Are LLCs Considered “Securities” under SEC v. W.J. Howey?
If you have an interest in an LLC, it’s prudent to assess whether it might be considered a security subject to the disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. The answer is not always crystal clear, but there are guidelines for determining what types of LLC interests are considered securities and exemptions to the reporting requirements. If you’re not clear about how your LLC interest should be classified, it’s important to speak with an experienced securities attorney before you sell the interest.
Apply the Howey Test to The LLC Investment
Federal law defines a security as a transaction where money is invested with the expectation of accruing profits from somebody else’s efforts. The goal of the law is to distinguish money earned through active work from passive investments, but that distinction is not always that clear. To assist in making this determination about whether an LLC interest is a security, the courts apply the test that was developed in the Supreme Court case SEC v. W. J. Howey Co. In this case, the Howey Company sold groves of citrus to buyers that would immediately lease back the land. Howey Company staff would exclusively tend, harvest and sell the citrus without any help from the buyers. The Supreme Court held that the Howey Company should have registered the leaseback arrangement contracts as securities. To come to this conclusion, the court established four criteria, known as “The Howey Test” to determine whether business arrangement constitutes a security:
- An investment of money;
- In a common enterprise;
- With the expectation of profit
- To be derived from the efforts of others.
In Howey, the buyers only invested capital and had no active role in the production of the fruit, not even in an advisory capacity, as they had no experience whatsoever in the industry. Applying the Howie test, you’re interest in an LLC is likely to be considered a security if you have invested nothing but money in the business.
The Securities Act of 1933, which is still the law of the land, makes it clear that any offer to sell securities must either be registered with the Securities and Exchange Commission (SEC) or meet an exemption. It’s important to understand that this rule applies to even the tiniest business, selling one share to a single person, but there are exemptions that may apply to a particular situation. The most common exception is under Section 4(a)(2) of the Securities Act of 1933, known as the private placement exception. Some courts have held that transactions that don’t involved a public offering are exempt from registration, distinguishing a private offering from a public one. The purpose of registering securities is to protect buyers from scams, so some courts have held that it’s not necessary when the buyers are sophisticated enough to make this determination on their own. For many years, there was little clarity about when the exemptions applied.
In 2013, the SEC created a safe harbor for investors to create more certainty about whether an LLC interest needed to be registered with the SEC. Regulation D does not alleviate all uncertainty because your transaction could still be subject to SEC scrutiny, but it does provide much clearer guidance about what is required to meet an exemption. Under Regulation D, it’s possible to transfer an interest in an LLC without registering it as a security with the SEC based on the following factors:
- The investor is sophisticated enough to make a decision without the information that would be provided with SEC registration;
- The amount of the the investment is small;
- The timetable for the transaction and
- Whether a private placement memorandum (PPM) is prepared.
As you can see, this guidance is helpful, but not crystal clear because the SEC could decide that what you thought was small enough, is actually too big or that your sophisticated investor was actually green and naive. That’s why the SEC further defined these factors, creating much more certainly about when an exemption in applicable.
The Securities Act of 1933 distinguishes between accredited and non-accredited investors. In order to qualify as an accredited investor you must either have a minimum net worth of $1,000,000 or an annual income of at least $200,000 for a single person or $300,000 for a couple. Some types of high risk investments are considered suitable only for sale to accredited investors with the assumption that they can afford to lose the money. There has not been complete consensus on this issue and there are forces pushing the SEC to include people that have less less financial resources, but who have job experience, education or professional knowledge related to a particular investment to be considered “accredited.” An accredited investor can also be an entity with assets in excess of five million dollars or a bank, savings and loan association. Registered investment companies and brokers are also considered accredited investors. To meet the requirements of an accredited investors, investors can be grouped together. For example, if several family members are investing, their total assets and income can be pooled to meet the requirements.
The SEC further refined their guidance with rules 504, 505 and 506. Under Rule 504, the sale of an LLC does not require registration if it’s part of a private placement selling for less than one million dollars, regardless of whether the buyers are accredited. This exemption is rarely used because it requires registration in every state where there are investors and excludes certain types of businesses. Rule 505 applies to the sale of securities up to a value of five million dollars, limits the number of investors to thirty five and has disclosure and audit requirements. This exemption is even more rarely used than 504 due used because the requirements are usually more cumbersome that SEC registration. Rule 506 is the most commonly used exemption because it doesn’t require state registration and there is no disclosure requirement when selling to accredited investors. There are other limited exemptions for LLC’s that might otherwise be subject to SEC reporting requirements as a security, but it’s important to remember that the safest course is always to register your investment as a security.