LLC Interests as Securities
In some circumstances, a limited liability company (“LLC”) membership interest can qualify as an investment contract and, consequently, a security under Arizona law. This article analyzes when an LLC membership interest constitutes a security under Arizona law.
Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
The definition of a “security” in the Arizona Securities Act includes “investment contract.” Ariz. Rev. Stat. § 44-1801(26). Although an LLC membership interest is not expressly recognized in the statute, such an interest will constitute a security if the character of the interest conforms to the statutory phrase “investment contract.
According to the Supreme Court of the United States, an investment contract exists if a person (1) makes an investment of money or other consideration, (2) in a common enterprise, (3) with an expectation of profit, (4) earned solely through the efforts of the promoter or a third party. S.E.C. v. W.J. Howey Co.,
328 U.S. 293, 298-99 (1946). When determining whether a financial arrangement constitutes an investment contract, “substance controls over form,” because “the definition of a security ‘embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.’” Nutek Info. Sys., Inc. v. Ariz. Corp. Comm’n, 194 Ariz. 104, 108, 977 P.2d 826, 830 (Ariz. Ct. App. 1998) (quoting Howey, 328 U.S. at 299). Indeed, in just the narrow realm of management structure, an LLC can be member-managed, manager-managed, or a hybrid of both and can differ in numerous ways including member participatory and voting rights, the centralization of management, operating functions, or even the creation of membership interests. As a result, the answer to whether an LLC interest constitutes a security will be determined on a “case-by-case basis.” Id. at 114, P.2d at 836.
Typically, the procurement of an LLC membership interest involves a monetary investment in a common enterprise with the expectation of profit; thus, the primary issue for a court to resolve is whether the investor, at the time of investment, expected profits based solely on the efforts of a third party. See, e.g., Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies: Tax and Business Law, ¶ 11.03 (Thomson Reuters 2012) (explaining that consideration for an LLC membership interest constitutes an “investment” and that an LLC is a “common enterprise” due to sufficient comminality and pooling); J. William Callison & Maureen A. Sullivan, Limited Liability Companies: A State-by-State Guide To Law And Practice, § 13.4 (Thomson Reuters 2013); see Nutek, supra (“[T]he parties agree that the first two prongs of the Howey test are satisfied and contest only the third element of the test . . . .”). Notably, “the term ‘solely’ should not be taken literally . . . [and] is satisfied if ‘the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.’” Nutek, supra (quoting S.E.C. v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973)).
When determining whether an investor expected profits to result solely through the efforts of a third party, Arizona applies a three factor test developed by the Fifth Circuit in Williamson v. Tucker,
645 F.2d 404 (5th Cir. 1981). According to the Williamson test, an LLC membership interest can be designated a security if any of the following are established: (1) an agreement between the LLC and member left so little power in the hands of the member that the arrangement effectively prevented the member from exercising meaningful control over the LLC; (2) the member was so inexperienced and unknowledgeable in business affairs that he was incapable of intelligently exercising his LLC powers; or (3) the member was so dependent on some unique entrepreneurial or managerial ability of the manager that he could not replace the manager or otherwise exercise meaningful LLC powers. Nutek, 194 Ariz. at 109, 977 P.2d at 831 (citing Williamson, supra). This list of factors “is not exhaustive” and each factor is “not [to be] viewed in isolation,” rather “the transaction [should be] considered as a whole.” Id. (citing Koch v. Hankins,
928 F.2d 1471, 1476-78 (9th Cir. 1991)). Moreover, the test focuses on a member’s expectations when she originally invested, not “what actually transpire[d] after the investment [was] made, i.e., whether the investor later decide[d] to be passive or to delegate all powers and duties to a promoter or managing partner.” Koch, 928 F.2d at 1477.
Notably, some commentators and courts suggest the Supreme Court of the United States fashioned a second test, or at least another factor, as a supplement to the Howey test. See, e.g., Carol R. Goforth, Article, Why Limited Liability Company Membership Interests Should Not be Treated as Securities and Possible Steps to Encourage this Result, 45 Hastings L.J. 1223, 1278 (1994); Jeffrey E. Beck, Note, From Orange Groves to Wireless Communications Systems: Arizona Applies the Howey Test to Limited Liability Companies, 31 Ariz. St. L.J. 1021, 1032 (1999); William J. Carney, Article, Defining a Security: The Addition of a Market-Oriented Contextual Approach to Investment Contract Analysis, 33 Emory L.J. 311, 314 (1984); Marini v. Adamo,
812 F. Supp. 2d 243, 255 (E.D.N.Y. 2011) (“The Supreme Court also added a fifth requirement in Marine Bank….”). In Marine Bank v. Weaver, the Court partially based its holding on the fact that the agreement was negotiated “one-on-one” in a “private transaction,” rather than “publicly.” 455 U.S. 551, 559-60 (1982). Accordingly, commentators suggest Marine Bank requires a court to consider whether “the instrument was a privately negotiated transaction (in which case it probably does not constitute a security) or whether it was being offered publicly to a large number of investors (in which case it probably does constitute a security).” 31 Ariz. St. L.J. 1021, 1032. However, the Arizona Court of Appeals completely ignored Marine Bank in its Nutek opinion and, as discussed infra, arguably appeared to incorporate the Court’s additional factor into its analysis. Thus, Marine Bank will not be evaluated further.
Each of the three Williamson factors is discussed in turn below.
II. Member’s Level of Control
The first factor considers whether an agreement between the LLC and the members effectively prevented the members from exercising meaningful control over the LLC. When analyzing this factor, a court must look beyond the partnership agreements “to other documents structuring the investment, to promotional materials, to oral representations made by the promoters at the time of the investment, and to the practical possibility of the investors exercising the powers they possessed pursuant to the partnership agreement.” Nutek, 194 Ariz. at 109, 977 P.2d at 831 (quoting Koch, 928 F.2d at 1478).
“Membership interests in a closely held, member-managed LLC, in which all members actively participate in the business, should not be treated as securities.” Limited Liability Companies: A State-by-State Guide To Law And Practice, § 13.4 (emphasis added). Such an interest could reasonably be compared to a general partnership interest because of a general partner’s high level of involvement in the partnership business. Id; see 1 Robert Thompson & F. Hodge O’Neal, O’Neal and Thompson’s Close Corporations and LLCs: Law and Practice, Applicability of federal and state securities laws § 2:19 (Rev. 3d ed. 2004) (“In a typical member-managed LLC, members appear more like partners who have sufficient control.”); see 31 Ariz. St. L.J. 1021, 1032 (“Most commentators who assert LLC interests should not be treated as securities argue that LLCs resemble closely held and member-managed general partnerships, with each partner retaining control of the management of the entity.”).
However, “even members in a member-managed LLC may be unable as a practical matter to exercise any meaningful control, perhaps because they are too numerous, inexperienced, or geographically disparate.” Robinson v. Glynn, 349 F.3d 166, 174, Fed. Sec. L. Rep. (CCH) ¶92,617 (4th Cir. 2003) (citing Nutek, 194 Ariz. at 109-10, 977 P.2d at 831-32). Further, “a difficult question arises when the members have voting or veto powers, but management is otherwise centralized in one or more managers or managing members.” Limited Liability Companies: A State-by-State Guide To Law And Practice, § 13.4. If an LLC’s members retain voting or veto power, but management is otherwise centralized in one or more managers, “a court likely will focus on whether the members have acted to delegate management authority to others, whether they have the power to reverse such delegation and to retain management power, and whether the non-managing members are sufficiently sophisticated, informed, and independent to avoid domination by the managers.” Id.
For example, even if an LLC’s “articles of incorporation unambiguously provide that the member-investors [have] legal control,” if “several factors work against the members’ ability to exercise effective control,” the LLC membership interests likely constitute securities. See Nutek, 194 Ariz. at 109-10, 977 P.2d at 831-32 (reasoning that members did not possess meaningful control because “the construction and management agreements turned over all principal management functions” to a third party, “the members had little or no input in deciding to enter into . . . agreements because the agreements were already in place before most members were recruited to invest,” and “the large number (920) of geographically dispersed investors and LLCs diluted partnership power to such an extent that it prevented the members from exercising effective control of the business”).
Furthermore, as a general rule, “[w]hen management is vested in non-member managers or in fewer than all members, LLC interests offered or sold to non-participating members should be considered securities, unless the non-participating members retain voting or veto powers over significant events affecting the LLC’s business.” Limited Liability Companies: A State-by-State Guide To Law And Practice, § 13.4. In such cases, the membership interest could be analogized to a limited partnership interest due to a limited partner’s minimal control over a partnership. Id.
Similarly, a manager-managed LLC is more likely to be considered a “security” than a member-managed LLC because of a participating member’s lack of control. See O’Neal and Thompson’s Close Corporations and LLCs: Law and Practice, Applicability of federal and state securities laws § 2:19. For example, if an LLC agreement makes it “impossible to replace the manager” or “prevent[s] investors from exercising meaningful control over the LLC,” an LLC membership interest likely constitutes a security. Nutek, 194 Ariz. at 112, 977 P.2d at 834. However, “while interests in manager-managed LLCs may often be securities, their members need not necessarily be reliant on the efforts of their managers.” Robinson, 349 F.3d at 174-75; see Great Lakes Chem. Corp. v. Monsanto Co., 96 F. Supp. 2d 376, Fed. Sec. L. Rep. (CCH) ¶90,988 (D. Del. 2000) (reasoning that members in a manager-managed LLC had meaningful control because they “had the power to remove any Manager with or without cause, and to dissolve the company”).
In sum, an interest in a member-managed LLC likely is a non-security interest. However, numerous elements can rebut this presumption and make such an interest a security, e.g., the size and breadth of the investor base or the geographical disparity between the investors. On the other hand, an interest in a manager-managed LLC likely is a security. Nevertheless, several factors can rebut this presumption, e.g., the members’ ability to vote on and veto significant business transactions. Accordingly, whether an LLC membership interest constitutes a security interest will depend on the specific facts and circumstances of each case.
III. Member’s Level of Experience
The second factor considers whether “the [member] is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his [LLC] powers.” Nutek, 194 Ariz. at 110, 977 P.2d at 832. The federal circuits dispute the proper focus of this factor. The Ninth Circuit focuses on whether an investor has business knowledge “generally,” rather than within a specific business context. Koch, 928 F.2d at 1477. However, Arizona rejected the Ninth Circuit’s approach and adopted the Fifth Circuit’s analysis which focuses on whether the individual investor possessed sufficient and “meaningful” business acumen “in relation to the nature of the underlying venture.” Nutek, supra (citing Long v. Shultz Cattle Co., 881 F.2d 129, 134 n.3 (5th Cir. 1989)) (emphasis added). Arizona justifies its departure from the Ninth Circuit by arguing that the securities laws were designed to protect the “vulnerable investors” “without specialized knowledge of the business” who are “far more likely” to “rely on third parties to manage their investments.” Id. at 111. Accordingly, in Arizona, the second factor’s analysis “should focus on the individual investor’s knowledge of the particular business being operated.” Id. (emphasis added).
Unlike a general partnership interest, an LLC membership interest is not burdened by “the strong presumption that it is not a security.” Id. Indeed, a “general partner’s personal liability necessarily gives the partner an incentive to be highly informed about the business. At the same time, personal liability discourages involvement by unsophisticated investors. It follows that LLCs may have greater securities law exposure than general partnerships.” Id. at 111-12 (citing Robert R. Keatinge et al., The Limited Liability Company: A Study of the Emerging Entity, 47 Bus. Law. 378, 404 (1992)). In other words, because LLC members are not burdened with personal liability outside of their contribution, they will be less motivated to become informed about the LLC’s operations. See Nutek, 194 Ariz. at 112, 977 P.2d at 834 (reasoning that LLC members may not “rely on one another’s knowledge” in order to satisfy the second factor because, due to “diminished incentive[,] . . . LLC members will actually be less likely to assist one another in [a] meaningful fashion”).
IV. Member’s Level of Dependence
The third factor considers whether members were so dependent on some unique entrepreneurial or managerial ability of the manager that they could not reasonably replace the manager or otherwise exercise meaningful LLC powers. In order for an LLC membership interest to constitute a security under this factor, the members must have relied “on some ‘non-replaceable expertise’ on the part of the promoter or manager[, such] that ‘there [was] no reasonable replacement for the investments’ manager.’” Holden v. Hagopian, 978 F.2d 1115, 1122, 1992 U.S. App. LEXIS 28266, 19-20 (9th Cir. 1992) (quoting Williamson, 645 F.2d at 424).
For example, if “a common enterprise, managed by . . . third parties with adequate personal and equipment is . . . essential [for] investors . . . to achieve their paramount aim of a return on their investment,” the membership interests likely constitute securities. Id. Accordingly, if an LLC’s investors rely on the manager’s managerial skills to coordinate the “technical and financial aspects of the operation” to make the enterprise a “viable business operation,” the membership interests likely constitute securities. Id.; see also In re Radical Bunny, L.L.C., 2013 WL 1624312, *96, No. 73768 (Ariz. Corp. Com. 2013) (reasoning that the third prong of Howey was met because an LLC managers’ “significant efforts” and “close association” with another company “determined the success of [the LLC] and Participants’ profits”).
As another example, if “the investors [are] irretrievably bound to the management decisions” of the manager or member, the investors “[can] not exercise meaningful control over LLC business operations.” Id. Consequently, because the members would not have meaningful control over the LLC, the membership interests likely constitute securities. Id.
On the other hand, in cases where an LLC’s manager enjoys “only ministerial duties, the investors can more easily replace the manager,” and the membership interest are less likely to constitute securities. Id. (citing Holden v. Hagopian, 978 F.2d 1115, 1122-23 (9th Cir. 1992).
In closing, the ultimate issue boils down to control. If an LLC’s members can exert meaningful control over the LLC, the membership interests will not likely constitute securities. However, if the members are prevented from exerting control, are so inexperienced in the particular industry as to be powerless, or are so reliant on the LLC’s manager to effectively preclude removal of the manager, the membership interests likely constitute securities.
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