There was no such thing as a limited liability company in 1933, 1934 or even 1968. Thus, Congress and the California legislature had no reason to consider whether a membership interest in an LLC constitutes a security when they drafted the Securities Act, the Exchange Act and the Corporate Securities Law. When California enacted the Beverely-Killea Limited Liability Company Act (SB 469), it amended Corporations Code Section 25019 to include within the “laundry list” of securities interests in a limited liability company and any class or series of those interests (including any fractional or other interests in those interests). Congress hasn’t amended either the Securities Act (Section 2(a)(1)) or the Exchange Act (Section 3(a)(10)) to specifically include membership interests within the definitions of “security”.
In a recent decision, Judge Anthony Battaglia noted that a “partnership or membership interest may constitute a ‘security’ under the federal Securities [Exchange] Act.” Hardisty v. Moore, 2012 U.S. Dist. LEXIS 146524 (S.D. Cal. (Oct. 9, 2012). However, to constitute a security, the interest must satisfy the three-part test established by the U.S. Supreme Court in Securities & Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946). Thus, there must be (1) an investment of money; (2) in a common enterprise; (3) based on an expectation of profits to be derived solely from the efforts of individuals other than the investor.
In Hardisty, Judge Battaglia found that no security existed because the plaintiff was a sophisticated business man and the chief manager of the company. Thus, the the third element of Howey was not met. His ruling is somewhat unclear because he refers to the company as a partnership (“because Plaintiff has failed to offer sufficient facts to refute that he had a security interest in the partnership”). However, he elsewhere describes the company as a limited liability company.
Judge Battaglia did not address the definition of “security” in Section 25019. For the sake of completeness, however, it should be noted Section 25019 includes the following exception:
except a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company; provided that evidence that members vote or have the right to vote, or the right to information concerning the business and affairs of the limited liability company, or the right to participate in management, shall not establish, without more, that all members are actively engaged in the management of the limited liability company . . .
I’ve always found this exception somewhat troubling because it cannot logically be established at the time that the membership interest is sold. The exception may only be established after the fact by the active engagement in the management of the company.