Selling interests in LLCs: what you were afraid to ask about the securities laws
You have a small company and formed the business as a limited liability company. You think that securities laws are only for large companies. But If you think that the Securities and Exchange Commission is not interested in selling some membership interests in your LLC, you may want to think again – and read this article.
You have to be worried about federal and state securities laws only if you are selling securities. The big question is whether membership interests in an LLC are “securities.” The sale of certain limited liability company interests may fall within the ambit of a securities transaction. This article addresses the question of whether ownership interests in a LLC are subject to securities laws. In the next article, we will discuss what are the implications of treating the sale of ownership interests in a LLC as a securities transaction. Then you need to think about who you can sell those LLC interests to and who can represent your company in finding investors.
Related article: Selling a Small Business: Not as Easy as you Thought
What are limited liability interests?
You have a limited liability company and the company issues some sort of indicia of ownership that may be called ownership interests or membership interests or some sort of combination of those words depending on the jurisdiction in which the LLC was formed. Some courts have referred to ownership in a LLC as a hybrid between a corporation and a partnership.
In general, in whatever jurisdiction the LLC is formed, members are getting two different rights. One is the right to receive distributions, which is what you would get if you were getting stock in a corporation. The second is what is known as non-economic rights, such as the right to participate in the deliberations of the company. Depending on the operating agreement for the LLC, some of the owners may be getting economic rights but not non-economic rights, similar to a limited partnership. The major question is whether rights as represented by interests in a limited liability company are securities.
The Securities and Exchange Commission regulates “securities”
So you have this bundle of rights and now you want to know whether it is a security. The Securities Act of 1933, Section 2(a) provides this definition of a security: “The term ‘security’ means any note, stock…transferable share, investment contract…” One court gave this definitive rule: “LLCs are particularly difficult to categorize under the securities laws.”
The courts have looked at various rights in a company to determine whether the right is a security to determine whether the ownership interest in a LLC is an investment contract. You probably first want to know what an investment contract is. In a case from 1946, the Supreme Court defined “investment contract” as “a contract, transaction or scheme whereby 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.” SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946).
This definition has been refined into a three-element test named of course the “Howey test”. Under the Howey test, the plaintiff is required to establish that the contract or transaction at issue was: (1) an investment, (2) in a common enterprise, (3) with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
If you are selling stock in a corporation, the securities laws by definition apply to you. A share of stock is a security. But what about a membership interest in a limited liability company, which is somewhat like a share of stock in that it represents an ownership interest in the business. It is not a share of stock, but it may be part of what the securities laws call an “investment contract,” which is a security. How does the Howey test apply to ownership interests in a LLC? You would hope that there would be some predictability in the courts’ application of the Howey test.
Figuring out whether ownership interests in a LLC are an investment contract
The courts have not had an easy time grappling with whether a particular LLC transaction comes within the investment contract definition. One court candidly admitted that it is “exceedingly difficult to declare that LLCs, whatever their form, either possess or lack the economic characteristics associated with investment contracts.” When faced with this prickly issue, courts are trying to figure out whether the investor was a passive investor (similar to a limited partner) entitled to the protections of the securities laws or an active investor (similar to a general partner) not entitled to these protections.
The courts may start the discussion with whether the LLC is manager-managed or member-managed, but that only is the beginning of the discussion. The courts have looked closely at the operating agreement to see if the investor has meaningfully participated or could have participated in the management of the company. As one court indicated, this issue “does not turn on whether the investor actually exercised its rights,” but rather on “what ‘legal rights and powers [were] enjoyed by the investor.'”
Federal and state securities laws may come up with different answers
And even if the interest in the LLC may not be a security under the federal securities laws, it may be considered a security under state law. Some states define “security” slightly differently under their own state laws than under the federal Securities Act. For example, in Pennsylvania Section 102(t) of the Pennsylvania Securities Act provides that a “security” includes any membership interest in a limited liability company “of any class or series.” The definition excludes membership interests for which all of the following conditions are satisfied: (A) the company is not manager-managed; and (B) the purchaser of the membership interest enters into a written commitment to be engaged actively and directly in the management of the company; and (C) the purchaser of the membership interest, in fact, does participate actively and directly in the management of the company. Accordingly, the analysis of whether a membership interest in an LLC is a security must be analyzed both under federal law and the controlling state law.
Securities laws may apply to purchase and sale of LLCs
Securities laws may apply to your purchase or sale of membership interests in a limited liability company. If you either a purchaser or a seller, it would make sense to seek the services of a lawyer who can help guide you through maze of securities laws for LLCs. In our next article, we will discuss what happens even if you have a securities transaction, you may be able to meet the requirements of one of the exemptions from registration.