A federal law known as the 1933 Securities Act (15 U.S. Code Section 77b(a)(1)
) defines security as:
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.
Although the term “LLC membership interest does not appear in the above definition of security that does not mean that LLC membership interests are never securities. If a membership interest is considered “an investment contract” then for federal securities law purposes the membership interest is a security.
The term “investment contract” was defined in the famous U.S. Supreme Court securities law case called “SEC v. Howey, 328 U.S. 293 (1946). In the Howey case the U.S. Supreme Court found that the sale of real estate was an investment contract and therefor a security under the 1933 Securities Act. The court said:
[A]n investment contract for purposes of the Securities Act means 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 . . .
(328 U.S. at 298). Later court opinions have loosened the “solely” part of this definition with the result an investment contract exists if the purchaser of the investment contract expected that profits would be derived primarily through the efforts of others. In other words if the promoter says give me money and you can site back on the couch while we make profits for you then you are buying an investment contract, which is a security.
Courts that have considered whether California LLC membership interests have used the general partnership vs. limited partnership analysis. The general rules are that: (i) a general partnership does not involve the issuance of a security because all of the general partners have management powers, and (ii) a limited partnership issues a security when it issues a limited partnership interest because limited partners by definition lack management powers. Many California securities attorneys believe that courts will equate member managed LLCs with the general partnership and manager managed LLCs with the limited partnership.
The courts may find that California LLCs that are manager managed that issue membership interests are issuing securities to the non-manager members in the form of investment contracts. The courts may also find that California LLCs that are member managed do not involve investment contracts or securities, but if a member is prohibited from being involved in management the court may find that the member acquired a security in the form of an investment contract.