The issuance or sale of securities is subject to regulation by the United States Securities Exchange Commission and by authorities in every state, including the Securities Division of the Office of the Indiana Secretary of State. Depending on the situation, a member’s interest in a limited liability company may or may not be within the definition of a “security” and, therefore, may or may not be subject to federal and state securities laws. If the securities laws apply, the consequences can be signficant because, as my friend and retired securities lawyer Steven Lund says, “There are three types of securities: registered, exempt, and illegal.”
Contrary to what you may sometimes hear, there is no exemption for securities that are issued or sold to family members or close friends, and there is no sale of securities that is exempt solely because the value is less than a certain amount. In addition, certain parts of the securities laws, such as those prohibiting securities fraud, apply to every securities transaction, even if it is exempt from registration requirements. An illegal sale of securities can have serious ramifications, including civil lawsuits and potentially even criminal charges. And there can be ramifications even if there is never a lawsuit or governmental enforcement action For example, a debt incurred through a securities violation cannot be discharged in bankruptcy. Owners of small businesses who set up new LLCs, or bring new members into existing LLCs, without obtaining the advice of a lawyer with experience in corporate and LLC law expose their businesses and themselves to signficant risk.
But if there is no security, there can be no securities violation. The basic definition of a security is called the investment contract or Howey test, named after the U.S. Supreme Court case that first announced the definition, SEC v. W.J. Howey Co., 328 U.S. 293 (1946). As the Howey test currently stands, after being modified a bit by subsequent Supreme Court decisions, a “security” is a contract, transaction, or scheme involving:
- an investment of money or other consideration;
- in a common enterprise;
- with the investor having an expectation of profits, whether from income or from capital appreciation of the investment;
- derived primarily from the managerial or entreprenurial efforts of others.
Courts have had no problem determining that, if the above criteria are satisfied, a member’s interest in a limited liability company is a security. Most LLCs — excluding those that are formed for non-business purposes with no expectation of profits, such as holding a family vacation cottage solely for the members’ enjoyment — satisfy the first three criteria. The question in any particular situation is whether the profits will be derived primarily from the efforts of others. Unfortunately, there are no bright line answers to that question. Instead, each case must be evaluated independently by considering both the LLC itself and the member who holds the interest in the LLC.
In general, if the member has the meaningful right to participate in the management of the company, as well as the expertise and knowledge of the company’s area of business to enable the member to do so, the interest owned by that member is not a security. Or as another court decision, Williamson v. Tucker, 645 F2d 404 (5th Cir. 1981), analyzed the question, if the management structure of the business is similar to that of a general partnership, with all the owners having equal rights to participate in the management of the company, the interest is not likely to qualify as a security. On the other hand, if the management structure is similar to that of a limited partnership, with most of the authority to make decisions about the company’s business and affairs reserved to a small number of owners, the interests of the other owners will likely qualify as securities.
Whether the member has the meaningful right to participate in the management of the company depends, in part, on whether the member has a voice in decisions such as
- admitting or removing a member;
- appointing or removing managers or officers;
- making significant capital expenditures or investments;
- selling or transferring a substantial amount of assets;
- establishing budgets;
- borrowing or lending money;
- acquiring or merging with another entity;
- starting or discontinuing a line of business;
- dissolving the company or filing for bankruptcy;
- issuing capital calls or forgiving an obligation to make a capital contribution;
- initiating, defending, or settling litigation; or
- making a distribution.
It may be obvious that interests in member-managed LLCs are less likely to qualify as securities than interests in manager-managed LLCs, but the analysis cannot stop there. One must consider the rights and authority of members and managers under the Indiana Business Flexibility Act and the LLC’s operating agreement. For example, the operating agreement for a member-managed LLC may delegate certain decisions to a small subset of the members, causing the interests held by the other members to qualify as securities. Or if a majority of the voting rights is held by one member or by a block of members who will generally vote together (such as a married couple), the interests held by the minority members may qualify as securities, even though all members have the nominal right to vote on all decisions. On the other hand, interests in a manager-managed LLC may not qualify as securities if all the members are also managers or if the operating agreement places reserves to the members the authority to make enough crucial management decisions.
If you would like to discuss setting up a new LLC or adding new members to an existing LLC, please feel free to contact us for an initial consultation.