When Does an LLC Membership Interest Become a Security?
While business interests are generally presumed to not be securities, there are certain situations where membership interests actually are securities. The distinction between a purely business interest and a security interest is important for owners seeking to sell memberships in their companies, as securities bring with them a large body of regulations and may impose strict obligations on both the owner and the member. Unintentionally selling securities under the name of an LLC membership can also cause the company to run afoul of registration rules, potentially leading to harsh sanctions from the SEC and costly suits from the investors.
So when does an LLC membership turn into a security?
Under Williamson v. Tucker, business interests are not automatically insulated from the reach of federal securities laws. Where a business interest is essentially a hidden security, the courts, and the SEC, will treat it as such. The determination of whether a business interest has turned into a security focuses on three areas of investor control: legal control, practical control, and capacity to control.
Legal control looks at the language of the membership agreement and considers whether the members actually receive authority to control the company, such as voting rights.
Practical control considers whether, for example, a single person in the company has such unique expertise that he essentially controls the company and cannot be replaced, even if the members technically have the right to remove him.
Capacity to control takes into account the members’ own sophistication to determine if they have the knowledge and skill to actually utilize the control granted to them.
If any one of these facets of control are missing, members could argue that they warrant the protections of securities laws, and the interest may be deemed a security.
What does this mean for the company?
The practical effect for business owners is that they must be careful with the terms and restrictions on interests they sell, lest they find themselves accidentally beholden to securities laws. If an LLC has been selling membership interests that lack any of the member control mechanisms above, it could be liable for selling an unregistered security. Alternatively, the company would need to meet certain requirements to qualify to sell those securities without registration; those requirements include restrictions on how the company can sell and who they can sell to.
Before selling interests in your company, it’s important to be aware of what rights and obligations may be attached to those interests. Vennum Law is here to answer all your questions about selling interests in your company. Click here to schedule a consultation.