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Are your LLC interests actually securities?

The distinction has vast implications for whether you must comply with State Blue Sky laws and SEC registration requirements.

The distinction has vast implications for whether you must comply with State Blue Sky laws and SEC registration requirements.

Disclaimer: This post is designed for general informational purposes only and may contained outdated information by laws enacted or federal or state cases decided after this post. You should consult with a legal and financial advisor to discuss your potential circumstances to determine whether an LLC interest constitutes a “security” under state or federal law. This post shall not be construed as legal advice.

Blue Sky Laws and SEC Regulations

“Blue sky laws” is a phrase used to describe state regulations, like those of Washington State, that are designed to protect investors against securities fraud. They require issuers of company stock in a corporation to register their offerings and provide financial details of the deal and entities involved. Similarly, all securities must be registered with the U.S. Securities and Exchange Commission unless exempted (but even then, you have to file documents showing you’re exempt).

Is it a security under federal and/or Washington law?

The Securities Exchange Act of 1933. Under Section 2(1) of the 1933 Act, unless the context otherwise requires, "[t]he term 'security' means any note, stock, treasury stock, bond, 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, fraction of undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, 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 right to subscribe to or purchase, any of the foregoing."

Washington has adopted what’s commonly referred to as the “risk capital test” to determine whether an LLC interest is an “investment contract” and therefore a security. Under Washington law, the membership interests may fall within the definition of an investment contract, which is: “investment of money . . . in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise the practical and actual control over the managerial decisions of the venture.” RCW 21.20.005(17)(a).

The risk capital test balances six factors to determine whether something is a security: (1) the length of term–longer terms tending to favor finding an instrument a security; (2) collateralization–an unsecured instrument favoring a security characterization; (3) the form of the obligation; (4) the circumstances of issuance–whether to a single party or to a class of investors; (5) the relationship between the amount borrowed and the size of the borrower’s business–the larger the amount, the greater the risk; and (6) the contemplated use of funds–whether enterprise formation or ongoing business financing. The ultimate inquiry in the risk capital test is whether the plaintiff contributed “risk capital” subject to the entrepreneurial or managerial efforts of others.

Cases seem to indicate that the ultimate inquiry is whether the plaintiff contributed ‘risk capital’ subject to the entrepreneurial or managerial efforts of others. If it is not an investment contract, then it is not a security and you do not need to comply with any SEC or Washington State blue sky registration requirements.

If it is a security, what are my registration requirements?

If your transaction is involving a “security,” then you should first determine whether it is exempt and even if exempt whether you have to register with the SEC and/or Washington State Department of Financial Institutions. Falling into an exemption would simplify the transaction and substantially decrease your compliance costs.

RCW 21.20.320 and accompanying WAC 460-44A govern exempt transactions where there are no filing requirements including but not necessarily limited to:

  • Non-issuer transactions by a non-control person with no more than 3 sales in Washington during prior 12 months;

  • Non-issuer isolated transactions by control person where sale conducted by registered broker-dealer or sale during prior 12 months doesn’t exceed 1% of outstanding units of the membership class;

  • Isolated transactions by the issuer limited to 3 sales during prior 12 months;

  • Non-public offerings qualifying under Section 4(a)(2) of SEC Act of 1933 and SEC Commission Securities Act Release No. 4552;

  • Manual exemptions for offers or sales by broker-dealers of outstanding securities of issuers listed in nationally recognized securities manual or that files certain reports on EDGAR;

  • Unsolicited orders where sale conducted by registered broker-dealer;

  • Transactions between issuer and underwriter;

  • Sales of whole loans secured by real estate except in certain cases involving bonds;

  • Transactions by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

  • Transactions by bona fide pledgee;

  • Sales to financial institutions, such as banks, saving institutions, trusts, insurance companies, and investment companies;

  • Small offerings under SEC Rule 504 less than $1 million;

  • Non-public offerings under Rule 506(b) and and RCW 21.20.320(1);

  • Sales to accredited investors pursuant to public solicitation;

  • Sales to existing security holders;

  • Red herring exemptions;

  • Stock dividends;

  • Mergers/reorganizations;

  • Secondary trading exemption for sales of securities through registered brokers-dealers; and

  • Transactions by cooperative organizations.

You should note, however, that many of these still have filing and registration requirements, either before or after the sale of the security, under Federal Law with the SEC, if not with the State of Washington. Those requirements are for a later day, and are too lengthy to include in this post.

Key Take-Aways & Considerations

  • Individuals who obtain interests in an LLC through initial capitalization before or at the time of organizing the LLC do not typically fall within the definition of securities. The analysis goes to post-formation sales of LLC interests.

  • The overarching purposes of the blue sky state laws and the SEC regulations is to protect investors from fraud and misleading financial statements and promises. The less sophisticated the investor, the more scrutiny given to the sale of membership interests.

  • The rights given to the new member matter. It if the LLC is manager-managed, then it is possible that the new member is simply an investor who has acquired a security from the seller with the expectation of receiving profits from the entrepreneurial efforts of others. If the LLC is member-managed and the new member has voting rights and is obligated and expected to participate in running the LLC itself, then it is unlikely to be an investment contract, since he is not solely relying on profits from the work of others.

  • It is important to stay compliant with laws by memorializing the decisions of the company. For example, does your LLC have member resolutions and unanimous consent requirements for decisions on behalf of the LLC? If unanimous consent is required, then the new member is participating in the management of the LLC.

  • If it is a security, then there are exemptions as set forth above, but you still might have to register.

Talk to a Lawyer Before you do Anything!

It is always important to speak with your legal and financial advisor if you are planning to buy or sell membership interests in an LLC. It is far simpler to avoid inadvertently falling into the sales of a security by bringing in new members who will participate in the management of the company on a continuous basis. If you do want “silent investors,” you should hire a lawyer to perform a fully analysis in order to determine what your exemptions might be and what registration requirements there are. Failure to adhere to state or federal securities laws may result in civil or criminal fines and the imposition of personal liability from investors bringing lawsuits if the deal goes sour.

The Mayo Law Group PLLC can help.

The Mayo Law Group has extensive experience in forming LLCs and providing guidance in member transactions of their interest units. For this reason, Mack Mayo has been selected for seven straight years as a Washington State Super Lawyer Rising Star and Top Spokane Lawyer, including for corporate and business law. We can assist in forming your LLC, registering with the department of revenue and IRS, preparing operating agreements, and navigating the often treacherous waters of LLC membership interest transactions. Schedule your free consultation today to see if we can help.

Not Legal Advice; No Attorney-Client Relationship Formed.

You should not rely on this post for guidance in your business formation or transaction. The content of this post does not constitute legal advice. You should always meet personally with a lawyer and financial advisor to fully understand your legal rights and obligations, including exemptions or registrations with the SEC or Washington State regulatory bodies. You are not a client of The Mayo Law Group PLLC by reading this post. No attorney-client relationship shall be formed simply by making an appointment with The Mayo Law Group for a consultation. No attorney-client relationship shall exist until (and if) a written representation agreement is signed by you and us.

Mack Mayo