¶ 4701
Overview
Scope of the chapter. An LLC raises capital by admitting members, and every admission for value is a sale of an interest. Whether that interest is a security determines whether the sale must be registered or exempt under the Securities Act of 1933, whether the antifraud provisions of the Securities Exchange Act of 1934 apply to it, whether the persons who sell it must be registered brokers, and whether the LLC itself may be an investment company. This chapter examines those questions as they arise for LLCs. It begins with the statutory definition of "security" and the reasons an LLC interest does not fall within its named categories, turns to the investment contract test of SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and to the line of cases that apply it to LLC interests, and then examines the exemptions on which LLC offerings ordinarily rely, the Investment Company Act and Investment Advisers Act as they affect holding and fund LLCs, the Exchange Act registration threshold, the liability regime, digital and token-based interests, and the drafting of offering and transfer documents.
Why the question is unsettled for LLCs. The definitions of "security" in the two principal statutes were written in 1933 and 1934, half a century before the first LLC statute. They name stock, notes, bonds and "investment contract," among other instruments. Each closes with "any interest or instrument commonly known as a 'security.'" 15 U.S.C. §§ 77b(a)(1), 78c(a)(10). An interest in a limited partnership has long been treated as a security because the limited partner, by statute, does not manage. An interest in a general partnership is presumed not to be one because the general partner does. The LLC sits between them. Its members have limited liability like limited partners, and in a member-managed LLC they have management power like general partners. Because the operating agreement may allocate management in almost any way, the statute's label tells a court little, and the courts have declined to adopt a categorical rule. Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003). The result is a fact-specific inquiry that turns on how power is allocated in the agreement and how it is exercised in practice.
Why the question matters. The consequences of treating an interest as a security are significant in both directions. If the interest is a security, every sale must be registered or exempt; a sale that is neither gives the purchaser a right to rescind under section 12(a)(1) of the Securities Act, 15 U.S.C. § 77l(a)(1), whatever the seller's good faith. The persons who solicit investors for compensation must be registered as brokers or associated with one. 15 U.S.C. § 78o(a)(1). Fraud in the sale or purchase of the interest is actionable under section 10(b) and Rule 10b-5, with the remedies and the statutes of limitation those provisions carry. State securities laws apply in parallel and are often broader. If the interest is not a security, none of these regimes applies, and a member defrauded in the purchase or sale of an interest must rely on contract, common-law fraud, fiduciary duty and the remedies of the operating agreement. Members, promoters and managers therefore have opposite interests in the characterization, and the same parties may take opposite positions at different stages: a sponsor may argue in an enforcement proceeding that units were not securities, after relying on Regulation D in the offering as though they were.
Approach of the chapter. The practical rule that emerges from the cases is that interests sold to passive investors in a manager-managed LLC are usually securities, interests held by active members of a closely held, member-managed LLC usually are not, and the cases between depend on the facts. Prudent practice treats any offering of LLC interests to persons who will not manage as an offering of securities and structures it within an exemption. The chapter refers to Chapter 29 for the transfer of interests under the LLC statutes and Article 8 of the Uniform Commercial Code, which is a different question from the securities-law characterization; to Chapter 52 for private funds and holding structures; and to Chapter 53 for DAO LLCs.