Federal securities laws apply to transactions involving investment contracts. The Supreme Court case has defined a security to include any “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.”
An LLC undoubtedly involves an investment of money in a common enterprise with an expectation of profits. The critical question is whether profits are expected “solely from the efforts of the promoter or a third party,” so that the investors can be said to rely on disclosures concerning the management’s track record and other facts bearing on whether management can be expected to produce profits. In a LLC where each member participates actively in the business, the members probably do not expect profits from the efforts of others.
The difficult case concerns a LLC where management is vested in a manager but the members have significant voting or veto powers. The determination is fact specific. Some cases hold that LLC interests are not securities in this case, relying on LLC members’ powers under the operating agreement. Others have held them to be securities based on the members’ lack of power or inability to exercise their powers.
Courts have stated that because LLCs lack standardized membership rights or organizational structures, they can assume an almost unlimited variety of forms. Certainly the members in a member-managed LLC will often have powers too significant to be considered passive investors under the securities laws. And yet 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. By the same token, while interests in manager-managed LLCs may often be securities, their member need not necessarily be reliant on the efforts on their managers. The cases are highly fact intensive.
Under state law, there is often an exception for LLC interests being defined as a security. For example, Idaho law, § 28-8-103, specifically states that LLC interests are not securities except under narrow circumstances. Thus, it is possible that your LLC interest could be a security under federal law but not under state law.
Assuming LLC interests are securities under federal law, offerings of the securities must be registered under the Securities Act of 1933 unless the sales are exempted under that act. Important exemptions include those for limited offerings under Regulation D, for secondary (non-issuer) transactions under Rule 144, for private re-sales under Rule 144A, and for intrastate transactions under Rule 147. These and other exemptions would be applied to LLC interests just as they are to other securities.
Also, if interests in LLCs are securities, they are subject to the antifraud provisions of the 1933 Act and the 1934 Act even if they are sold in a transaction that is exempt from 1933 Act registration. Thus, it behooves owners of LLC interests or limited liability companies issuing or selling interests in LLC’s to ensure all securities rules and laws are being followed, usually by hiring an attorney familiar with the relevant issues.