Are your LLC interests securities?

An issuer, purchaser or seller of an interest in a limited liability company (LLC) must consider whether the LLC interest constitutes a “security” under state and federal securities laws. If an LLC interest is a “security,”

(1) the issuance and transfer thereof must be registered or satisfy an exemption from registration, (2) purchasers are protected by anti-fraud rules,

(3) broker registration likely is required for anyone compensated for selling the LLC interest, and (4) state and federal regulators have jurisdiction.

Failure to comply with securities laws may trigger, among other consequences, rescission rights, damages, civil and criminal penalties.

A recent opinion by the Court of Appeals for the 10th Circuit in Avenue Capital Mgmt. II, L.P. et al. v. Schaden et al., 843 F3d 876 (10th Cir. 2016) illustrates the analysis federal and Colorado courts apply when examining whether an LLC interest is a security. The plaintiffs in Avenue Capital had purchased an LLC interest in a member-managed LLC and brought securities fraud claims against former officers and managers of the LLC, alleging they misrepresented the LLC’s financial condition.

LLC interests are not listed in the Securities Act of 1933’s definition of “security” and courts instead examine whether an LLC interest is an “investment contract” using the test laid out in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946): an investment contract exists when a transaction involves (1) an investment of money, (2) in a common enterprise, (3) with profits to come solely from the efforts of others. Only the third prong of the test was at issue in Avenue Capital. Courts examine the facts and circumstances, and focus on the level of control an investor has, either alone or as a member of a group, over profitability of the investment. An investment is less likely to be an investment contract the greater control an investor has.

In assessing control, the 10th Circuit considered, among other things, the plaintiffs’ contribution of time and effort to the success of the company, their contractual powers and access to information, finding the plaintiffs had control over the profitability of the investment in three ways and therefore the LLC interests were not investment contracts in the hands of the plaintiffs:

• The plaintiffs combined held approximately 80 percent of the LLC interests and therefore had the power to freely amend the LLC agreement. The court noted that this would enable the plaintiffs to amend the LLC agreement to take direct control or dissolve the company.
• The plaintiffs had the combined power to appoint eight of nine managers and remove the managers they had appointed without cause. The appointed managers selected the CEO, who served as the ninth manager. The managers had power to dissolve the company and also appointed officers controlling daily operations. The court found that the plaintiffs’ power over the managers permitted the plaintiffs to dissolve the company and supervise the individuals in control of daily operations.
• The court found that the plaintiffs were “sophisticated and informed investors, allowing them to make informed investment decisions and intelligently exercise control over” the company. They could receive audited and unaudited financial information, designate non-voting observers to attend board meetings and inspect, examine and copy company books.

The plaintiffs argued that they did not intend to exercise control and instead were relying on the managers and officers to operate the company. The court stated that the control test is objective and what matters is the amount of control the plaintiffs could exercise, not the control they intended to exercise.

The court did not examine whether the LLC interest could constitute “stock” or “instruments commonly known as securities” under the Securities Act of 1933’s definition of “security” because the plaintiff did not raise the issue in the lower court. The 10th Circuit has never decided whether membership in an LLC constitutes “stock” or “instrument commonly known as securities.” The U.S. Supreme Court has noted five characteristics of a “stock”: (1) the right to receive dividends contingent upon an apportionment of profits; (2) negotiability; (3) the ability to be pledged or hypothecated; (4) voting rights in proportion to the number of shares owned; and (5) the capacity to appreciate in value. Research did not reveal any case in which a federal court has found that an LLC interest was “stock” for purposes of the Securities Act’s definition of “security.” Further, courts apply the “investment contracts” analysis when analyzing whether an investment constitutes an “instrument commonly known as a security.” Therefore, analyzing whether an LLC interest is one or the other should presumably reach the same result.

Issuers, purchasers and sellers of LLC interests are well-advised to analyze whether such LLC interests are securities. If in doubt, it would be prudent for issuers and sellers to assume that state and federal laws apply, and purchasers the opposite, in most cases.