California Limited Liability Company Securities Laws Overview
John E. Ohashi, Esq.
Clients and attorneys must consider various factors, such as liability, tax considerations, and governance issues in selecting a LLC as an appropriate business entity. Another factor is the securities laws issues relating to LLC’s.
Securities Laws Issues.
The threshold question is whether a LLC interest is a security. If a LLC interest is a security, then the LLC must comply with the “Securities Laws,” which consists of two broad categories of investor protection provisions under federal and state laws governing the purchase and sale of securities: (1) the registration and qualification provisions; and (2) the anti-fraud provisions i.e., disclosure requirements.
Dual Laws - Federal and State Securities Laws.
A LLC that issues securities must comply with both federal and state securities laws. The relevant federal securities laws are the Securities Act of 1933 as amended (“33 Act”) and the Securities Exchange Act of 1934 as amended (“34 Exchange Act”). Broadly speaking, the 33 Act generally deals with “issuer” transactions, that is, a company selling its securities to investors. The 34 Exchange Act generally deals with secondary trading, that is, the buying and selling of securities among investors after a company has sold securities pursuant to the 33 Act.
Each state, including California, has its own set of securities laws. The securities laws of the various states are commonly referred to as “Blue Sky Laws.” The Blue Sky Laws generally track the 33 Act and the 34 Exchange Act; however, each state will have its own unique issues, so it is important to look at the applicable Blue Sky Laws in each state where you have a prospective LLC member. The California securities laws are found at California Corporations Code Section 25000 et. seq.
Is a LLC Membership Interest a Security?
The threshold question is whether a LLC membership interest is a security. Federal law looks at the 33 Act and common law to determine if a LLC interest is a security.
Federal Law – Howey Test. The definition of a “security” is found in Section 2(1) of the 33 Act. Section 2(1) does not directly address whether a "LLC interest" is a “security.” Rather, a LLC interest must be analyzed to determine if it fits within the statutorily defined term “investment contract,” which is a security under 33 Act. SEC v. W.J. Howey Co. 328 U.S. 293, provides a four-prong test (referred to as the “Howey Test”) to determine if an interest (i.e., LLC membership interest) is an “investment contract” and therefore a security under federal law. Howey provides that an investment contract (i.e., a security) is a contract, transaction or scheme whereby a person: (1) invests money, (2) in a common enterprise and (3) is led to expect profits (4) solely from the efforts of a promoter or a third party. Items (1), (2), and (3), above, are almost always present, and only item (4) is usually open to interpretation - i.e., is the investor passive or actively engaged in the business.
The federal court cases use the differences between a general and limited partnership as the framework to determine if a LLC interest is a security. If the LLC members act like general partners because they actively participate in the LLC’s management and affairs, then the LLC interest may not be a security. On the other hand, if the LLC interest is analogous to a limited partnership interest, because of the investor’s limited participation in management, then the LLC interest will probably be classified as a security.
California - Presumption. California law, unlike federal law, presumes that an LLC interest is a security. California Corporations Code Section 25019 provides:
"Security" means any. . .; interest in a limited liability company 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.”
Section 25019 has potential traps. A LLC’s interest is a security unless “all of the members are actively engaged in the management of the limited liability company.” The term “all of the members” apparently does not carve out members, such as founders, who are managing members. Thus, if a LLC’s members consist of founders, who are active in managing the LLC, and an employee, who receives an incentive interest but does not participate in management, then all of the LLC interests are securities. There is also uncertainty as to how 25019 works if a founding member, who, along with the other founder members, is active in management, but then retires and becomes a passive investor. The issue is whether the founders’ membership interests which were not securities at the time they were issued become securities upon the retirement of a founding member.
Registration/Qualification Provisions
Every security offered or sold in the United States, including a LLC interest, if it is a security, must be registered with the Securities and Exchange Commission (“SEC”) or qualify for an exemption from registration (Section 5 of the 33 Act). The security must also be registered or exempt from registration or qualification under Blue Sky laws, including California (Corporations Code Section 25110). The burden of proof always rests with the LLC to demonstrate the availability of an exemption for its securities. A registered offering of securities is referred to as a “public offering”, and an offering pursuant to an exemption is generally referred to as a “private placement”.
Registration and/or qualification of securities involve extensive legal, accounting, and regulatory fees and is time consuming and expensive. If the LLC’s membership interests are securities, then the goal is to find an available exemption from registration and/or qualification under both federal and state securities laws i.e., a private placement. Most clients cannot begin to fully appreciate the depths and consequences of a public offering. If a client even contemplates consideration of a “public offering” in the context of a start-up business, then it may make sense to “reality check” the LLC’s business plan with the client, and if a “public offering” is still part of the discussion, then consider if a corporate structure is more appropriate.
Federal Intrastate Exemption. Section 3(a)(11) of the 33 Act and Rule 147 provides a federal exemption if a LLC’s business is in California and it limits sale of its membership interests to California residents.
Federal Private Placement Exemption. Section 4(2) of the 33 Act exempts from registrations “transactions by an issuer not involving a public offering.” The difficulty in applying 4(2) is that it relies on subjective standards that are discussed in SEC v. Ralston Purina Co. 346 U.S. 119 (1953) in determining whether an offering is public or private. SEC Release No. 33-4552 (November 6, 1962) follows-up Ralston Purina with a discussion of various factors that evidence private transactions, such as the number of investors and their relationship to the issuer, the disclosures provided to the investors, and the manner of the offering. The critical factor in determining whether an offering is private appears to be whether an investor needs the protection provided by the registration requirements of the federal securities laws.
Safe Harbor Rules of Regulation D (Reg D). In response to the subjective and uncertain nature of 4(2), the SEC adopted Regulation D (Reg D). Reg D is a “safe harbor” that provides objective standards to obtain a federal exemption. Reg D’s specific requirements include limitations on the number of investors, and in some instances, limitations on dollar amounts of an offering, and disclosure requirements.
California Private Placement Exemption. California has a series of available exemptions from qualification, including the limited offering exemption provided by California Corporations Code Section 25102(f). 25102(f) generally tracks Reg D, and provides an exemption from qualification if the issuance of securities satisfies the following:
1. Sales to no more than 35 purchasers (subject to certain exclusions);
2. Purchasers must have a preexisting relationship with the issuer or financial experience or advice from a professional advisor who is not compensated by the issuer;
3. No advertisements; and
4. Purchasers must represent that they are purchasing for their own accounts.
25102(f) provides for the filing of a Notice of Transaction. The LLC does not lose the exemption if it fails to file the Notice; however, the Department of Corporations can mandate its filing.
A violation of the California qualifications requirements under Section 25110 can lead to drastic remedies including investor rescission rights under Section 25502. As stated above, California law presumes that an LLC interest is a security, so it only makes sense to make sure that the LLC’s offer and sale of membership interests complies with the qualification provisions or, given its relative ease, is subject to an exemption from qualification i.e., 25102(f).
Out of State Investors. A LLC may have multiple members/investors, some of whom reside outside of California. If an investor resides outside of California, then the LLC must look at that investor’s state’s Blue Sky Laws. Most states have a private placement exemption that is similar to Reg D and 25102(f), which are not difficult to fulfill. Some states may require a filing before an offer or sale is made in the state.
Anti-fraud Provisions.
Both federal and California laws provide for a private cause of action for securities fraud. The federal anti-fraud provisions are found in Section 12 of the Securities Act and Section 10(b) and Rule 10b-5 of the 34 Exchange Act:
The California anti-fraud provisions are Corporations Code Sections 25401 and 25501. Section 25401 states:
“It is unlawful for any person to offer or sell a security in this state or buy or offer to buy a security in this state by means of any written or oral communication which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”
A violation under Section 25401 triggers Section 25501, which creates a private cause of action by an investor against the issuer for violation of Section 25401. Additionally, Section 25504 provides that violations under Section 25501 can create direct personal liability against certain persons for the company’s violation of Section 25401.
Anti-Fraud Provisions - Disclosure Requirements.
Every prospective member/investor in your client’s LLC, and his or her affiliate, successors, and assigns, is a potential plaintiff in a securities action. Accordingly, the LLC, with counsel’s assistance, must review the sophistication and financial standing of an investor, the investor’s relationship to the LLC’s management, and the investor’s access to and ability to understand information about the LLC, and the extent to which the prospective investor can protect himself or herself in deciding whether or not to invest in the LLC transaction. Using that information as guidance, the LLC must determine the appropriate disclosures to make to the prospective investor.
The anti-fraud provisions require that a LLC provide prospective investors with all material facts relating to an investment in the LLC. In determining whether a fact is material, consider: “whether the existence or nonexistence of the fact in question is a matter to which a reasonable man would attach importance in determining his choice of action.” Casella v. Webb (9th Cir 1989) 883 F.2d 805.
Material information would include, but not be limited to a discussion of the LLC's business, its goals, proposed use of investor funds, and the risk factors attendant to its business plan. Every disclosure must be unambiguous and substantiated. An issuer cannot engage in verbal camouflage. If any statement made to a prospective investor, whether verbally or in writing, can be interpreted in more than one way, then the statement is ambiguous. If you have to independently explain your statement to make it understandable, then it is ambiguous. There is no concept of creative writing in an offering document.
Common Trouble Areas.
A LLC that wants to raise money by offering membership interests may not want to incur the legal and other professional fees needed to prepare an offering document. A frequent question that founders ask is whether they need a “full blown” offering document such as a private placement memorandum to give to prospective investors or can they get by with something less. For example, a founder may want to know if it is acceptable to attach a Subscription Agreement or Operating Agreement to a business plan and treat them as an offering document. Another frequent scenario is a founder’s desire to draft a business plan and have counsel simply add the “legal boilerplate” to make it an offering document. Both scenarios are problematic.
The prohibition against creative writing in offering documents limits the LLC’s ability to simply “wrap” legal boilerplate and/or a Subscription Agreement around a business plan. Business plans prepared by a founder can provide a good start to a disclosure document, but even the most thoughtful and well articulated business plans require significant input, if not a complete rewrite, by securities counsel. Another common scenario is that a founder will prepare a business plan using “canned” templates (software programs) or language extracted from other unrelated business plans. Such business plans contain language that may “sound good” but such text is often nothing more than imprecise language and dangerous marketing hype, both of which can lead to liability. Consider the following boilerplate language taken from a software program:
“A core concept embraced by the Company is to enter into strategic alliances with key players in its industry segment to take advantage of synergies afforded by such relationships.”
On its face the quoted language seems entirely reasonable, but it is meaningless.
Another troublesome topic is the use of pro forma financials and projections in offering documents. The use of pro forma financials and projections involves numerous accounting and securities laws issues. At some level, every pro forma is wrong. Merely having a “forward looking statements” disclaimer is not enough to shield an issuer from liability. At a minimum, the issuer should consider the following standards:
“A projection or statement of belief contains at least three implicit factual assertions: (1) that the statement is genuinely believed, (2) that there is a reasonable basis for that belief, and (3) that the speaker is not aware of any undisclosed facts tending to seriously undermine the accuracy of the statement. A projection or statement of belief may be actionable to the extent that one of these implied factual assertions is inaccurate.” Marx v. Computer Sciences Corp., 507 F.2d 485 (9th Cir. 1974).
Another troublesome area relating to disclosure requirements is “friends and family” financing. Friends and family are often not provided the level of disclosure that is required under the securities laws because their desire to invest is based in large part on their relationship with a founder and not on a full understanding of the business plan. Friends and family, however, are, from an objective standard, often within the class of investor that the securities laws most intend to protect. A “friends and family” round of seed financing may be a practical necessity. However, some effort should go into explaining the risks to the client, including the preparation of a confirming letter to the client, and then using reasonable efforts to mitigate the risks associated with the “friends and family” offering. Your client’s Aunt would never sue your client - but what about her money hungry new husband. Also, is your client prepared to have every Thanksgiving dinner become a de facto “investors’ meeting?”
The securities laws provide plenty of traps. If, despite the non forgiving nature of the securities laws, the LLC’s management determines that compliance with applicable securities laws is too costly, time consuming, or difficult, then its alternative is to convene a management meeting to pray, meditate, and hope that the LLC’s securities offering can nonetheless escape liability by fiting within the good graces of the “happy investor” exemption.
