by LLC attorneys Richard C. Keyt, JD, MS (accounting), and Richard Keyt, JD, LL.M. (federal tax law)
What is a security under federal securities law?
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, pre-organization 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.
Does the issuance of a membership interest in a California LLC involve the offer and sale of a security subject to California state securities laws?
Sometimes yes and sometimes no, depending on the facts. If you are forming a California LLC you must know if your LLC will be issuing a security when it issues membership interests because if the LLC will issue membership interests a lot of bad things can happen unless the LLC complies with securities laws.
A California LLC cannot offer or sell a membership interest without registering or qualifying the security or unless the offer or sale is exempt from registration or qualification. When a membership interest is a security the LLC must comply with the anti-fraud provisions of federal and California securities laws, including the requirement that the LLC disclose all material facts with respect to the membership interests and the LLC and it cannot omit any material facts.
Corporations Code Section 25019 defines security as follows:
“Security” means any . . . interest in a limited liability company and any class or series of those interests (including any fractional or other interest in that interest), except a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company; provided that evidence that members vote or have the right to vote, or the right to information concerning the business and affairs of the limited liability company, or the right to participate in management, shall not establish, without more, that all members are actively engaged in the management of the limited liability company. [emphasis added].
Translation: California law starts with the assumption that all membership interests in an LLC are securities subject to California’s securities laws, but if all the members are ACTIVELY engaged in management the membership interest is not a security.
- Membership Interest Not a Security. California LLCs that are owned by one person, a husband and wife, registered domestic partners or a small group of people who are all actively involved in managing the member managed company should not be subject to federal or California securities laws.
- Membership Interest is a Security. If the California LLC is manager managed there is a presumption that the LLC membership interests acquired by members not involved in management are securities. There is little case law on this issue, but whether the issuance of a membership interest is a security depends on whether the interest is considered to be an “investment contract.” Federal and California securities laws define “investment contract” in the definition of a security.
The first bullet point above states the general rule, but there are exceptions to that rule. A member managed California LLC can be a security under California securities law if any of the following facts exist:
- Any member fails to be actively engaged in management. Even in a two member member managed LLC if one member is not regularly involved in management the membership interests are securities under California securities laws. All members must be regularly and continuously involved in management.
- The member managed LLC has too many members, which can by itself cause a court to find that one or more members is not actively engaged in management. For example, if there are 30 members of a member managed LLC the court could say that 1 vote out of 30 (s opposed to 1 out of 2 or 3) equates to little or no voice in actual management.
- There are facts that indicate that one or more members are not actually involved in management.
Warning: If your new California LLC will be deemed to be issuing investment contracts, i.e., securities, then at a minimum the LLC should have each member sign a Subscription Agreement that contains representations and warranties and the LLC should prepare and file a Notice of Transaction with the California Department of Business Oversight. For more about the Notice of Transaction see the following FAQ.
What is a Notice of Transaction and when Should a California LLC file it with the California Department of Business Oversight?
If your California LLC issues membership interests to any person or entity who is a resident of California and it is manager managed or member managed and one or more members will not be involved in managing the LLC, then it should file a Notice of Transaction with the California Department of Business Oversight’s DOCQNET online filing system.
Pursuant to California Corporations Code (“Code”) Section 25110, the offer and sale of securities in California must be qualified, unless exempt. If exempt, the firm should file the appropriate limited/small offering exemption notice. The definition of “Security” is found in Code Section 25019. The interests in a limited liability company and any class or series of such interests are considered a security and thus subject to either qualification of the securities or the filing of an exemption notice unless all of the members are actively engaged in the management of the limited liability company.
The appropriate securities/notice filing should be made with the Commissioner or, if you are not making the securities/notice filing, please provide the reason(s) the filing is not being made and a copy of your Articles of Organization showing that all members are managing members of the company. Please note that, if required, limited liability companies organized in California generally file a notice of transaction pursuant to either Corporations Code Section 25102(f) or 25102(h).
If a California LLC issues securities it must comply with California and federal securities laws. California Corporations Code Section 25110 states:
It is unlawful for any person to offer or sell in this state any security in an issuer transaction (other than in a transaction subject to Section 25120 [a recapitalization or reorganization]), whether or not by or through underwriters, unless such sale has been qualified under Section 25111, 25112 or 25113 (and no order under Section 25140 or subdivision (a) of Section 25143 is in effect with respect to such qualification) or unless such security or transaction is exempted or not subject to qualification under Chapter 1 (commencing with Section 25100) of this part.
California Corporations Code Section 25102 states,”The following transactions are exempted from the provisions of Section 25110:”
(f) Any offer or sale of any security in a transaction (other than an offer or sale to a pension or profit-sharing trust of the issuer) that meets each of the following criteria:
(1) Sales of the security are not made to more than 35 persons, including persons not in this state.
(2) All purchasers either have a preexisting personal or business relationship with the offeror or any of its partners, officers, directors or controlling persons, or managers (as appointed or elected by the members) if the offeror is a limited liability company, or by reason of their business or financial experience or the business or financial experience of their professional advisers who are unaffiliated with and who are not compensated by the issuer or any affiliate or selling agent of the issuer, directly or indirectly, could be reasonably assumed to have the capacity to protect their own interests in connection with the transaction.
(3) Each purchaser represents that the purchaser is purchasing for the purchaser’s own account (or a trust account if the purchaser is a trustee) and not with a view to or for sale in connection with any distribution of the security.
(4) The offer and sale of the security is not accomplished by the publication of any advertisement. The number of purchasers referred to above is exclusive of any described in subdivision (i), any officer, director, or affiliate of the issuer, or manager (as appointed or elected by the members) if the issuer is a limited liability company, and any other purchaser who the commissioner designates by rule. For purposes of this section, a husband and wife (together with any custodian or trustee acting for the account of their minor children) are counted as one person and a partnership, corporation, or other organization that was not specifically formed for the purpose of purchasing the security offered in reliance upon this exemption, is counted as one person. The commissioner shall by rule require the issuer to file a notice of transactions under this subdivision.
The failure to file the notice or the failure to file the notice within the time specified by the rule of the commissioner shall not affect the availability of the exemption. Any issuer that fails to file the notice as provided by rule of the commissioner shall, within 15 business days after discovery of the failure to file the notice or after demand by the commissioner, whichever occurs first, file the notice and pay to the commissioner a fee equal to the fee payable had the transaction been qualified under Section 25110. Neither the filing of the notice nor the failure by the commissioner to comment thereon precludes the commissioner from taking any action that the commissioner deems necessary or appropriate under this division with respect to the offer and sale of the securities.
If your California LLC will issue a security it must file a Notice of Transaction with the California Department of Business Oversight not later than 15 calendar days after the first sale of a security in the transaction in California. The first sale in California occurs when the LLC obtains a contractual commitment in California to purchase one or more of the securities the LLC intends to sell in connection with the transaction. No subsequent notices are required for sales in connection with the same transaction. The information in the Notice relates to the entire transaction, not just the first sale or sales in California.
The Notice of Transaction must be filed online using the California Department of Business Oversight’s DOCQNET online filing system. The Notice of Transaction shall be signed and dated by an authorized officer, director, general partner or trustee of the issuer (or a person occupying a position with the LLC of equivalent responsibility) or by the authorized attorney of the LLC. The LLC must print a copy of the Notice of Transaction and manually sign and date the Notice. The notice shall be executed before or at the time the electronic filing is made and shall be retained by the issuer for a period of five years from the date of filing.