Is Your Membership Interest In an LLC A “Security”?
This Could Affect Your Rights!
Is your membership interest in your LLC a “security” under Arizona law? In Arizona a “security” is defined as: “any note, stock, treasury stock, bond, commodity investment contract, commodity option, 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, real property investment contract 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 include a right to subscribe to purchase any of the foregoing.” See Nutek v. ACC, 194 Ariz. 104 (1998).
This definition is substantially similar to the definition of securities in both the Securities act of 1933 and the Securities Exchange Act of 1934. See Securities Act of 1933, 15 U.S.C.A. §77(b)(a) (1)(1997); Securities Exchange Act of 1934, 15 U.S.C.A. §78(c) (a)(10) 1997). Arizona courts therefore look to federal courts for guidance in interpreting the statute. Vairo, 153 Ariz. at 17, 734 P.2d at 114; Rose v. Dobras, 128 Ariz. 209, 211, 624 P.2d 887, 889 (App. 1981). In the Nutek case the court had to determine whether the LLC membership interests constituted “investment contracts” under A.R.S. §44-801(23). The U.S. Supreme Court has held that an investment contract is a security if a person (1) invests money (2) in a “common enterprise” and (3) is led to expect profits solely from the efforts of the promoter or a third party. S.E.C. v. W.J. Howey Co, 328 U.S. 293, 301. The Court also noted that the definition of a security “embodies a flexible rather than a static principle, one that is capable of adaption to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Thus, substance controls over form.
Often the key inquiry is whether investors were led to expect profits based solely on the efforts of another. We note first that Howey’s use of the term “solely” should not be taken literally. Rather, the third prong 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.” S.E.C. v. Glen W. Turner Enters, Inc., 474 F.2d 476, 482 (9th Circ. 1973).
A general partnership or joint venture interest can be designated a security if the investor can establish, that (1) an agreement among the parties leaves so little power in the hands of the partner or venture that the arrangement in fact distributes power as would a limited partnership; or (2) the partner or venture is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or (3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers. See the Nutek case.
In determining the level of investor control the courts assess both legal and practical control. The courts examine not only the formal agreement establishing the business enterprise (the articles of organization), but also look 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 [LLC] agreements”. The court importantly noted that reliance upon others does not exist merely because the partners have chosen to hire another party to manage their investment.” .
The Nutek court adopted a three factor test ultimately aimed at determining whether a person has been led to expect profits on the basis of the efforts of another. An investor’s knowledge of the business being operated provides one of the most reliable indicators of that investor’s ability to exercise control over the investment. When the investor does not possess specialized knowledge of the business, he or she is far more likely to expect profits based on the efforts of the promoter or manager. The securities laws (with their disclosure requirements) are designed to protect less than-prudent investors from giving their money to irresponsible or unscrupulous businessmen. Because investors without specialized knowledge of the business must rely on third parties to manage their investments, they are precisely the vulnerable investors the securities laws are designed to protect through disclosure and/or registration.
The critical difference between LLC’s and general partnerships is that the general partners’ 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.
More on LLC’s in future Commercial Corner articles. The McGill Law Firm is at 4421 N. 75th St., Scottsdale, AZ 85251; Ph: 480-970-6720 F:480-970-6727; email: email@example.com