LLC Interests May Constitute 'Securities'

What may be considered a “security” is a crucial inquiry for the purposes of the federal securities laws. Section 10(b) of the Securities Exchange Act of 1934 makes it illegal “[t]o use or employ, in connection with the purchase or sale of any security ' any manipulative or deceptive device.” Consequently, the Leonard court determined that “for the convictions of securities fraud and conspiracy to commit securities fraud to stand, there must be sufficient record evidence for the jury to have concluded that the interests in Little Giant and Heritage were 'securities' within the meaning of the 1934 Act.”

The federal securities laws define a security as, inter alia, “any note, stock, treasury stock, security future, bond, debenture ' investment contract ' or in general, any instrument commonly known as a 'security.'” The U.S. Supreme Court noted in Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985), that the definitions of “security” contained in the Securities Act of 1933 and the Securities Exchange Act of 1934 are virtually identical and should “be treated as such in ' decisions dealing with the scope of the term,” and ruled that if an interest falls within one of the enumerated categories, such as “stock,” then the analysis is fairly simple and the interest is a “security.” On the other hand, if the interest does not fall within one of the enumerated categories, a court must analyze whether the interest constitutes an “investment contract.” The U.S. Supreme Court defined an investment contract in the seminal case of SEC v. W.J. Howey Co., 328 U.S. 293 (1946), 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.” This formulation is commonly referred to as the “Howey Test.” Because interests in LLCs are not among the specific types of instruments enumerated in the federal securities law definition of security, the Leonard court analyzed the LLC interests under the Howey Test.

The Case

The issue in Leonard hinged upon the interpretation of the Howey factor requiring an expectation of profits derived “solely from the efforts of the promoter or a third party.” It is important to note that in applying the Howey Test, the court indicated that the phrase “solely from the efforts of” should not be interpreted literally, but rather by considering “whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter's contribution in a meaningful way.” Thus, the distinction lies “between companies that seek the 'passive investor' and situations where there is a 'reasonable expectation ' of significant investor control.'”

The court went on to explain that its consideration of whether the investors in Little Giant and Heritage viewed the units primarily as a passive investment “is complicated by the fact that Little Giant and Heritage were each structured as an LLC ' a relatively new, hybrid vehicle that combines elements of the traditional corporation with elements of the general partnership while retaining flexibility for federal tax purposes.” Due to this complication, the court found that there can be no bright-line rule regarding the classification of LLC interests as securities because of the myriad variations LLCs may take. Rather, the court viewed an LLC interest as “the sort of instrument that requires 'case-by-case analysis' into the 'economic realities' of the underlying transaction” and emphasized that “[s]uch consideration of the reality of the transaction is consistent with the Supreme Court's repeated instruction to prize substance over form in our evaluation of what constitutes a security.”

The Economic Realities

In examining the “economic realities” of the LLCs in Leonard, the court gave little credit to the fact that, on their face, the LLC organizational documents purported to give LLC members a significant and active role in the management of the companies. More persuasive to the court were the numerous factors indicating that the investors actually played a very passive role in the management of the companies and exercised little or no control, including:

• The investors rarely voted on issues although the organizational documents gave them voting rights.
• Though the organizational documents allowed for the formation of a number of committees, only two were ever formed and they included only a handful of investors as members.
• The investors' managerial rights did not accrue until the LLCs were fully organized; so-called “interim managers” handled almost every significant issue concerning the making of the films such that the entire picture was essentially produced before the investors had any input.
• The investors did not negotiate any terms of the LLC agreement, which were presented to them on a “take-it-or-leave-it basis,” and the fact “[t]hat they played no role in shaping the organizational agreements themselves raises doubts as to whether the members were expected to have significant control over the enterprise.”
• The investors “had no particular experience in film or entertainment and therefore would have had difficulty exercising their formal right to take over management of the companies after they were fully organized.”
• The large number and geographic dispersion of the investors left them “particularly dependent on centralized management.”

Case Law

A review of the relevant case law reveals that courts have also ruled that LLC interests should not be considered securities for the purpose of the federal securities laws. However, like the Leonard decision, these cases emphasized the importance of economic reality over form and only held that LLC interests were not securities after carefully analyzing the Howey factors and determining that the investors actually retained significant control. For instance, in Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003), the court affirmed a grant of summary judgment to the defendant in a securities fraud case because the LLC interests involved were not securities, noting that plaintiff Robinson had “sufficient managerial control to ensure that other managers like Glynn could neither harm nor dilute his investment.” Among other factors, the court noted that Robinson not only had the power to appoint two of the members of the board of managers, but that he assumed one of the seats and was named the board's vice-chairman. Moreover, Robinson served as the company's treasurer and had a veto over the company's incurrence of any indebtedness outside the normal course of business. The Robinson court found this to be a “level of control 'antithetical to the notion of member passivity' required to find an investment contract under the federal securities laws.”

Similarly, in Keith v. Black Diamond Advisors, Inc., 48 F. Supp. 2d 326 (S.D.N.Y. 1999), the plaintiff, Keith, had entered into a joint venture with Black Diamond, a venture capital firm, to form Pace LLC. In rejecting Keith's federal securities fraud claim that Black Diamond used its majority position to squeeze him out of control of Pace, the court observed that the LLC agreement and New York law provided Keith with a broad spectrum of rights and powers. For instance, Keith had the right to manage Pace (along with the other members), the right to vote in proportion to his holdings and the right to call meetings of Pace members. Thus, the court held: “[I]f at the time of his investment in Pace, Keith did not intend to be a passive investor, as he clearly did not, the Pace interests could not be securities. Furthermore, although the degree of control he actually exercised was less than he expected to exercise, that fact does not convert his interests into securities.”

Finally, in Great Lakes Chemical Corp. v. Monsanto Co., 96 F. Supp. 376 (D. Del. 2000), defendant Monsanto sold a 100% interest in NSC Technologies Company, LLC to Great Lakes Chemical Corporation. Great Lakes subsequently filed suit, alleging that Monsanto had violated Section 10(b) and Rule 10b-5 by failing to disclose material information in conjunction with the sale. In determining that that Great Lake's interests in NSC were not securities, the court pointed out that while the interest holders of NSC had no authority to directly manage NSC, Great Lakes, as the 100% owner, did have the power to remove any member from the managing board with or without cause and to dissolve the company, undiluted “by the presence of other ownership interests.”

These cases clearly demonstrate that, ultimately, the analysis of whether particular LLC interests constitute securities for purposes of the federal securities laws is fact-sensitive. As the Leonard court summed up the issue: “What matters more than the form of an investment scheme is the 'economic reality' that it represents. The question is whether an investor, as a result of the investment agreement itself or the factual circumstances that surround it, is left unable to exercise meaningful control over his investment.” Unlike the earlier decisions mentioned above, in Leonard, the court determined that the LLC interests did indeed constitute securities and affirmed the conviction of the defendants for securities fraud.

On June 11, 2008, the Second Circuit Court of Appeals, in affirming convictions for securities fraud and conspiracy to commit securities and mail fraud, ruled in U.S. v. Leonard, 2008 WL 2357233 (2nd Cir., June 11, 2008), that interests in various limited liability companies (“LLCs”) constituted “securities” for purposes of the federal securities laws. In so ruling, the court cited the U.S. Supreme Court's “repeated instruction to prize substance over form in our evaluation of what constitutes a security.” The Leonard analysis is instructive of the process that a court will follow in considering the status of non-traditional securities, such as LLC interests, under the federal securities laws.

The Leonard case arises from sales by defendants Paul Dickau and Nanci Silverstein of interests in two LLCs named Little Giant and Heritage Film Group, which they had formed to finance the production and distribution of movies. Interests in the LLCs were dubbed investment “units” and were priced at $10,000 each. Each sale of a unit generated a hefty commission of 42%-45% of the sale price; however, the offering memoranda used to market the LLC interests reflected a rate of no more than 20%. A federal jury returned guilty verdicts based on the misleading disclosures in the offering memoranda. The Second Circuit affirmed the convictions.

What Is a 'Security'?

What may be considered a “security” is a crucial inquiry for the purposes of the federal securities laws. Section 10(b) of the Securities Exchange Act of 1934 makes it illegal “[t]o use or employ, in connection with the purchase or sale of any security ' any manipulative or deceptive device.” Consequently, the Leonard court determined that “for the convictions of securities fraud and conspiracy to commit securities fraud to stand, there must be sufficient record evidence for the jury to have concluded that the interests in Little Giant and Heritage were 'securities' within the meaning of the 1934 Act.”

The federal securities laws define a security as, inter alia, “any note, stock, treasury stock, security future, bond, debenture ' investment contract ' or in general, any instrument commonly known as a 'security.'” The U.S. Supreme Court noted in Landreth Timber Co. v. Landreth , 471 U.S. 681 (1985), that the definitions of “security” contained in the Securities Act of 1933 and the Securities Exchange Act of 1934 are virtually identical and should “be treated as such in ' decisions dealing with the scope of the term,” and ruled that if an interest falls within one of the enumerated categories, such as “stock,” then the analysis is fairly simple and the interest is a “security.” On the other hand, if the interest does not fall within one of the enumerated categories, a court must analyze whether the interest constitutes an “investment contract.” The U.S. Supreme Court defined an investment contract in the seminal case of SEC v. W.J. Howey Co. , 328 U.S. 293 (1946), 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.” This formulation is commonly referred to as the “Howey Test.” Because interests in LLCs are not among the specific types of instruments enumerated in the federal securities law definition of security, the Leonard court analyzed the LLC interests under the Howey Test.

The Case

The issue in Leonard hinged upon the interpretation of the Howey factor requiring an expectation of profits derived “solely from the efforts of the promoter or a third party.” It is important to note that in applying the Howey Test, the court indicated that the phrase “solely from the efforts of” should not be interpreted literally, but rather by considering “whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter's contribution in a meaningful way.” Thus, the distinction lies “between companies that seek the 'passive investor' and situations where there is a 'reasonable expectation ' of significant investor control.'”

The court went on to explain that its consideration of whether the investors in Little Giant and Heritage viewed the units primarily as a passive investment “is complicated by the fact that Little Giant and Heritage were each structured as an LLC ' a relatively new, hybrid vehicle that combines elements of the traditional corporation with elements of the general partnership while retaining flexibility for federal tax purposes.” Due to this complication, the court found that there can be no bright-line rule regarding the classification of LLC interests as securities because of the myriad variations LLCs may take. Rather, the court viewed an LLC interest as “the sort of instrument that requires 'case-by-case analysis' into the 'economic realities' of the underlying transaction” and emphasized that “[s]uch consideration of the reality of the transaction is consistent with the Supreme Court's repeated instruction to prize substance over form in our evaluation of what constitutes a security.”

The Economic Realities

In examining the “economic realities” of the LLCs in Leonard, the court gave little credit to the fact that, on their face, the LLC organizational documents purported to give LLC members a significant and active role in the management of the companies. More persuasive to the court were the numerous factors indicating that the investors actually played a very passive role in the management of the companies and exercised little or no control, including:

• The investors rarely voted on issues although the organizational documents gave them voting rights.
• Though the organizational documents allowed for the formation of a number of committees, only two were ever formed and they included only a handful of investors as members.
• The investors' managerial rights did not accrue until the LLCs were fully organized; so-called “interim managers” handled almost every significant issue concerning the making of the films such that the entire picture was essentially produced before the investors had any input.
• The investors did not negotiate any terms of the LLC agreement, which were presented to them on a “take-it-or-leave-it basis,” and the fact “[t]hat they played no role in shaping the organizational agreements themselves raises doubts as to whether the members were expected to have significant control over the enterprise.”
• The investors “had no particular experience in film or entertainment and therefore would have had difficulty exercising their formal right to take over management of the companies after they were fully organized.”
• The large number and geographic dispersion of the investors left them “particularly dependent on centralized management.”

Case Law

A review of the relevant case law reveals that courts have also ruled that LLC interests should not be considered securities for the purpose of the federal securities laws. However, like the Leonard decision, these cases emphasized the importance of economic reality over form and only held that LLC interests were not securities after carefully analyzing the Howey factors and determining that the investors actually retained significant control. For instance, in Robinson v. Glynn , 349 F.3d 166 (4th Cir. 2003), the court affirmed a grant of summary judgment to the defendant in a securities fraud case because the LLC interests involved were not securities, noting that plaintiff Robinson had “sufficient managerial control to ensure that other managers like Glynn could neither harm nor dilute his investment.” Among other factors, the court noted that Robinson not only had the power to appoint two of the members of the board of managers, but that he assumed one of the seats and was named the board's vice-chairman. Moreover, Robinson served as the company's treasurer and had a veto over the company's incurrence of any indebtedness outside the normal course of business. The Robinson court found this to be a “level of control 'antithetical to the notion of member passivity' required to find an investment contract under the federal securities laws.”

Similarly, in Keith v. Black Diamond Advisors, Inc. , 48 F. Supp. 2d 326 (S.D.N.Y. 1999), the plaintiff, Keith, had entered into a joint venture with Black Diamond, a venture capital firm, to form Pace LLC. In rejecting Keith's federal securities fraud claim that Black Diamond used its majority position to squeeze him out of control of Pace, the court observed that the LLC agreement and New York law provided Keith with a broad spectrum of rights and powers. For instance, Keith had the right to manage Pace (along with the other members), the right to vote in proportion to his holdings and the right to call meetings of Pace members. Thus, the court held: “[I]f at the time of his investment in Pace, Keith did not intend to be a passive investor, as he clearly did not, the Pace interests could not be securities. Furthermore, although the degree of control he actually exercised was less than he expected to exercise, that fact does not convert his interests into securities.”

Finally, in Great Lakes Chemical Corp. v. Monsanto Co. , 96 F. Supp. 376 (D. Del. 2000), defendant Monsanto sold a 100% interest in NSC Technologies Company, LLC to Great Lakes Chemical Corporation. Great Lakes subsequently filed suit, alleging that Monsanto had violated Section 10(b) and Rule 10b-5 by failing to disclose material information in conjunction with the sale. In determining that that Great Lake's interests in NSC were not securities, the court pointed out that while the interest holders of NSC had no authority to directly manage NSC, Great Lakes, as the 100% owner, did have the power to remove any member from the managing board with or without cause and to dissolve the company, undiluted “by the presence of other ownership interests.”

These cases clearly demonstrate that, ultimately, the analysis of whether particular LLC interests constitute securities for purposes of the federal securities laws is fact-sensitive. As the Leonard court summed up the issue: “What matters more than the form of an investment scheme is the 'economic reality' that it represents. The question is whether an investor, as a result of the investment agreement itself or the factual circumstances that surround it, is left unable to exercise meaningful control over his investment.” Unlike the earlier decisions mentioned above, in Leonard, the court determined that the LLC interests did indeed constitute securities and affirmed the conviction of the defendants for securities fraud.