Many business owners and entrepreneurs choose to form a limited liability company (“LLC”) over a corporation, in part, to avoid the administrative burdens and rigidity that often accompany the corporate form. One of the most onerous burdens placed upon corporations is the regulation of the sale of securities (e.g., stocks) by both federal and state governments.
What may come as a surprise to both business owners and investors alike is that federal and Idaho securities laws can apply with equal force to interests in LLCs.
Being caught by surprise in this context can be very costly. Federal and Idaho securities laws require that any offering of securities either (i) be registered with the appropriate regulatory department or (ii) fall within an exemption from such registration. Failure to adhere to federal or state securities laws or regulations can result in civil or criminal penalties and provide investors a right of rescission (i.e., a right to demand back their investment). Further, any person connected with the offer or sale of a security may be subject to federal and state securities anti-fraud provisions.
Determining whether an interest in an LLC is a “security” for purposes of federal or Idaho securities laws is therefore imperative. Moreover, this determination must be made before LLC interests are offered to others.
I.Statutory Definition of Security
Under federal law, the Securities Act of 1933 and the Securities Exchange Act of 1934 (the “’33 Act” and the “’34 Act,” respectively) both essentially define the term “security” as any note or stock or bond or debenture, or as any number of other terms, including a catchall term—“investment contract.” As LLCs did not yet exist when the ’33 Act and the ’34 Act were enacted, a determination of whether an LLC interest constitutes a security for purposes of federal law will hinge on whether it qualifies as an investment contract in this context. Neither the ‘33 Act nor the ‘34 Act further define the term investment contract.
The Uniform Securities Act of 2004, adopted in Idaho, also defines the term security to include an “investment contract”, Idaho Code § 30-14-102(28). The Uniform Securities Act, however, goes on to expressly provide that an “investment contract” includes an “interest in a limited partnership and a limited liability company”, Idaho Code § 30-14-102(28)(e). It is unclear whether this statutory language means that (i) every interest in any LLC must be construed as an investment contract under Idaho law, or (ii) an interest in an LLC may be construed as such only so long as other conditions are satisfied.
Idaho courts have not answered this question, but have continued to analyze potential investment contracts using an analysis similar to the one used by federal courts to interpret federal law, which does not assume interests in LLCs are securities per se. Nonetheless, under the plain meaning of Idaho statutory language, an interest in an LLC may be construed as a security even if it fails the applicable tests under federal law.
II.The Howey Investment Contract Test
The Howey test was developed by the U.S. Supreme Court in the decision S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946) and is used by both Idaho and federal courts to determine whether a particular arrangement qualifies as an investment contract subject to securities laws. The Howey test requires four elements be satisfied to qualify as an investment contract: (i) an investment of money, (ii) a common enterprise, (iii) with a reasonable expectation of profits, and for those profits (iv) to be derived from the entrepreneurial or management efforts of others.
The first three elements of the Howey test are found in nearly all business endeavors. First, an investment of money can be satisfied by the contribution of personal or real or intangible property as well as the contribution of services. Second, common enterprise will be found if investments from others are pooled together or if the interests of investors are connected to those promoters of the investment. Third, nearly every purchaser of an LLC interest does so with an expectation of profits.
The question often turns on the fourth element that profits are to be derived from the entrepreneurial or management efforts of others. This element is clearly present when looking at stocks sold on a publically traded market, where investors remain wholly separated from the business and have no control over the management of the company.
As applied to LLC interests, the applicability of this fourth requirement is less clear. Sometimes each LLC member in a company is actively involved in the management of the business, and thus their LLC interests would not be considered investment contracts subject to the securities laws.
However, often times one or many LLC members are truly passive investors who rely on either a third-party or another member to manage the business. This is particularly true in the case of manager-managed LLCs, which by definition confer management rights to one or more specific individuals and provide members few if any inherent rights regarding management. These LLC interests are at risk of falling within the definition of an investment contract subject to securities laws because the members have little or no control over the company’s business.
III. Determining Whether Profits are Derived from the Efforts of Others
Courts take a fact-intensive look at LLCs and their relationship with members to determine whether profits of an LLC interest are to be derived from the entrepreneurial or management efforts of others. If the LLC member procured its interest without employing its own management skills, the offer or sale of such membership interest may be prohibited by the securities laws unless registered or exempt from registration.
This inquiry looks at several issues to determine whether such economic realities suggest an investment or a management interest in the LLC. The most influential factor in this determination is the amount of control exercised by the members under the LLC agreement.
An interest in a member-managed LLC, which vests management authority with its members, is not as likely to be considered an investment contract under the Howey test. However, courts will look at the economic realities of the relationship at issue to determine whether members as a practical matter exercise meaningful control. For instance, an interest in a member-managed LLC may be considered an investment contract under the Howey test if one or more of the following is true:
- the operating agreement vests ultimate control in others;
- the interests are sold to such large numbers of the general public that the interest does not provide any real control;
- the members lack sufficient business experience and knowledge to exercise management rights possessed by such member or members; or
- the members are, in fact, dependent upon the ability of a promoter or manager because of some unique expertise on the part of the promoter or manager.
On the other hand, an interest in a manager-managed LLC is not necessarily considered a security. Rather, where a manager enjoys only ministerial duties and the members retain robust management rights, or where the members can easily replace the manager or otherwise exercise meaningful LLC powers, interests held in such manager-managed LLCs may not be considered securities.
The onerous state and federal securities laws cannot be avoided by business owners and investors by relying on the LLC entity structure rather than a corporate entity structure. If an LLC interest is an investment contract, it is unlawful to offer or sell such interest without registering the sale or falling within an exemption from registration. If you are concerned about your LLC interests please contact one of our business attorneys both to advise you on whether such interest falls within the securities laws and whether an exemption to registration may apply.
For more information, please contact our Business Group or call 208.344.6000.