enjoyed a return of $2.05 plus $1.20 for distributing the original film. On Empire, Lucasfilm would take $2.74 for every $4 ticket sold, with Fox receiving 68 cents.
What happens when costs overrun?
The original budget for Empire was set at $18 Million. Set construction alone was estimated at $3.5 Million. By comparison, Star Wars had been budgeted at $8 Million and came in over at $11 Million. This movie was always going to push the boundaries, both on and off screen; but when production, shooting and related costs overran by $5 Million, Bank of America, pulled their loan.
That was Wednesday. Lucasfilm still had to somehow make a $1 Million payroll the following Friday.
Lucas said “We were like twenty per cent away from finishing the movie and I was afraid I was going to have to go back to Fox and beg forgiveness. I would have to give them the movie and then I wouldn’t have my freedom”.
He had to find another $5 Million, and quickly, to get it over the line. “The despair was we had to find the money as quickly as possible. We had to make payroll. So we said we’d pay everybody every other week instead of every week.
That was a delaying tactic until we could actually find a way out. The big question was, could we get it done in time? I was trying to keep the picture going and we couldn’t let the cast and crew realise that we were in financial trouble – we had to go on as if everything was fine”.
A new hope
In critical situations such as these, it’s important to take professional advice. Under English law, company directors owe duties to creditors as well as their shareholders, so it is vital that they are cognisant of and able to exercise their statutory law duties to ensure that the company remains solvent and able to pay its debts as they fall due.
“I’m faced with a situation where everything I own, everything I ever earned, is wrapped up in Empire. If it isn’t a success, not only could I lose everything, but I could end up being millions of dollars in debt, which would be difficult to get out from under. It would probably take me the rest of my life just to get even again. It has to be the biggest grossing sequel of all time just for me to break even”.
Timing was critical. Lucas managed to refinance the movie “in something like 10 days” with First National Bank of Boston at around $31 Million under the terms of a ‘revolving credit agreement’, comprising a bank loan of almost £28 Million. The top slice of $3 Million above the $28 Million mark was being guaranteed by Fox in return for principal terms to distribute the third film (which eventually became Episode VI: Return of the Jedi). Fox also seized that opportunity to negotiate a more favourable distributor/producer split of gross box office receipts than they had on Empire.
Lucas noted “I wanted my independence so badly, we managed to do it in a way that I paid Fox just a little bit more money. But they didn’t get any of the licensing and they didn’t get the sequels. If I had to pay a few extra points, I could do that. I think Fox was just as concerned as we were that the movie get finished”.
Expert advice is key
A corporate refinancing is a complex legal and financial transaction, particularly when dealing with creditor(s) who have their interests secured.
This is often achieved on major capital loans by a document known as a ‘debenture’, which is executed in favour of a lender and contains a binding contractual promise (a ‘covenant’) to, firstly, repay that lender and, secondly, grant security over the whole (or substantially the whole) of a borrower company's assets.
In most cases, the security created by a debenture would comprise a ‘fixed charge’ over those company’s assets which are not disposed of ‘in the ordinary course of its business’ and a ‘floating charge’ over the remainder of the company's business.
Professional advice on the loan and security terms are key. They are particularly useful because, under English law, while the existence of the charge is registered publicly at Companies House, the financial terms are not disclosed.
By the time production had wrapped and all costs were in, it was estimated that Empire would have to earn over $57 Million in order to make a profit. This included over $6 Million in interest from the refinancing, the cost of production at $30.5 Million and Fox’s distributor fee of over $20 Million.
But the refinancing had meant that Lucasfilm, the ultimate parent company, had to borrow and guarantee the loans directly itself. Despite the initial efforts to ringfence it from risk by using the Chapter II subsidiaries, if the film was not successful, Lucasfilm itself was now exposed.
In business, there is no such thing as luck
Empire has to date grossed $538.4 Million. As the (highly recommended) documentary film, Empire of Dreams, recalls - Lucas had , in essence, ‘bet the farm’ and won. In my personal view, it’s the best film of the saga too, proving the old adage that nothing worthwhile in life ever came easy…
So, the lessons we can take away here are:
- Consider using a special purpose vehicle subsidiary company (and/or, if appropriate for tax efficiency, a company incorporated in the local jurisdiction of your place of supply of services) for any significant new venture in order to ringfence the core business from both operating and financial risk, while optimising tax efficiency. Take professional advice before you proceed.
- Ensure that financial management budgeting and reporting allows you to remain in control of your company’s finances, otherwise you could be at risk of trading while insolvent. Under English law, directors owe and must comply with their statutory duties under the Companies Act 2006 and should also be mindful of ‘wrongful trading’ (where they ought to have known that the company was unable to pay its debts as they fall due) and ‘fraudulent trading’ (where they did actually know that the company was unable to pay its debts as they fall due), both of which are criminal offences.
- Where refinancing is needed, take professional advice as early as possible. Prudent legal action can, depending on the circumstances, ultimately help to save a business in financial difficulty and, even if this is not feasible, will ensure that your board members have acted appropriately and lawfully at all times, mitigating any potential risks of their personal liability.
“I don’t…. I don’t believe it.” Luke Skywalker“That, is why you fail.” Yoda, Episode V: The Empire Strikes Back
Note: Star Wars®™ and all related character names are copyright © and the exclusive property and trademarks of Lucasfilm Entertainment Company Ltd. LLC, which are referenced here only for the purposes of the illustration of legal concepts in general terms only. Muckle LLP is no way affiliated to nor associated or connected with Lucasfilm Entertainment Company Ltd. LLC, Lucasfilm Ltd.™ or LFL Ltd.™ or any of their respective film(s) or franchise(s). This document and its contents are not endorsed by Lucasfilm Ltd.™ or any of its affiliates.
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