In our conversations with clients, we often are asked, “When are limited liability company interests a security?”
Section 2(a)(1) of the Securities Act defines the term “security” as follows:
“The term ‘security’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security,’’ or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” [Emphasis added]
Most state definitions of securities closely mirror the federal definition.
Supreme Court’s Definition of ‘Investment Contract’
In 1946, the U.S. Supreme Court further defined the term “investment contract” when it determined that “an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor, was an offering of an ‘investment contract’,” U.S. v. Howey, 328 U.S. 293 (1946). The Supreme Court held that: “The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”
Based on Howey and subsequent case law, the current standard for determining whether an investment constitutes an “investment contract” has been reduced to a four-prong test (called the “Howey 4-Prong Test”) including:
- An investment of money
- In a common enterprise
- With the expectation of profit and
- Based solely on the efforts of the promoter or a third party.
Based on this test, here is a good rule of thumb: Whenever you take control of an investor’s money, and that person is relying on someone other than himself or herself to make a profit, you have created a security.
When are Limited Liability Company Interests a Security?
How does this translate to interests in a limited liability company?
When forming a limited liability company, you generally have two choices: Will it be managed by the members or managed by a manager? In some states, you are required to make this election when filing the formation documents with their secretary of state or other business formation agency.
A member-managed limited liability company, in which all members participate in management of the company, is not treated as an investment contract, as it does not meet the fourth prong of the Howey Test, primarily because all members are presumed to be “managing members” and each is relying on his/her own efforts to generate a profit.
Conversely, forming a manager-managed limited liability company, where there are one or more managers and passive investor-members, always creates a security because the passive investors will be dependent on the manager to generate a profit on their behalf, thus meeting the fourth prong of the Howey Test.
If you would like to know more about member-managed limited liability companies, read our article “Joint Ventures or Securities -What’s the Difference?”