Limited liability company interests as securities: a proposed framework for analysis

Limited liability company interests as securities: a proposed framework for analysis

A flurry of legislative activity during the past few years.

A flurry of legislative activity during the past few years has firmly placed the limited liability company (LLC) into the business-entity spotlight. What is an LLC? It is a hybrid entity that combines the best characteristics of partnerships and corporations. LLCs are viewed as beneficial primarily for three reasons. First, they provide members with limited liability. Second, they provide members with the benefit of “pass-through” taxation. Third, they provide members with flexibility in terms of the management structure of the firm.(1)

Legal scholars have analyzed not only how LLC laws should be interpreted, but also how LLCs should be viewed with regard to other existing laws. One particularly unsettled area of concern is whether LLC interests are securities for state and federal securities law purposes. This issue has important public policy and managerial implications.

In terms of public policy, if LLC interests are not considered securities, investors will not be protected under the securities laws from fraudulent investment schemes conducted by businesses organized as LLCs. The LLC-interest-as-security issue has already arisen in the context of lawsuits by the SEC and state securities commissioners against wireless cable companies organized as LLCs.(2) In one case, the SEC alleged that the defendant violated securities laws by using high pressure sales techniques, falsely depicting first-year investment returns, and making a number of other fraudulent statements.(3) In another case, the Kansas Securities Commissioner issued an emergency cease and desist order against a Nevada wireless cable company operating as an LLC after finding that it violated the Kansas securities laws by fraudulently offering membership interests for sale.(4) The SEC has filed ten injunctive actions against investment schemes involved in wireless cable and telecommunications technologies,(5) and at least one federal district court has implicitly found that an LLC membership interest in a wireless cable company is a security.(6)

From a practical, managerial perspective, those members of LLCs charged with management of the firm no doubt would prefer to avoid the extensive paperwork and regulatory compliance that would accompany treatment of an LLC interest as a security. In addition, if no clear test exists for determining whether an LLC interest is a security, firms considering the LLC as a form of business organization will be discouraged from forming LLCs because of the fear of jumping into uncharted waters. In short, the LLC-interest-as-security issue is a double-edged sword. If LLC interests are considered securities, the investing public may benefit from protection from securities fraud. On the other hand, it can be argued that investment and entrepreneurship may be stymied if LLC interests are subject to the securities laws.

This article addresses the legal principles surrounding LLC interests and whether they should be treated as securities. The first section of the article discusses the general nature of LLCs, including their history, benefits, and formation requirements. This section also includes a comparison of LLCs to corporations, general partnerships, and limited partnerships. The unique hybrid nature of the LLC has important implications for the LLC-interest-as-security issue.

The second section analyzes the leading United States Supreme Court cases that have addressed the definition of a security. This section traces the development of the Howey test–the traditional judicial definition of a security–as well as the present standards for determining whether an instrument is a security. This part examines Supreme Court decisions in the 1970s and 1980s that placed formalistic limitations on the traditional definition of a security, and the Court’s most recent opinions which signal a return to a more liberal and traditional approach. Under present definitional standards, the Court continues to focus on the substance or “economic reality” of a particular investment rather than its legal form to determine whether it is a security.

The third section examines the application of the traditional test for a security to interests in partnerships and other forms of business organizations that resemble an LLC. The courts have developed standards to judge whether interests in general partnerships, joint ventures, and limited partnerships are securities. This part critically examines those standards to determine their potential application and usefulness to the LLC-interest-as-security question.

The final section notes the differing and unsatisfactory approaches adopted by the states to resolve the LLC-interest-as-security issue, and then proposes a framework for analysis that is consistent with the purposes of securities law and the Supreme Court cases for determining whether an LLC interest constitutes a security. Rather than suggest a “bright line” rule for LLCs that would conclusively presume that LLC interests are or are not securities, we propose a flexible test that takes into consideration the unique hybrid nature of the LLC. Our analytical framework strikes an appropriate balance of the competing public policy and managerial interests, one that provides some guidance to those planning LLC ventures, but that ultimately judges whether a particular LLC interest is a security based on the “economic reality” of the investment.

What Is A Limited Liability Company?


In order to understand fully the issues related to the treatment of LLC interests as securities, it is helpful first to review the general nature of LLCs. An LLC is a hybrid entity. That is, it possesses characteristics of both partnerships and corporations. The LLC is not the first unincorporated business entity to limit member liability. Partnership associations and business trusts have long existed as means to limit business liability without incorporating.(7) Apparently, none of these types of entities was sufficient for an oil company seeking to organize in Wyoming. In 1977, the Wyoming legislature solved the oil company’s problem by enacting special interest legislation, a Limited Liability Company Act.(8) In 1982, Florida became the second state to enact an LLC law. The Florida legislature believed that the availability of LLCs would encourage businesses, particularly foreign enterprises, to move to Florida.(9)

In 1980, the Treasury Department issued proposed regulations that would have denied partnership tax classification to any organization in which no member had personal liability for the organization’s debts.(10) The proposed regulations cast a cloud over the tax status of Wyoming LLCs. Eventually, the Treasury Department withdrew the proposed regulations, and in 1982 a study was begun to determine the proper tax classification of LLCs.(11) Six years later, the Internal Revenue Service issued a public ruling concluding that a Wyoming LLC would be taxed as a partnership.(12) Since the ruling, nearly every state has either enacted or considered enacting LLC enabling legislation.(13)

Formation of Limited Liability Companies

LLCs are formed through a central filing of articles of organization with a state agency, such as the Secretary of State, and the payment of a filing fee. Most LLC statutes require that an LLC have more than one member.(14) Having two members helps ensure partnership tax classification. The articles of organization typically must include the name of the firm,(15) the address of its principal place of business or registered office, and the name of the agent for service of process. Some LLC statutes also require a statement as to whether the firm will be managed by managers and the names of the initial managers, if any.(16)

The articles of organization also typically must contain the names and addresses of members, the duration of the firm, the members’ right to continue the firm after disassociation of a member, limitations on the power of a member or manager to bind the firm, the firm’s purpose, the amount of member contributions, and the right to admit additional members.(17) LLC members also usually enter into a written or oral operating agreement. The operating agreement addresses matters such as capitalization, management, distributions, admission and withdrawal of members, fiduciary duties, and dissolution.

Benefits of Limited Liability Companies

LLCs are desirable as a form of business organization primarily for three reasons. First, LLCs offer members limited liability. An LLC owner is not personally liable for the debts and obligations of the LLC unless the owner agrees to personal liability by, for example, personally guaranteeing LLC debt. Second, LLCs provide members with the benefit of “pass through” taxation. In other words, LLCs may be taxed as partnerships and thereby avoid double taxation.(18) Third, LLCs provide managerial flexibility. The business can opt for a partnership model of governance, with members directly managing the business, or a corporate model of governance, with a manager or a managing board similar to a board of directors. This allows the organization to fashion its governance structure to meet the needs of the business, rather than being locked into one model of governance or another.

LLCs are entitled to partnership status for federal income tax purposes as long as they lack two of the following three corporate characteristics: 1) continuity of life

A corporation has continuity of life because it continues to exist even if one of the original owners dies, retires, resigns, suffers insanity, files bankruptcy, or is expelled.(20) A business entity lacks continuity of life if, under local law, any member has dissolution power.(21) Most LLC laws may be interpreted as not providing continuity of life for the LLC, but under some state LLC laws the continuity of life issue is open to question.(22)

Free transferability of interest exists if members owning substantially all of the LLC interests have the power to transfer their ownership to a person who is not a member without obtaining the other members’ consent.(23) Most LLC statutes provide that consent to a transfer of interest by a majority of the LLC members is necessary unless the operating agreement or regulations provide otherwise. Consequently, free transferability of interest usually does not exist.

Centralized management exists if there is a concentration of exclusive authority to make independent business decisions on behalf of the organization and those decisions do not require member ratification.(24) If the LLC does not have a manager or managing board, it will likely not be considered to have centralized management.(25) Some commentators believe that the centralized management issue is not important because LLCs will generally be able to establish lack of continuity of life and lack of free transferability of interest.(26)

Certainly, some state LLC laws may allow LLCs to cross the line between partnership and corporate taxation. The LLC statutes in these states are known as “flexible” statutes. In other states, the mandatory provisions of the LLC statutes virtually guarantee that a properly formed and operated LLC will be treated as a partnership for tax purposes. The LLC statutes in these states are considered “bulletproof.”(27) An eye toward meeting at least two of the three prongs of the IRS test for partnership tax status should be comforting to those LLCs that comply with the “flexible” state LLC laws.

Comparison of Limited Liability Companies and Other Entities

Corporate Comparison

Typically, corporations fall within one of two categories: C corporations and S corporations.(28) S corporations are somewhat similar to LLCs. They provide the benefit of limited liability for shareholders and pass through tax status. However, in order to receive these benefits, an S corporation must be a “small business corporation.” The Internal Revenue Code defines a “small business corporation” as one that, among other things, does not have more than thirty-five shareholders.(29) The Code’s narrow definition of “small business corporation” effectively eliminates the S corporation as an option for many business organizations. An LLC, on the other hand, is entitled to partnership tax status simply by passing the three-step test described above.

LLCs are formed in the same manner as corporations. A central filing with a state agency, such as the Secretary of State, is required. In the absence of contractual restrictions, corporate stock is freely transferable under state corporation laws. LLC statutes, on the other hand, generally state that only financial rights are assignable. Full management rights of LLC membership may be acquired only by the unanimous consent of the members.(30) A corporate shareholder “withdraws” from the corporation by selling his or her stock. LLC statutes typically provide that a member may withdraw after giving all other members six months notice in writing, unless the articles of organization or the operating agreement state otherwise.(31)

Corporations are managed by a board of directors. In contrast, LLC statutes generally provide that the LLC is to be managed directly by the members.(32) An elected manager or a managing board may manage the LLC.(33) The members’ voting rights are allocated in proportion to their interest in the LLC’s profits.(34) Corporations may be dissolved upon a vote by the directors and shareholders and the filing of articles of dissolution.(35) LLCs are typically dissolved upon death, withdrawal, or consent, although the LLC may be continued if the non-disassociating members unanimously consent to the continuation.(36)

Finally, LLCs may not be as readily recognizable in foreign states as are corporations because of the many different ways that states define LLCs. Therefore, a foreign LLC, unlike a foreign corporation, runs the risk of failing to be recognized as a liability-limiting entity outside its state of organization.(37) This risk has become less of an issue because the vast majority of states now recognize the LLC form of business organization.

General Partnership Comparison

The limited liability of members distinguishes LLCs from general partnerships. General partners are liable for partnership debts and obligations. Unlike LLCs, no formal filing is required to create a general partnership and, in fact, a general partnership may be created without an intent to do so.(38) LLCs are similar to general partnerships to the extent that both interests are not freely transferable. Also, LLC members may, like partners, withdraw at will and receive the full value of their interest. However, most LLC statutes require that members give six months notice prior to withdrawal.

Unless there is a contrary agreement, general partnerships are managed directly by the partners.(39) LLCs are managed in the same way, but LLC members vote in proportion to their contributions, while each partner in a general partnership has an equal vote.(40) LLCs and general partnerships are both dissolved when a member disassociates himself or herself from the firm. However, unlike a general partnership, an LLC may continue if all remaining members agree to do so. Also, when a partner withdraws from a general partnership, the remaining partners may continue the business of the partnership, but the partnership itself ceases to exist. When remaining LLC members agree to continue the LLC, the LLC itself continues in existence. General partners also must contribute toward the partnership’s debts upon dissolution, while LLC members have no such obligation.(41)

Limited Partnership Comparison

In a limited partnership, there must be at least one general partner who is personally liable for the partnership debts and obligations, but limited partners, as long as they do not participate in the management of the partnership, are not so liable.(42) LLCs are very similar to limited partnerships. The important difference between the two entities, however, is that LLC members participate in the management of an LLC, whereas limited partners usually do not participate in the running of the limited partnership. Also, and as a result, unlike the limited partner who participates in control of the limited partnership, LLC members who are involved in the management of an LLC do not thereby risk becoming personally liable for the LLC’s debts and obligations.

Transferability of interest also differs somewhat in a limited partnership. In an LLC, a membership transferee usually does not obtain management rights unless the non-transferring members consent to the transfer. In a limited partnership, consent of the non-transferring partners is required, but the partnership may “pre-agree” to admit transferees.(43) Most LLC dissolution statutes have been modeled after the Revised Uniform Limited Partnership Act. One difference, though, is that an LLC usually dissolves upon the occurrence of a dissolution event as to any member. A limited partnership dissolves only if there is a dissolution event as to a general partner. Limited partnerships also have an advantage over LLCs in some states because a partnership interest may be obtained in exchange for services rendered or to be rendered.(44)

The Hybrid Nature of LLCs Causes Securities Law Uncertainty

As the above general discussion indicates, LLCs share the characteristics of several different types of business entities. An LLC, like a corporation, is a creature of statute and a separate legal entity. Like the corporation, it provides its members with limited liability. Although an LLC usually has a decentralized, partnership form of governance, the LLC can opt for centralized management, creating an organizational structure that is similar to the corporation. Given these characteristics of an LLC, the argument can be made that LLC interests are the functional equivalent of stock, and, therefore, the sale of such interests should be governed by the securities laws. On the other hand, an LLC shares some of the features of a general partnership. Like a partnership, it is usually managed by its members. It is treated in most instances as a partnership for tax purposes, and like interests in a partnership, LLC interests are not freely transferable. Thus, members in an LLC will often be active participants in the venture, not passive investors in need of security law protection. The case can be made that the LLC is closer to a partnership, and, therefore, the sale of LLC interests, like the sale of general partnership interests,(45) should not fall within the scope of the securities laws. Thus, the hybrid nature of LLCs, while beneficial to those firms desiring limited liability and pass through taxation, has caused some confusion about whether LLC interests are securities under state and federal securities laws. The commentary on the issue is divided.(46) The remainder of this article will analyze whether LLC interests are indeed securities and propose an analytical framework to resolve that issue.

From Joiner to Reves: The Court Struggles to Define Security

The Supreme Court has assumed the role of defining the scope of the federal securities laws in a series of cases in which it has attempted to fashion workable standards for the definition of a security. Although both the Securities Act of 193347 and the Securities Exchange Act of 1934(48) contain a section defining security, Congress simply set forth the types of instruments covered by the acts rather than provide a general test or criteria for the concept of a security. For example, Section 2(1) of the Securities Act of 1933 lists numerous forms of securities, including stocks, bonds, and debentures. The definition section also includes, however, other forms of instruments which are described in more general terms, including “investment contract,” and “any interest commonly known as a security.”(49) As a result of the lack of a clear definition, the SEC, the courts, and ultimately the Supreme Court have had to resolve the issue of what types of investments and instruments fall within the reach of the securities laws.

The Development of the Traditional Test for a Security

Securities and Exchange Commission v. Joiner Leasing Corp.

The Court’s first attempt at defining security came in 1943 in the case of SEC v. Joiner Leasing Corp. (Joiner)(50) which involved the assignment of oil leases by Joiner Leasing (Joiner). Joiner acquired oil leases on three thousand acres under an agreement with the landowners to drill a test well.(51) To finance the test well, Joiner in turn sold small parcels of the acres (usually between two and a half to five acres) to numerous investors scattered throughout the country.(52) The lower courts found that Joiner had committed fraud in connection with the sale, but refused to grant the SEC an injunction against Joiner, holding that the assignments of oil leases were transfers of interests in land, not sales of securities under the 1933 Act.(53)

The Court reversed the lower court’s decisions finding that the sales involved securities as defined under the 1933 Act.(54) In holding the transfers to be sales of securities, the Court adopted a broad interpretation of the definition section of the Act and laid the groundwork for its future approach to the definitional question. Moreover, it rejected a number of arguments that would have restricted securities to traditional investment instruments.

The Court rejected the formalistic approach to the definition of a security urged by Joiner.(55) The mere fact that the assignments of the leasehold interests conveyed interests in real estate did not take them out of the reach of the securities laws. “The test rather is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”(56) In applying this analytical approach to the sales by Joiner, the Court found that Joiner was selling more than “naked leasehold rights.”(57) Joiner was offering investors an opportunity to share in the discovery of oil, the drilling of the test well being an integral part of the overall investment scheme. It was “the thread upon which everybody’s beads were strung,” the investors “paying both for a lease and for a development project.”(58)

Joiner argued that because the statutory list included sales of leasehold subdivisions by undivided shares, it implicitly excluded leasehold subdivisions by the acre.(59) It further argued that the more specific provision relating to leasehold subdivisions should be interpreted to restrict the more general phrases (e.g., investment contract) within the statute.(60) The Court, however, opted for an interpretation of the statute in light of its purposes and the intended legislative policies.(61) Thus, the Court found that the term security was intended to cover many instruments in which there was “common trading for speculation or investment,” including not only standardized instruments but also “novel, uncommon, or irregular devices.”(62) The Court reasoned, therefore, that instruments may be included within any of the definitional categories if they “answer to the name or description.”(63) Similarly, the Court rejected the argument that because the definition section included “fractional undivided interests” in mineral rights, it necessarily excluded sales by parcels.(64) It believed that Congress included fractional interests because they were the form of mineral interests most often used for speculative purposes.(65) Congress did not thereby intend to immunize other sales of mineral interests that fell within the concept of an “investment contract.”(66)

Joiner is important for a number of reasons. First, the Court chose to interpret the definition section in a broad manner, rejecting numerous arguments advanced to restrict the words in the definition section. Second, in determining whether the instruments were securities, the Court judged the instruments from an economic and practical perspective, not from a formal, legalistic perspective. This “economic reality” approach is later explicitly adopted in Howey in which the Court established the traditional definition of a security.

Securities and Exchange Commission v. Howey Co.

The Court’s seminal case on the definition of a security is its 1946 decision in SEC v. Howey Co.(67) W. J. Howey Co. (Howey) owned large tracts of citrus acres in Florida, parts of which were sold to investors.(68) Howey sold one or more acres in narrow strips of the land, an acre consisting of a row of 48 trees.(69) The strips were sold under land sale contracts to business and professional persons — doctors, lawyers, and other mostly out-of-state individuals.(70) Most became aware of the investment when they stayed at a nearby resort owned by Howey and toured the groves.(71) Coupled with the land sale, Howey offered the investors a service contract for the groves through Howey-in-the-Hills, a related company.(72) Under the 10-year service agreement, Howey-in-the-Hills cultivated, harvested, and marketed the citrus crop, and the investors received profits based on the returns from their citrus acres.(73) The Securities and Exchange Commission brought an action to enjoin the sales, claiming that they were unregistered and nonexempt securities, the case reaching the Court after the lower courts had denied the injunction on the basis that the citrus interests were not securities.(74)

The Court framed the issue in terms of whether the land sale and the service contracts together constituted an “investment contract” under the Securities Act of 1933.(75) As in Joiner, the Court turned to the Blue Sky laws in its interpretation of this language.(76) It noted that the term “investment contract” had been given a broad construction by the state courts in order to give maximum protection to the investing public.(77) Any schemes under which individuals invested money in an enterprise expecting profits from the efforts of others fell within the scope of the “investment contract” concept.(78) Moreover, “[f]orm was disregarded for substance and emphasis was placed upon economic reality.”(79) The Court adopted the state court approach, creating the well known three-part formula for the definition of a security:

An investment contract . . . means a contract, transaction or scheme
whereby [1] a person invests his money [2] in a common enterprise
and [3] is led to expect profits solely from the efforts of the promoter
or a third party, it being immaterial whether the shares in the
enterprise are evidenced by formal certificates or by nominal interests
in the physical assets employed in the enterprise.(80)

This definition, the Court reasoned, was necessary to further the legislative purpose of full and fair disclosure.(81) The “economic reality” approach also “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”(82)

Applying the test to the citrus grove interests, the Court concluded that they were investment contracts.(83) Howey was offering more than just an orchard or a farm

The Howey Court also categorically rejected the rationale embraced by the court of appeals that only “speculative” or “promotional” enterprises were covered by the Act when the interest that was being sold had “intrinsic value” independent of the success of the enterprise.(88) Such limiting criteria were considered inconsistent with the central policy of the Act to give broad protection to the investing public.(89)

VALIC and United Benefit Life

The Howey Court embraced a liberal reading of the securities laws, creating an economic approach to the definitional issue. Consistent with that opinion, the Court in SEC v. Variable Annuity Life Insurance Co. (VALIC)(90) and SEC v. United Benefit Life Insurance Co. (United Benefit Life)(91) found that a variable annuity and a deferred annuity were securities. In each case, the Court was confronted with the interpretation of an exemption in the 1933 Act for “any insurance . . . or annuity contract” subject to state regulation by a state insurance commissioner or regulatory agency.(92)

In VALIC, the majority opinion concluded that the meaning of the words “insurance” and “annuity” under the securities laws was a question of federal law despite the history of state control over the insurance industry and its contracts.(93) The Court reasoned that annuity traditionally referred to a contract under which the annuitant received fixed periodic amounts beginning at a certain age.(94) Variable annuities, like the one offered by Variable Annuity Life Insurance Co., did not guarantee the annuitant a fixed amount

In a concurring opinion, Justice Brennan provided a stronger public policy rationale for confining the exemption to fixed annuities. He argued that securities regulation is based on the concept of full and fair disclosure

Justice Brennan’s public policy rationale was explicitly adopted by the Court in United Benefit Life. That case involved a so-called Flexible Fund Annuity contract offered by United Benefit Life Insurance Co.(102) The contract was similar to a variable annuity in that premiums paid were invested in a separate account by the insurance company.(103) But at maturity, the annuitant’s interest in the account terminated, and he or she could opt for the cash value of the account or a fixed-payment annuity.(104) The SEC argued that the pre-maturity period was separable and was a security, but the lower courts, relying on VALIC, concluded that the fixed-payment part of the contract involved the type of investment risk characteristic of insurance contracts which the VALIC majority cited as the important distinguishing feature of an insurance contract.(105)

The United Benefit Life Court, however, rejected such a narrow reading of VALIC. Citing language in the concurring opinion in VALIC, the Court reasoned that:

The exemption was to be considered a congressional declaration
“that there then was a form of ‘investment’ known as insurance . . . which
did not present very squarely the sort of problems that the
Securities Act . . . was devised to deal with, and which were, in
many details, subject to a form of state regulation of a sort which
made the federal regulation even less relevant.”(106)

The Court noted that the flexible fund arrangement was attractive because of the ,potential for growth due to professional investment and management, not on the basis of “stability and security.”(107) And even if the annuitant was entitled to a guarantee of net premiums paid should the insurance company’s investments be poor ones, the assumption of some investment risk did not render it an insurance contract.(108) Moreover, applying the economic reality approach of Howey to the contractual arrangement, the Court noted that the “Flexible Fund” contracts competed with mutual funds because of the similar appeal to investors looking for professional management.(109) Since mutual fund investments are considered securities, and investors in such funds protected by the disclosure requirements of the law, “Fixed Fund” annuities should also be considered securities.(110)

This restrictive reading of the insurance and annuity exemption of the law, and the economic approach to defining such contracts, builds upon the Howey opinion and the investor protection rationales underlying that decision. By focusing the analysis of the insurance exemption on the underlying purposes of the securities laws, the Court developed an integrated approach to the definition issue, one that mandated an economic and policy analysis of any investment instrument to determine whether it was a security or was exempt from securities regulation.

Tcherepnin v. Knight

In 1967, the Court faced the issue whether a withdrawable capital share tn a savings and loan association was a security under the Securities Exchange Act of 1934. Tcherepnin v. Knight(111) was the Court’s first opportunity to construe the definition provision of the 1934 Act.(112) Noting the almost identical definition in the 1933 Act, and the remedial nature of the securities laws, the Court looked to its prior decisions in interpreting the definitional language.(113) It first noted the essential characteristics of such shares under Illinois law. They were issued as a means of raising capital, entitled the member/holder to vote, and entitled the member to a share of the association’s profits (but no guaranteed returns).(114) Given these characteristics, the Court found that the shares fell within the concept of an “investment contract” under the Howey test. The members were participants in a money-lending business who shared in the profits of that business and who were relying on the efforts of the association’s management for a return on their investment.(115) The Tcherepnin Court went beyond this holding, however, and found that the shares fell within other types of securities. It held that the shares could be considered “certificates of interest . . . in any profit-sharing agreement,” “stock,” or “transferable shares.”(116)

The Court’s decision was bolstered by the legislative history of the Securities Act of 1933, which indicated that the savings and loan industry sought an exemption from the registration requirements but not the antifraud provisions of the Act.(117) Thus, both Congress, in granting the registration exemption, and the industry, in seeking it, assumed that shares in their associations would constitute securities.(118)

The Court also rejected the restrictive gloss placed on the definition section by the court of appeals. The lower court had reasoned that the language “instrument commonly known as a security” was a limitation on the other more specific terms in the definition section.(119) The Court found this construction of the statute inconsistent with its opinion in Joiner where it refused to adopt a similar restrictive interpretation of the definition section of the 1933 Act.(120) The Court went further by holding that the lower court erred in its substantive analysis of whether the shares were “instruments commonly known as securit[ies].” The court of appeals had focused on specific legal attributes of the shares, particularly that the shares could be issued in unlimited amounts and the members had no preemptive rights. However, the Court reasoned that the same was true for mutual funds.(121) The lower court also had noted that the shares were nonnegotiable under state law.(122) But merely because the shares did not trade on the market did not preclude them from being securities, the Court reasoned, noting that the interests in Joiner and Howey were not traded either.(123) Although the legal characteristics cited by the lower court served to distinguish between different types of securities, the differences were not significant enough to change the essential character of the shares as securities.(124)

Similarly, the Court rejected a policy rationale for excluding shares in savings and loan associations based on the historical impetus for the passage of the 1933 and 1934 Acts. Because the stock market crash of 1929 was the catalyst for the federal securities laws, the lower court found that Congress was concerned with “speculative” investments that fluctuated in value and which were traded in a national capital market.(125) Thus, the shares were not considered within the scope of the securities laws by the lower court. The Court found this policy rationale unpersuasive and inconsistent with its opinion in Howey.(126) Moreover, it found that the sale of the shares to investors implicated legitimate interests in protecting those investors from fraudulent sales and promotions.(127)

Tcherepnin is the high water mark in the Court’s liberal reading of the definition provisions of the 1933 and 1934 Acts. Its expansive reading of various concepts-stock, investment contract, transferable shares, instrument commonly known as a security-represented the broadest interpretation of those phrases. The Tcherepnin Court also refused to imply any restrictive limitation on the definition sections, based either on policy considerations or legislative intent. Finally, it continued with its “economic reality” approach in finding the shares the functional equivalent of stock. In a series of cases in the 1970s and 1980s, however, the Court departed from its traditional approach and developed limiting criteria for the definition of a security.

Restricting the Scope of the Securities Laws: Limiting Criteria under the Howey Test

United Housing Foundation v. Forman

The issue in United Housing Foundation v. Forman(128) was whether shares of stock entitling tenants to rent a residential unit in a building owned by a nonprofit housing cooperative were securities.(129) The Second Circuit Court of Appeals had found them to be securities based on two theories. First, the court took a literalist approach to the word “stock” and concluded that the interests in the building were securities because they were called “stock.”(130) Second, the court found that the stock was an investment contract, reasoning that the tenants would profit from tax deductions, below-market rental rates, and rent reductions in the event there was income produced by commercial facilities occupying space in the building.(131)

The Court rejected both arguments. Relying on the “economic reality” approach to the definitional question, the Court rejected the literalist interpretation of the word “stock.”(132) It reasoned that the definitional issue must be resolved by an analysis of the economic nature of the transaction since the securities laws were designed to regulate the capital markets for the protection of investors.(133) The Court noted, however, that there might be cases in which investors believe that they are protected by the securities laws because of the use of the word “stock,” but that tenants would not likely believe that stock entitling them to a residential unit is an investment security.(134) This was particularly the case where the “stock” had none of the typical characteristics of corporate stock, including the most significant feature, the right to receive dividends.(135)

Disposing of the literal reading of the word “stock,” the Court attempted to analyze the “investment contract” question. It first concluded that the phrases “investment contract” and “instrument commonly known as a security” were essentially the same, and thus the Howey test would be used to determine whether the “stock” fell within either phrase.(136) In doing so, the Court focused an the word “profits” in the third part of the Howey test. The Court interpreted profits to mean either participation in an enterprise’s earnings or capital appreciation of an investment in an enterprise.(137) It did not encompass, the Court stressed, benefits derived from purchases for consumption.(138) Given this restrictive interpretation of “profits,” the Court readily concluded that the financial benefits relied on by the court of appeals, tax benefits and below-market rentals, did not constitute “profits.”(139) The possibility that income from commercial tenants would result in reduced rentals could possibly be considered “profits,” but the Court believed that the potential profits were “too speculative and insubstantial to bring the entire transaction within the Securities Acts.”(140)

The Forman opinion is both consistent and inconsistent with the Joiner-Howey line of cases. The Court’s functional analysis of the “stock” issue and its rejection of the literalist approach to construing definitional phrases is perfectly in line with the “economic reality” approach to the definition issue. However, the Court’s attempt to restrict “profits” to dividends and capital appreciation was far too restrictive and also unnecessary. The Court could have grounded its decision on factors that it discussed in its analysis of the question of whether there was an expectation of profits. The purchasers were clearly not motivated by a return on their investment

International Brotherhood of Teamsters v. Daniel

The Court continued to limit the scope of the securities laws in the case of International Brotherhood of Teamsters v. Daniel,(142) finding that a noncontributory pension plan established under a collective-bargaining agreement was not a security. In so holding, the Court restricted the first element of the Howey test and continued to depart from the “economic reality” approach to the definitional issue.

The Court proceeded from a formalistic perspective in its interpretation of the investment-of-money element of the Howey test. It first noted the obvious — that an employee in a noncontributory pension plan makes no payment into the fund.(143) It went further in arguing that only in an “abstract” sense can it be said that an employee exchanges his or her labor for possible pension benefits.(144) But, even in a legalistic sense, pension benefits are part of the consideration received in exchange for an employee’s labor. Also, the Court’s argument that an employee’s interest in future pension benefits is an “insignificant” one seems contrary to the practical importance of pension benefits to workers. The Court was confronted with the economic reality of the transaction, but refused to concede the substantial interests at stake. From a realistic perspective, employer contributions to the fund are a form of compensation to the employees. The employer’s agreement as to wages will logically depend on the fringe benefits offered to employees. Workers could choose to receive more in wages and invest the excess in mutual funds which would clearly be considered securities. The fact that the parties chose to agree to a noncontributory pension fund should not matter, at least from the perspective of the investor protection interests that are at the core of the securities laws.

The Court also found that an employee had no expectation of profits from a common enterprise.(145) Here, again, the Court introduced an artificial limitation on the third part of the Howey test. The Court conceded that the pension fund depended upon earnings from its assets, but it reasoned that the fund’s financial health also depended to a significant extent on continuing contributions from employers.(146) And, it concluded that an employee’s rights were governed by the vesting requirements of the plan, and were not entirely dependent on the fund’s earnings.(147) Thus, the Court concluded that the third part of the Howey test was not present.(148) Finally, almost as an aside, it suggested that the passage of the comprehensive regulation of private pensions under ERISA was clear evidence that noncontributory pension plans should not be considered securities.(149) Such action, the Court reasoned, suggested that Congress assumed that present regulatory controls were not sufficient to protect plan participants.(150) Moreover, securities regulation of such plans became superfluous with the enactment of ERISA.(151)

Daniel is a major departure from the Joiner-Howey line of cases. The Court unduly restricted both the first and third elements of the Howey test, placing legalistic limitations on those elements of the traditional definition. As in Forman, the Court continued to depart from the traditional economic approach to the definitional issue. Also, the Court embraced a new factor, the existence or nonexistence of an alternative regulatory scheme, to consider in the investment contract analysis. Although this factor was not a critical part of the Court’s investment contract analysis in Daniel, the Court, in subsequent cases, adopted it as a new limiting criterion to consider under the Howey test.

Marine Bank v. Weaver

The Court further restricted the Howey test in the case of Marine Bank v. Weaver.(152) In Marine Bank, the Weavers purchased a certificate of deposit from Marine Bank and subsequently pledged the CD to the bank to secure a loan to Columbus Packing Co. as part of a contract with the owners of the business, the Piccirillos.(153) The Weavers were to receive 50% of Columbus’ net profits and $100 per month as long as they guaranteed the loan to Columbus.(154) The Weavers also were given the right to use Columbus’ barn and pasture and had the right to veto any future borrowing by Columbus.(155) The Weavers claimed it was fraud on the part of the bank to claim that the money would be used for working capital when, in fact, almost all of it went to pay off money owed to the bank and other creditors.(156) Columbus went bankrupt and the Weavers sued for securities fraud under Section 10(b) of the 1934 Act.(157)

The Court concluded that neither the CD nor the business agreement was a security. In reaching its decision, the Court read the context clause(158) of the statutory definition as a limitation on the broad scope of the definitional language.(159) Under the Court’s interpretation of the context clause, an instrument falling within the definitional language may not be a security if the factual or transactional “context” does not justify securities law protection. The Court reasoned that Congress did not intend to create a broad federal remedy for all fraud.(160)

This context clause limitation was the basis for the Court’s opinion that the CD was not a security. The Court distinguished CDs issued by federally-insured banks from other forms of long-term debt instruments.(161) Because investors, like the Weavers, who purchase federally-insured CDs are usually protected in the event of a bank failure, securities law protection was deemed unnecessary and the Weavers’ CD was not considered a security.(162)

The business agreement, however, presented the Court with a more difficult question. From an economic perspective, the Weavers had invested money in an enterprise, Columbus Packing Co., with the expectation of a part of the profits of the business from the efforts of the owner-managers, the Piccirillos. Nevertheless, the Court concluded that this “unique” agreement negotiated “one-on-one” was not a security.(163) Its analysis was based on the premise that “Congress intended the securities laws to cover those instruments ordinarily and commonly considered to be securities in the commercial world ….”(164) The Court reasoned that the unique business agreement was “not the type of instrument that comes to mind when the term security is used.”(165) Howey and Joiner were distinguished on the basis that the unusual instruments found to be securities in those cases involve. offers to a number of potential investors, not a private transaction.(166) Also, in direct conflict with the Joiner-Howey line of decisions, it found that the lack of public trading of the Weaver interests was significant, noting that the interests in Joiner and Howey could have been traded.(167) Given these unusual aspects of the Weavers’ business agreement, the Court held that the agreement was not a security transaction.

The initial problem with the Court’s context analysis is that it is based on a faulty premise. Congress intended that the definition of a security would change if the text of a specific provision of the securities laws provided otherwise.(168) It did not, as the Court suggests, require an ad hoc, factual examination of a particular security transaction to determine whether the securities laws were applicable.(169) Moreover, the Court did not elaborate on the context clause limitation, although such a limitation could constitute a broad restriction on the definitional language.(170) Under the approach followed in Marine Bank, a second step is required under the traditional investment contract analysis. The first step would be to determine whether the instrument is a security under the three-part Howey test. The second step requires an examination of the transaction in which the security is being sold to determine whether the instrument should be considered a security.(171) Although it is clear that one factor to consider in the transactional analysis is the existence or nonexistence of an alternative regulatory scheme for the protection of investors, Marine Bank created uncertainty in terms of what other facts should be considered in such an open-ended “context” analysis. The only guidance was in a footnote to its opinion, in which the Court made the following observation:

It does not follow that a certificate of deposit or business agreement
between transacting parties invariably falls outside the definition of
a “security” as defined by the federal statutes. Each transaction
must be analyzed and evaluated on the basis of the content of the
instruments in question, the purposes intended to be served, and
the factual setting as a whole.(172)

This “totality of the circumstances” approach provides little or no guidance to the courts, administrative agencies, or those planning business ventures as to whether the “context” of a particular instrument’s sale causes the transaction to fall outside of the scope of the securities laws. Moreover, the theoretical foundation upon which this “context” limitation rests is never articulated by the Court.(173) The Marine Bank Court never explained the purpose of an analysis of context, other than to indicate that the securities laws were not designed to provide a federal remedy for fraud outside of the security sale context. After Marine Bank we are left with a sort of “common sense” inquiry. Is this the type of instrument or transaction that we usually think of when we use the term “security”? In Marine Bank, the Court concluded that it was not based primarily on the fact that the business agreement was a private, one-on-one transaction with contractual terms and conditions that are uncommon in most investment settings.

Thus, Marine Bank superimposed another restrictive element on the Howey test. The public transaction/private transaction distinction could be read as requiring a traditional investment instrument or secondary trading for an investment to be a security. In this sense, the opinion runs counter to two principles firmly established under the Joiner-Howey line of decisions. First, unique business agreements are not immunized from regulation under the securities acts. To protect the investing public, the securities laws were designed to deal with both customary and non-traditional forms of investments. Investment instruments are to be viewed from a substantive economic perspective (not a formal legal perspective) to see if the three-part Howey test is met. Second, and perhaps more important, secondary trading never had been a requirement for an investment contract to be a security. For example, the shares in Tcherepnin were nonnegotiable under Illinois law, but this legal attribute was not sufficient for the shares to fall outside of the scope of the securities laws. The Tcherepnin Court considered a number of “unique” legal attributes of such shares as unimportant to the question of whether the shares were securities. Moreover, a requirement of secondary trading is inconsistent with the overriding purpose of the laws to protect the investing public not only from fraud in the ongoing trading in the national financial markets, but also from deception in the initial sale of securities to the general public. After all, the primary purpose of the Securities Act of 1933 is to control the initial issuance of securities to ensure that investors are provided with material information before a security is traded on any secondary market.

In a more limited light, Marine Bank could be read as requiring more than one investor for an investment to constitute a security. One theoretical basis for such a requirement is that Howey requires a multiplicity of investors under the second prong, the common enterprise element.(174) What is a common enterprise or, in other words, what type of commonality is required is an issue that has divided the federal circuit courts, and one that the Court has unfortunately chosen to avoid.(175) In some federal circuits, this element can be satisfied only if there is “horizontal commonality,” which requires that there be a pooling of investments in a venture, often combined with a)pro rata sharing of profits.(176) In contrast, other circuits, although recognizing horizontal commonality, also allow “vertical commonality” to establish the common enterprise element.(177) Vertical commonality requires only that there be a relationship between the investor or investors and the promoter, “one in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties.”(178) Under the broadest view of vertical commonality, a private investment transaction satisfies the common enterprise element if the investor’s returns are tied to the managerial or entrepreneurial efforts of the promoter.(179) A more strict view of vertical commonality requires that the investor’s returns be tied to the promoter’s returns, not merely the promoter’s efforts.(180) The one-on-one business agreement in Marine Bank would satisfy either the broad or strict view of vertical commonality, but would fail to meet the requirement of a pooling of investments under the horizontal commonality approach.

An alternative rationale would be to link the requirement of a multiplicity of investors to the third prong of Howey.(181) That is to say, a single investor in a privately negotiated transaction is not expecting profits from the efforts of others. The investor is not dependent on others because he or she can bargain for contract-related protections from risk as well as for the type of disclosures mandated by the securities laws.(182) Therefore, some type of “public” sale involving a multiplicity of investors is essential to satisfy the third prong of Howey. Thus, Marine Bank may suggest that the Court is usually going to require a multiplicity of investors for the common enterprise element to be met(183) or as an essential implied element under the third prong of Howey.

Back to the Future: The Court Returns to the Traditional Test for a Security

Landreth Timber v. Landreth

In Landreth Timber v. Landreth,(184) the Court appeared to retreat from the broadest reading of the Marine Bank opinion. The case involved the issue whether the sale of 100% of the stock in a closely-held corporation was the sale of a security.(185) The lower court had adopted the so-called sale-of-business doctrine under which the transaction was viewed as a commercial venture (a sale of business assets) as opposed to a typical passive investment in corporate stock.(186) The sale-of-business doctrine could be traced to Forman and was supported by the “context” analysis the Court embraced in Marine Bank. These cases appeared to necessitate an economic analysis to determine whether any securities transaction, including a sale of corporate stock, fell within the reach of the securities laws.(187)

In declining to adopt the sale-of-business doctrine, the Court relied on a number of arguments. It rejected the analogy to Forman, reasoning that the stock in Forman was not considered a security because it did not have the typical attributes of corporate stock.(188) Unlike the co-op stock in Forman, the stock in Landreth possessed all of the normal incidents of common stock.(189) The Court also rejected the notion that “stock” should not be considered a security if the underlying transaction does not satisfy the Howey test.(190) The Court reasoned that an economic reality analysis had been employed only in transactions involving instruments that did not readily fit into the definitional language.(191) Also, the Howey test, and the “economic reality” approach, were designed to determine the scope of the “investment contract” concept, not to define other instruments, like stock, listed in the definition section.(192) It further held that the premise of the sale-of-business doctrine was flawed

In support of a bright line rule that any sale of traditional stock is a security transaction, the Court made several policy arguments. First, it reasoned that stock is the paradigmatic security under the Acts. Persons trading in stock, therefore, reasonably believe that they will be protected under the securities laws.(194 Second, identifying the attributes of traditional stock is a relatively straightforward task, and, therefore, stock lends itself to a plain meaning definition.(195 Finally, the sale of business doctrine, the alternative to a bright line rule, is based on a passage of control to the purchaser, a determination that is both factually and legally difficult to make.(196 The difficulty of formulating the standards for a transfer of control when the interest sold is less than 100%, as well as the additional burden on the courts to make such difficult judgments, were considered important policy reasons to reject the sale-of-business doctrine and to adopt a per se rule for stock.(197

Landreth departs from the restrictive approach of Forman and Daniel and conflicts with Marine Bank in several respects. First, the Court impliedly repudiated the public transaction/private transaction distinction created in Marine Bank. The Court recognized that the securities laws were designed to protect not only passive investors purchasing securities in the open market, but also investors who purchase stock in private transactions for the purpose of actively managing an enterprise. Second, unlike the “context” analysis of Marine Bank, the Court refused to consider the underlying nature of the Landreth stock transaction to determine whether the securities laws applied to the transaction. The Court reasoned that a substantive analysis was unnecessary because the “economic reality” approach of the Joiner-Howey line of cases applied only to investment contracts. Although this may explain why the Court did not analyze the transaction under the Howey test, it does not adequately address the Court’s failure to engage in a “context” analysis of the particular stock transaction, the second step it employed in Marine Bank. Justice Stevens, in a dissenting opinion, made the “context” case that Congress did not intend the securities laws to cover a private sale of a substantial ownership interest of a business simply because it is structured as a sale of stock.(198 His theory was that Congress was primarily concerned with the protection of investors who do not have inside information and who are not in a position to protect themselves from fraud.(199 The Landreth majority refused to engage in an analysis of the context of the transaction, and simply opted for a clear rule applicable to a change of control involving stock. Thus, the Landreth Court appeared to retreat from the public transaction/ private transaction distinction and the “context” limitation adopted in Marine Bank.

Reves v. Ernst & Young

Reves v. Ernst & Young,(200) coupled with the Landreth decision, suggests that the Court has now abandoned some of the limiting criteria adopted in Forman, Daniel, and Marine Bank and returned to a more traditional approach to the definitional issue.(201) Reves involved the issue of whether demand notes sold by a bankrupt farm cooperative were securities.(202) The notes were issued by the co-op to raise operating monies, sold to numerous members and nonmembers, and paid a variable rate of interest to the holder.(203) The investors brought suit under Section 10(b) claiming fraud in the sale of the notes. A jury awarded them $6.1 million.(204) The Eighth Circuit Court of Appeals reversed, however, finding that the notes were not “securities” under the Howey test.(205)

The Court’s opinion is Reves is a synthesis of its prior opinions and an attempt to clarify the uncertainties created by its recent decisions. Landreth was viewed as a special case because stock is the paradigmatic security.(206) Thus, the per se rule for stock is unique to corporate stock, and the Court declined to adopt that approach for the word “note.”(207) Notes, unlike corporate stock, the Court logically reasoned, serve multiple commercial functions, not all of which involve investments.(208)

At the same time, the Court declined to adopt the Howey test for notes, reasoning that standard applied to investment contracts, not other instruments listed in the definition section.(209) Applying the Howey test to other listed instruments would, in effect, render their inclusion meaningless and would be inconsistent with Congress’ intent to regulate the entire spectrum of investments to protect the investing public.(210)

In lieu of the Howey test, the Court adopted the “family resemblance” test as a workable framework for analysis.2″ The “family resemblance” test presumes that a note is a security unless it falls within a list of notes, developed by the courts, that are not considered securities.(212) So, for example, if a note is given in connection with consumer financing, it is not considered an investment note.(213) Notes that resemble one of the instruments identified as not being securities also fall outside the scope of the securities laws.(214) The Court, however, added substance to the test by requiring an analysis of what economic factors are important in differentiating investment notes from noninvestment notes.(215) The Court identified four key factors for the courts to consider: the motivations of the reasonable seller and buyer, the plan of distribution for the instruments, the reasonable expectations of the investing public, and the existence or nonexistence of an alternative regulatory scheme that reduces the risk of the instrument.(216)

After applying the four-factor analysis to the notes of the co-op, the Court concluded that the notes were securities. First, the co-op’s motivation or purpose was to sell the notes to raise monies for the general operation of the business

Reves can be viewed as a revival of the traditional test under a multi-factor test for the definition of a security.(222) Although the factors identified by the Reves Court were used to distinguish investment from noninvestment notes, the Court characterized the factors as “the same factors this Court has held apply in deciding whether a transaction involves a ‘security.”‘(223) Thus, at the same time that it was adopting a test to determine whether a note is a security, the Court established a more general framework for analyzing whether an instrument is a security. Also, it returned to an “economic reality” approach under its multi-factor analysis. The economic motivation of seller and buyer, the plan of distribution, and the reasonable expectations of the investing public have always been part of the definitional analysis under the rubric of the three-prong Howey test. The fourth factor, the existence or nonexistence of an alternative regulatory scheme, is of more recent origin, originally appearing in Daniel and followed in Marine Bank. This multi-factor analysis, therefore, is a combination of the critical factors under the traditional test with the addition of the new “alternative regulatory protection” factor.

Just as important as the factors mentioned by the Court is the absence of certain factors that the Court apparently had embraced as limiting criteria under the Howey test. The model does not incorporate the public transaction/private transaction distinction created in Marine Bank which was implicitly repudiated in Landreth. Similarly, the Court explicitly repudiated the notion that “common trading” required for a security requires secondary trading of an investment contract. In analyzing the plan of distribution factor in Reves, the Court found that the sale of notes to numerous investors was all that was necessary for there to be “common trading.” And finally, the restrictive definition of profits that surfaced in Forman–profits being limited to a share of earnings or capital appreciation of an investment-is not applied to the notes in Reves, where the Court found that the interest paid to the noteholders was sufficient for the “profit” factor to be present.(224)

The Court’s opinion in Reves gives some indication of the Court’s future direction with respect to the scope of the securities laws. Although there is still uncertainty regarding the application of Reves outside of the note context, the opinion signals a return to a more traditional approach to the definitional issue. It also has implications for the question whether LLC interests are securities and the proper framework to resolve that issue. Before an analytical framework for resolving the LLC issue is suggested, however, it is instructive to consider the interpretation of the third prong of the traditional Howey test and its application to partnerships and joint ventures, business organizations that resemble the limited liability company.

Partnerships, Joint Ventures, and the Third Prong of the Howey Test

In determining whether LLC interests are securities under the traditional Supreme Court definition, the critical issue is the third prong of the Howey test. LLC investments will almost invariably involve an investment of money, and, except for two-person LLCs, an LLC will satisfy the common enterprise element because of the presence of horizontal commonality. The third prong, as stated in Howey, requires the investor to be relying “solely” on the efforts of the promoter or third party for there to be an investment contract. In an LLC,is the investor relying “solely” on the efforts of the promoter or third parties? This issue initially involves the proper interpretation of the third prong. Does the phrase “solely from the efforts of the promoter” mean that any investment scheme under which the investor participates in the business is not a security? Or is the phrase to be given a realistic interpretation in light of the “economic reality” approach to the definitional issue? In addition to the proper interpretation of that phrase, its application to LLCs must be addressed. Because LLC members will have some degree of control over the management of the LLC, it can be argued that the LLC members are not passive investors, but rather active participants in the operation of the business. Thus, under the Howey test, the argument can be made that LLC interests are not securities based on the legal control that LLC members have over the enterprise. The courts have addressed the proper interpretation of the third-prong of Howey and faced analogous issues in the application of the third prong to partnership and joint venture investments. An examination of those cases provides insight into the resolution of the LLC securities law issue.

The Glenn Turner Formulation of the Third Prong of Howey

How has the third prong of the Howey test been interpreted in cases in which an investor is directly involved in the business or in some way contributes to the success or failure of the venture? Although a literal interpretation of the third prong would suggest that interests in such enterprises are not securities, the lower federal courts have adopted a liberal interpretation of the Howey language. Nominal participation by an investor in an investment scheme does not preclude the interest from being a security under the Howey test. The seminal case on this issue is the decision of the Ninth Circuit in SEC v. Glenn W. Turner Enterprises, Inc.(225)

In Glenn Turner, a wholly owned subsidiary of the defendant Turner, Dare To Be Great, Inc., marketed get-rich-quick schemes in what the Ninth Circuit characterized as a “gigantic and successful fraud.”(226) Purchasers were sold plans called “Adventures,” which involved seminars and materials on self-improvement and sales ability.(227) Purchasers of Adventures III and IV, which cost $2,000 and $5,000 respectively, became “independent sales trainees” of Dare with the right to sell Adventure plans to others with a commission on any sale.(228) The sales trainee’s job was to convince prospects to come to a Dare meeting.(229) At the meeting, Dare employees used various techniques to convince prospects of the lucrative nature of the Dare program.(230) When the SEC brought an action to enjoin the fraudulent sale of the Dare plans, the issue was whether the plans were securities under federal law.(231)

The securities issue focused on the third prong of the Howey test and, in particular, the language indicating that the investor had to be relying “solely” on the efforts of others for an offering to involve an investment contract.(232) Obviously, the Dare investors had to bring in prospects to the seminars for them to derive income from the scheme, and, therefore, they were not relying solely on the efforts of Dare for a return on their investment.(233) Thus, the Ninth Circuit was confronted with the proper construction of the Court’s language in Howey.

Relying on the remedial nature of the securities laws, and the overriding purpose of protecting the investing public from all types of fraudulent investment schemes, the court concluded that the language should not be read in a literal way so as to impose an unrealistic limitation on the Howey test.(234) The court reasoned that such a mechanical approach would result in an unduly restrictive definition of an investment contract, one that would not adequately protect the investing public.(235) Moreover, it would invite sellers of fraudulent securities to impose some participation requirements on purchasers in order to immunize the investments from the securities laws and thereby evade the requirements of the law.(236)

The court interpreted the third prong of Howey to mean that the “efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”(237) Applying this test to the Dare investment scheme, the court readily concluded that it was a security. The Dare investor was in effect purchasing a share of the proceeds of Dare’s selling efforts. “[T]hose efforts are the sine qua non of the scheme

The liberal interpretation of Howey announced in Glenn Turner has been cited by other federal courts in various investment contexts(239) and represents the accepted view on the issue.(240) Although the Supreme Court has not addressed the issue, it has cited to Glenn Turner with apparent approval. In Forman, the Court restated the third-part of the Howey test to require only a “reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”(241) Therefore, investors need not be relying solely on the efforts of others for an investment to constitute a security

General Partnerships and Joint Ventures

The courts have considered the issue of whether interests in noncorporate business organizations constitute securities under this liberal reading of the third prong of Howey. Outside of the corporation context, a business can take many forms, from a general partnership to a limited partnership to a joint venture. Since LLCs are a hybrid form of business organization, sharing characteristics of both partnerships and corporations, the cases on partnerships have particular importance to the securities law issue. General partnership and joint venture interests are not usually considered securities because the owners are active participants in the business who directly control it.(242) Thus, the third-part of the Howey test, expectation of profits from the managerial efforts of the promoter or third parties, is not usually present.

Williamson v. Tucker

The general rule regarding the security status of general partnership interests has been qualified by the courts to give effect to the economic reality as well as the legal form of the investment. The leading decision in this area is the Fifth Circuit’s opinion in Williamson v. Tucker.(243) In Williamson, sophisticated businesspersons invested monies in several joint ventures that acquired interests in a 160 acre tract of land between Dallas and Fort Worth near the proposed location of the Dallas-Fort Worth airport.(244) One of the sellers, Godwin Investments, was able to attract the investors based on the investment potential of the land and the expertise of Godwin in developing property.(245) The expectation was that Godwin would manage the property and after a period of appreciation, either sell or develop it.(246) The joint venturers did, however, retain significant control over the venture in that a vote of sixty to seventy percent was required to approve any development.(247)

In applying the Howey test to the joint venture, the Fifth Circuit reviewed cases where investors retained control over a business venture, including cases involving general partnerships and joint ventures, and concluded that such investments are generally not securities.(248) The rationale was that such investors have access to information that protects them from a dependence on others and that the partners’ control rights are significant (not nominal) ones.(249) Therefore, partners should be on notice that the securities laws will not protect them.(250)

The court recognized, however, that an investor in a partnership may be dependent on a promoter or third party to such an extent that in reality the powers retained are illusory.(251) In such cases, the investment should be considered a security.(252) However, the court placed a heavy burden on a partnership investor claiming the protection of the securities laws:

Such an investor must demonstrate that, in spite of the partnership
form which the investment took, he was so dependent on the
promoter or on a third party that he was in fact unable to exercise
meaningful partnership powers.(253) A general partnership or joint
venture interest can be designated a security if the investor can
establish, for example, that (1) an agreement among the partners
leaves so little power in the hands of the partner or venturer that
the arrangement in fact distributes power as would a limited partnership
or (2) the partner is so inexperienced and unknowledgeable
in business affairs that he is incapable of intelligently exercising his
partnership or venture powers
so dependent on some unique entrepreneurial or managerial ability
of the promoter or manager that he cannot replace the manager of
the enterprise or otherwise exercise meaningful partnership or
venture powers.(256) The investors in Williamson, who retained significant powers and were capable of exercising those powers, were unable to demonstrate such dependence on Godwin.(257) Nor could they establish any unique entrepreneurial skills of Godwin upon which they were relying.(258) Thus, the joint venture interests were not considered securities.(259)

Post-Williamson Cases on General Partnerships and Joint Ventures

Williamson provides a useful framework for analyzing whether partnership interests are securities, and it has become the prevailing view on the issue.(260) It is subject to criticism, however, because of its undue emphasis on the legal aspects of general partnerships, the latent control retained by the general partners, to the exclusion of the economic reality of a particular partnership or joint venture investment.(261) Moreover, the test is extremely rigid, requiring a lack of sophistication or a type of dependence on unique skills that will rarely be present in an investment setting. The test does not recognize that there are different degrees of dependence and levels of business knowledge, and that the important question should involve the reasonable expectations of the parties regarding the partners’ participation in the venture and his or her reliance on others’ managerial or entrepreneurial skills.

The inflexibility of the Williamson test is amply demonstrated by several post-Williamson decisions of the federal circuit courts. Perhaps the most extreme is the Fourth Circuit’s opinion in Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc.,(262) an opinion written by retired Supreme Court Justice Powell. The case involved a Virginia general partnership with twenty-four partners that was formed to own and operate fishing boats and engage in commercial fishing.(263) The issue of the partnership interests as securities under federal law arose when the partners sued numerous individuals for securities fraud.(264)

Justice Powell “embraced” the Williamson test, characterizing it as a “narrow exception” to the general rule that general partnership interests are not securities.(265) He limited the court’s substantive analysis under Williamson to an examination of “the partnership agreement and circumstances of a particular partnership.”(266) Thus, he placed significant emphasis on the rights retained by the partners under the partnership agreement.

When … a partnership agreement allocates powers to the general
partners that are specific and unambiguous, and when those powers
are sufficient to allow the general partners to exercise ultimate
control, as a majority, over the partnership and its business, then
the presumption that the general partnership is not a security can
only be rebutted by evidence that it is not possible for the partners
to exercise those powers.(267)

In terms of the sophistication of the investors, he noted that it is inappropriate to examine the “actual knowledge and business expertise of each partner

Similarly, with regard to the third exception recognized in Williamson, investor dependence on the unique entrepreneurial skills of the managers of the partnership, Justice Powell reasoned that this dependence cannot be established by showing that the partners were passive investors rather than active participants in the management of the business. “The fact that some of the general partners may have remained passive . . . does not affect the result. General partners who are capable of exercising significant managerial powers cannot convert their partnership interests into a security merely by remaining passive.”(271) On the other hand, in finding the general partnership interests not to be securities, Justice Powell relied in part on the conduct of the partners in participating in managing the business.(272) He reasoned that this conduct established that “they were not dependent on the irreplaceable skills of others.”(273) Thus, the partners’ active involvement in the business is used to support the proposition that the interests were not securities. However, Justice Powell precludes the use of contrary evidence of passivity to support a finding of dependence under the third exception in Williamson.

Justice Powell’s opinion in Rivanna Trawlers comes close to a conclusive presumption that an interest in a general partnership is not a security,(274) the position adopted by the Third Circuit in Goodwin v. Elkins & Co.(275) Other post-Williamson decisions have employed a less restrictive approach to the issue. Illustrative is Koch v. Hankins,(276) a case in which the facts closely parallel the circumstances in Howey. Like the sale of interests in a citrus farm in Howey, Koch involved the sale of interests in a jojoba plantation. One hundred and sixty investors, mostly medical professionals, invested between $23,000 and $500,000 in a 2700 acre jojoba farm.(277) The investments were being promoted by a group of accountants and attorneys, some of whom had longstanding professional relationships with some of the investors.(278) The investment scheme consisted of thirty-five general partnerships, each of which acquired eighty acres of the plantation from a common seller.(279) The investors were told that it was not economically feasible to farm jojoba in eighty-acre parcels, and, therefore, the investors did not consider their general partnership investments as separate from the 2700 acre plantation.(280) Each general partnership had its own operating partner, but the partnerships hired a common foreman who was to manage the farm operations with the consultation of experts on jojoba.(281) When the investment in the “super bean of the future” went sour, the plaintiff-investors sued the promoters for securities fraud.(282)

The Ninth Circuit considered the issue whether the investments were securities in the context of an appeal from a summary judgment for the defendants.(283) The court applied the Williamson test to the general partnership interests.(284) Unlike Rivanna Trawlers, however, the court did not confine itself to the partnership agreement.

In determining whether the investors relied on the efforts of others,
we look not only to the partnership agreement itself, but also to
other documents structuring the investment, to promotional materials,
to oral representations made by the promoters at the time of
the investment, and to the practical possibility of the investors
exercising the powers they possessed pursuant to the partnership

Although it considered all of these factors, it employed a strict application of the Williamson test. Under the first Williamson exception, it rejected the argument that the structure of the investment scheme distributed power in much the same way as a limited partnership.(286) The court concluded that this exception is limited to a consideration of “the legal powers afforded the investor by the formal documents,” not the ability of the partners to effectively exercise those powers.(287) Limiting the exception in this fashion, the court readily concluded that the partners retained significant powers, including the authority to replace the operating partner, to cease doing business, and to terminate the contract with the foreman.(288)

The investors fared only slightly better under the second exception. The court conceded that none of the investors had any experience in jojoba farming, and it was undisputed that jojoba farming was new to the United States.(289) But it concluded that the focus under Williamson’s second exception should be on the investors’ knowledge and experience in business affairs, not experience in the specific type of business involved in the investment scheme.(290) Although it noted that all of the investors were professionals with substantial monies to invest and that some had prior experience in similar ventures, it made no finding on the factual issues of sophistication and experience underlying the second exception, remanding the matter to the trial court for determination.(291)

Finally, with respect to the third exception, the court concluded that the structure of the investment scheme made it impossible for the investors to replace the manager of the enterprise.(292) Although the partners could terminate the manager of their eighty-acre plot, there was no legal mechanism or practical means to change the management of the entire plantation.(293) The only way of accomplishing such a change would be to secure the approval of the other thirty-five partnerships, a task that would be extremely difficult.(294) The court further reasoned that even if a partner could secure the concurrence of all thirty-five partnerships, finding a replacement jojoba manager would likewise be problematic.(295) Thus, the court concluded that the investors had raised an issue of fact for trial regarding whether the partnership interests were in fact securities.(296)

Even though the investors in Koch were able to make a triable claim under the Williamson test, the rigidity of the Williamson framework is quite apparent from the court’s application of the test in Koch. In part, this is caused by the need to pigeonhole a particular investment scheme within one of three narrowly confined and limited exceptions. In addition, however, the focus on an unrealistic type of dependence seems to be misplaced. For example, in Howey, the investors would not have been able to meet the strict requirements of dependence under Williamson. The Howey investors, like the investors in Koch, were professionals who presumably were sophisticated in business affairs. Similarly, the Howey investors would have had a difficult time establishing that they were relying on some unique entrepreneurial skills of the managers or promoters when, in fact, there were other businesses that could have managed the investors’ citrus acres. But even if the Howey investments were structured as a joint venture or partnership, as opposed to a sale of land, an analysis of the economic substance of the scheme would have led to the inescapable conclusion that the interests were securities under the traditional standard for an investment contract.

The above analysis suggests that the Williamson test needs to be modified to be consistent with the traditional Howey test. A more flexible and practical analysis was employed by the Sixth Circuit in Stone v. Kirk.(297) John Kirk, a certified public accountant, convinced his client, David Stone, a mechanic with a high-school education, to invest in tax shelters to reduce his tax liability.(298) Each tax shelter was structured as a joint venture which was set up to lease “master recordings” of country music singers from Sagittarius Recording Co.(299) Kirk, who was designated the agent for the joint ventures, received secret commissions from Sagittarius.(300) When the IRS disallowed the tax benefits and Kirk went into bankruptcy, Stone and his wife brought a Rule 10b-5 suit against Kirk.(301) The issue whether the joint venture interests were securities was one issue Kirk raised on his appeal of a judgment for the Stones.(302)

Kirk argued that the third prong of Howey was not present because the joint venturers were responsible for the management of the “master recording” leases.(303) Conceding that the joint venturers were, from a legal perspective, general partners, the court looked beyond the legal form of the agreement to the economic substance of the arrangement between Kirk and Stone. “[T]he notion that anyone envisioned the investors themselves carrying on manufacturing and marketing efforts is simply not correct.”(304) The court reasoned that the Stones were not experienced in the music business and thus had no intention of becoming active in the business.(305) Rather, as the joint venture agreements indicated in the broad delegation of management authority to Kirk, the investors were looking to Kirk and relying on his financial expertise to run the business of the joint ventures.(306) Thus, the joint venture interest was a security because the joint venturers were passive investors who invested in reasonable reliance on the efforts and expertise of the managers.(307)

As in Williamson, the court in Stone v. Kirk considered the structure of the partnership agreement, the sophistication of the investors, and the expertise of the promoters in determining whether the interests were securities. In contrast to the restrictive approaches in Rivanna Trawlers and Koch, the Sixth Circuit engaged in the sort of “economic reality” analysis that is at the heart of the traditional Howey test. This was accomplished by focusing on the ultimate issue of whether the investors were reasonably relying on the efforts and expertise of the promoters in the management of the enterprise. This comports with the third prong of Howey, the requirement of “reasonable expectations of profits to be derived from the entrepreneurial or managerial efforts of others.”

Thus, the factors listed in Williamson, if applied in a liberal fashion, can provide a workable standard in the partnership area. A multifactor analysis similar to Reves that would consider the substance of the partnership agreement, including the sophistication of the investors, their actual reliance on the managers of the business, and their dependence on the entrepreneurial skills of the managers or promoters, would be preferable to Williamson. The Williamson framework should not, however, be totally abandoned. The major advantage of the Williamson approach is that it adds a degree of certainty to the securities law issue. By placing the burden on investors to demonstrate that general partnership or joint venture interests are securities, Williamson creates a presumption that such interests are not securities. Thus, business planners and attorneys can proceed on that assumption in structuring their business ventures. Similarly, investors in such businesses are put on notice that the securities laws will provide them limited protection when they enter into an investment contract where they have retained significant control rights and are not relying on the managerial expertise of the promoters or managers.

Limited Partnerships

In contrast to general partnership interests, limited partnership interests are generally considered securities because the limited partner is a passive investor who does not participate in management and who is thus dependent on the managerial skills of the general partner for a return on his or her investment.(308)

Limited partners … do not share the kind of authority wielded by
general partners. Their liability for the partnership is limited to the
amount of their investment. They cannot ordinarily dissolve the
partnership, nor can they bind other partners. Further, they have
little or no authority to take an active part in the management of
the partnership. A limited partner’s position is analogous to that of
a stockholder in a corporation.(309) Thus, the weight of judicial authority is that interests in limited partnerships are at least presumptively securities.(310)

This presumption regarding the security status of limited partnership interests is very strong?(311) A typical example of the courts’ approach is the Seventh Circuit’s opinion in Goodman v. Epstein,(312) a case in which a small group of sophisticated individuals invested in a limited partnership involved in a residential real estate development.(313) When the plaintiffs lost their securities fraud case at trial, they appealed claiming, among other things, that the trial court should have determined that the limited partnership interests were, as a matter of law, securities.(314) Although one of the limited partners had been actively involved in setting up the financing for the venture,(315) the appellate court deemed that participation insufficient to overcome the fact that the limited partners were effectively prohibited from managing the business, and, in fact, had not been involved in “any of the essential management decisions affecting the basic direction of the partnership.”(316)

As suggested by the Goodman court, the presumption that limited partnership interests are securities can be overcome only by a showing of a significant degree of managerial control by the limited partners, i.e., control to such an extent that the limited partners are not relying on the managerial effort of the general partners for profits from the business venture. Thus, in Frazier v. Manson,(317) a limited partner’s interest was not considered a security when that partner was also a general partner.(318) James Frazier had entered into a general partnership with Dean Manson to engage in real estate ventures through limited partnerships.(319) The Frazier-Manson partnership acted as the general partner in the five limited partnerships that were later formed, the partners expecting profits from Manson’s soliciting efforts and Frazier’s property management skills.(320) The Fifth Circuit affirmed a dismissal of Frazier’s securities claim against Manson that was predicated on Frazier’s status as a limited partner, agreeing with the trial court that Frazier’s partnership interests were not securities because both Manson and Frazier were to be involved in the “management and profitability of the limited partnership.”(321)

Similarly, when a limited partnership is structured like a general partnership in terms of the control rights of the limited partners, the partnership interests have been treated like general partnership interests for securities law purposes. The leading case is Gordon v. Terry,(322) in which Edwin Gordon invested $4 million in a real estate syndication promoted by E. G. Green.(323) Green claimed that because of his contacts, he could acquire undeveloped land in central Florida for below-market prices and, within two years, sell the property for a profit.(324) Four of the syndications were set up as trusts, a fifth was structured as a limited partnership.(325) The limited partnership agreement provided, however, that majority consent of the partners was required for any disposition of the property, effectively giving the limited partners control over the most significant decisions of the partnership.(326) Although the Eleventh Circuit recognized the general rule as to the security status of limited partnership interests, the court concluded that the real estate partnership lacked the traditional attributes of a limited partnership because control was vested in the limited partners.(327) The securities law issue, therefore, was analyzed under the Williamson test for general partnership interests.(328) The court allowed the case to proceed to trial against Green on the theory that the partners could have been dependent on the unique expertise of Green in the Florida real estate market, expertise that Green touted in promoting the deal to the investors.(329)

The critical importance of managerial control is further illustrated by the Fifth Circuit’s opinion in L & B Hospital Ventures, Inc. v. Healthcare International, Inc.(330) In L & B Hospital Ventures, a limited partnership was formed to operate an inpatient treatment facility in Houston, Texas.(331) The limited partners — three psychiatrists and a medical corporation — claimed fraud by the general partner, Brown Schools, Inc., in the sale of the limited partnership interests to the general partner(332) The trial court concluded that the physicians’ active involvement in the hospital, and their contribution to the success of the enterprise, precluded a finding of a security under the third prong of Howey.(333) Although conceding that “the key is managerial efforts,”(334) the circuit court distinguished between the “professional or clinical control” of the limited partners, and the “managerial control” exercised by the general partner.(335) The court concluded that the limited partnership interests were securities because the limited partners did not exercise managerial control over the facility nor did they have the power to do so.(336) This conclusion was supported by the terms of the partnership agreement, under which the limited partners had no managerial rights, and the actual operation of the facility, whose essential business functions were performed by the general partner.(337)

Relying on the legal nature of the limited partnership, the cases establish a strong presumption that limited partnership interests are securities. This presumption is beneficial because it puts business planners and limited partnership promoters on notice that they will usually have to comply with the securities laws and will be subject to securities fraud liability. Limited partnership investors also are assured that they generally will be protected under the securities laws. The “control” test that emerges from the limited partnership opinions suggests that this presumption can be rebutted, thereby creating an exception for limited partnerships in which the limited partners exercise essential managerial control. This “control” exception is in line with the third prong of Howey, that investors expect profits from the managerial efforts of others, not their own efforts. Resolution of the “control” exception, however, requires the same sort of flexible “economic reality” analysis that should be employed under Williamson, one that considers a range of relevant facts, including the structure of the partnership, the sophistication of the investors, the purported expertise of the promoters, and the actual operation of the business. Such an approach could integrate the standards for determining the security status of both limited partnership and general partnership interests under one analytical framework.

An analysis of the court decisions on general and limited partnerships provides insight into the proper resolution of the LLC-interest-as-security issue. Any test to determine the security status of LLC interests should take into consideration the legal attributes of LLCs but should not give controlling effect to such formal characteristics. Additionally, any test should provide a degree of certainty for the benefit of businesses planning LLC ventures while at the same time allowing the courts and administrative agencies flexibility to judge a particular LLC investment from a substantive perspective in order to protect LLC investors. Prior to proposing such an analytical framework, we explore the various approaches adopted by the states to resolve the LLC issue.


Divergent State Approaches to the Issue of LLC Interests as Securities

The issue of whether limited liability company interests are securities has been addressed by state legislatures and state securities administrators. A number of different approaches to the issue have been adopted.(338) In a handful of states-Alaska,(339) New Mexico,(340) Ohio,(341) and Vermont(342) — the definition section of the Blue Sky Law has been amended expressly to include, without qualification, limited liability company interests.(343) To reduce the burden of regulatory compliance caused by subjecting all LLCs to the state securities laws, these states have usually provided a specific registration exemption for some LLCs, typically for private sales to a small number of LLC investors.(344) For example, in New Mexico, a New Mexico LLC is exempt from registration if there are no more than twenty-five members after the sale, the issuer reasonably believes that the buyers are purchasing for investment (not resale), there is no general advertising or solicitation, and no sales remuneration is paid to unlicensed persons.(345)

California and Indiana have adopted a unique statutory approach to the question. In both states, an LLC interest is included within the security definition.(346) However, each state provides an exclusion from the definition for LLC interests if the person claiming the exemption proves that “all of the members are actively engaged in the management of the limited liability company.”(347) California law provides some additional guidance as to what constitutes being “actively engaged” in management.

Evidence that members vote or have the right to vote, or the right
to information concerning the business and the 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.348

Thus, it appears that the exclusion is a limited one, applicable to only a closely-held limited liability company in which all of the members participate in the company’s business decisions. One passive member is sufficient to preclude the application of the exclusion, subjecting the issuer not only to the anti-fraud provisions, but also, absent an exemption, to the registration requirements of the state securities law.

Recently, Pennsylvania adopted an approach that is similar to California’s exclusion. Under Pennsylvania’s definitional provision, a membership interest in an LLC is a security unless three conditions apply: (1) the LLC is not managed by managers

The California and Pennsylvania statutes have some serious drawbacks. First, the problem of what constitutes being actively engaged in management (active and direct under Pennsylvania law) is unclear. This may cause some of the same definitional problems experienced by the courts in interpreting similar language under the Uniform Limited Partnership Act.(350) Second, the exclusion provisions are underinclusive. The statutory exclusions are clearly designed to cover LLCs that are structured like a traditional general partnership. But, by requiring all members to be actively involved in the LLC, the exclusion is too restrictive, eliminating a typical arrangement under which one partner manages the business affairs while the other partner or partners provides most of the financing. Pennsylvania’s approach does not necessarily solve the problem. Although the Pennsylvania law requires a partnership model of governance and a written commitment from the partners to participate actively in the business, the passive investor in such an enterprise still will be able to claim that his or her interest is a security.

An alternative approach is to adopt a rebuttable presumption that under certain conditions an LLC interest is a security. Wisconsin law, for example, presumes that an LLC interest is a security if the right to manage the LLC is vested in one or more managers or there are greater than thirty-five members after the sale of the LLC interests.(351) If the LLC vests managerial authority in the members, and the LLC has fewer than thirty-five members, the LLC interests are not presumed to be securities.(352) Wisconsin law also provides a safe harbor that excludes from the definition of security any interest in a Wisconsin LLC where the right to manage is vested in the members and there are fewer than fifteen members.(353) North Carolina has also adopted a rebuttable presumption by administrative regulation. LLC interests are presumed to be securities if (1) not all members are managers by virtue of their status as members

In a majority of states, the definitional provisions have not been amended to provide for LLC interests, leaving the issue to be resolved through the application of the general test for an “investment contract.” Although LLC interests will be deemed securities in New Jersey(355) and Kentucky, most state administrators have informally indicated that the issue will be resolved on an ad hoc basis applying the traditional Howey test.(356) This informal advice has been supplemented by a host of no-action letters addressing the issue in the context of specific LLCs.(357) Several state administrators have attempted to provide more specific guidance as to when an LLC interest will be considered a security. In New York and South Carolina, the primary factor will be the structure of the limited liability company, i.e., whether the members are passive investors. If they do not manage the company, the investment will be considered a security.(358) In Tennessee, a policy statement indicates that an LLC interest will be considered a security if the Williamson factors are present, the interests have the attributes of stock under Landreth, or the interests are sold to large numbers of the general public.(359) The Connecticut Banking Commissioner has also issued an interpretive release indicating that it will judge whether an LLC interest is a security under the Howey test, but, like Tennessee, will apply the Williamson test for member-managed LLCs.(360)

Enforcement actions have also resulted in administrative opinions on the issue of limited liability company interests as securities. In a leading decision, In re Express Communications, Inc., a hearing officer held that a public sale of membership interests in a wireless cable LLC fell within the scope of the Illinois securities act.(361) In his decision, the hearing officer noted that the definition of security under Illinois law was broader than under federal law.(362) He recognized the general rule regarding general partnerships and cited the Williamson exception with approval.(363) He reasoned that in determining whether a partnership investment is a security, the critical issue is whether there is “a separation of ultimate real control from ownership.”(364) Applying this analysis under the Howey test, he held that the investors were expecting profits from the efforts of Express, reasoning that the investors were unsophisticated and that they were relying on the promoters who claimed to be experts in this new technology field.(365)

The above review of state law reveals that the states have not settled on any uniform approach to resolve the issue whether LLC interests are securities. Substantial disagreement exists among the states, not only in terms of the means of addressing the issue (by statute or administrative action), but also regarding the standards by which to judge LLC interests. While some states have opted for bright line rules, others have left the issue to be resolved on an ad hoc basis. In some states, like Ohio, an LLC interest will be deemed a security while in other states, it will depend on a number of considerations including the structure and management of the LLC. Uncertainty at the state level caused by the introduction of new statutory and administrative standards is compounded by the failure of many states to amend the definition section of their Blue Sky laws to address the LLC question. This leaves the area of law confused and unsettled. Like the SEC and the federal courts, state securities administrators and state courts need a workable analytical framework to resolve the LLC issue.

A Proposed Framework for Analysis

An argument can be made that the courts and legislatures should adopt a bright line rule for LLC interests like the per se rule for stock in Landreth. In the interests of certainty and simplicity, LLC interests could be deemed securities, or, in the alternative, a sale of such interests could be considered outside the scope of the securities laws.(366) Some commentators have taken that position, arguing that LLC interests should not be considered securities on policy grounds.(367) Professor Mark Sargent has argued that LLC interests are probably not securities, reasoning that LLCs are more closely analogous to general partnerships than to limited partnerships because LLC members have ultimate control over the company.(368) Others have argued that LLC interests generally should be considered securities.(369) Professor Marc Steinberg and attorney Karen Conway presented the case that LLC interests are usually securities, drawing an analogy to corporate stock.(370) They argue that an LLC interest meets the Landreth “attributes of stock” test and should otherwise be considered an investment contract under Howey or as an “interest commonly known as a security.”(371)

Any bright line rule relying on the securities law treatment of partnerships or corporations and the legal attributes of LLCs places undue emphasis on the legal form of the LLC in the abstract and disregards the economic realities of different LLCs. For several reasons, it is extremely difficult to make a compelling argument that an LLC is closer to either a partnership or a corporation. First, an LLC is truly a hybrid form of business organization sharing features of both traditional forms of business organizations. This suggests that an analytical framework for resolving the LLC-interest-as-security issue should be developed that takes into consideration the unique characteristics of LLCs within the overarching “economic reality” framework. Second, and perhaps more important, any comparison of the LLC with the partnership or corporation in the abstract is flawed because an LLC is a legal chameleon that can take the form of a partnership or a corporation. Thus, a closely-held LLC in which all of the members are actively involved in the management of the business is nothing more than a general partnership in its actual operation. Interests in such a partnership-LLC should usually fall outside the scope of the securities laws. On the other hand, if LLC interests are mass-marketed to investors, and management authority is delegated to managers who actually run the business, there exists the functional equivalent of a corporation with the members, like shareholders, being passive investors. Interests in such a corporate-LLC should be regulated as securities for the protection of those investors and to avoid any evasion of the securities laws. Between these two polar extremes lies a gray area for which the courts need to have a workable framework to judge whether LLC interests are securities.

Most states have recognized this and have attempted to formulate standards to determine whether a particular LLC interest is a security based on the characteristics of the LLC and the nature of the sale of the LLC interests. In establishing a workable framework for analysis, we need to identify those aspects of an LLC that are important in determining whether the securities laws should apply. Certainly, one important factor is the organizational structure of the LLC

First, the courts should consider how the LLC interests were marketed. In differentiating investment contracts from non-securities, the courts have placed considerable importance on the way in which an investment was promoted and represented.(372) For example, in Joiner, the Court noted that the sales literature stressed the “character of the purchase as an investment and as a participation in an enterprise.”(373) And in Reves, the Court underscored the importance of the marketing of an investment in its discussion of the reasonable expectations of the investing public: “We have consistently identified the fundamental essence of a ‘security’ to be its character as an ‘investment.’ The advertisements for the notes here characterized them as ‘investments,’ and there was no countervailing factors that would have led a reasonable person to question this characterization.”(374) Not only do the promotional materials play a critical role in establishing the expectations of the investors, but the courts have argued that it is reasonable that “promoters’ offerings be judged as being what they were represented to be.”(375)

In examining the marketing of a sale of LLC interests, the courts should consider whether the interests were sold to the general investing public or to a knowledgeable segment of the investing public.(376) Promoters’ targeting of unsophisticated investors through general advertising or sales promotion suggests that the LLC interests are securities. In contrast to persons experienced in the LLC’s business field, such investors most likely will be investing on a passive basis relying on the managerial skills of others for a return on their investment.(377) More importantly, the courts should examine whether the informational materials and the oral statements of the promoters represented the interests as a passive investment opportunity. For example, if the promoters’ statements claimed any special managerial skills or expertise in the LLC’s business field,(378) or touted their experience in successfully managing the enterprise,(379) such representations would lead investors to believe that the LLC profits would come from the efforts of the expert managers.

Second, the courts should consider the number and geographic distribution of the investors.(380) As in Howey and Reves, if the LLC interests are sold to a large number of dispersed members, there is the “common trading” typical of a security offering. Moreover, the presence of a large number of investors is important for other reasons. If there are numerous investors, voting power may become so dispersed that each member’s control rights become the functional equivalent of a shareholder’s voting rights in a corporation.(381) Also, whenever an organization has a large number of investors there will be the practical need for centralized management, regardless of the organizational structure formally adopted by the LLC,(382) and the investors will have less incentive either to participate in management or actively inform themselves concerning the management of the business. Finally, from a policy standpoint, a large group of small investors needs the protection of the disclosure requirements of the securities laws. It can be argued that Marine Bank was premised on the notion that an investor does not need the information provided under the securities laws in a private transaction where the investor can demand full disclosure and has a strong incentive to acquire information on the risks of the venture.(383) In contrast, small investors do not have the same economic incentive to acquire risk-related information,(374) particularly when the investors are not personally liable for the liabilities of the business.(385) Thus, from an economic policy perspective, the number of investors is an important consideration in the resolution of the LLC-interests-as-securities issue.

Third, the courts should consider the investors’ dependence on the managerial skill or expertise of others in the operation of the LLC’s business by examining the sophistication of the investors and the expertise of the managers or promoters in the LLC’s business field. This examination should not be limited to the sort of unrealistic dependence envisioned by the Williamson court. Sophistication and expertise should be considered two interrelated factors that determine the extent to which the investors were relying on the manager’s abilities.(386) Moreover, the court should not confine itself to an examination of the investors’ sophistication in business affairs, but should also consider the investors’ sophistication in the LLC’s business venture.(387) It is questionable whether “sophistication in one field of business will always transfer to another field.”(388) Also, an investor who is unsophisticated in the LLC’s business will likely be relying on the LLC’s managers to make strategic business decisions. Conversely, investors who are sophisticated in the business of the LLC have less need for securities law protection in that they are in a better position than unsophisticated investors to judge the risks associated with the particular business venture. Along with the investors’ sophistication, the expertise or managerial abilities necessary to manage the LLC’s business affairs should be part of the calculus. Where the investors are involved in an enterprise that does not depend on any particular expertise or specialized entrepreneurial skills, as with the speculative land venture in Williamson, there is little or no reliance on the managerial skills of others.(389) In contrast, the jojoba plantation in Koch, the “master recording” leasing in Stone v. Kirk, and the wireless telecommunications field in Express Communications all required specialized skill or expertise. Thus, expertise, like sophistication, should be judged in relation to the LLC’s field of business to determine the degree to which the investors are dependent on others in the management of the LLC.

Fourth, the courts should consider the actual management of the LLC and the degree to which members participate in management. Who is managing the business, the members directly or managers? Also, to what extent do the members participate in the ongoing affairs of the business? Do they merely vote on the election of managers once a year or are they more actively involved in strategic decision making? If the members are actively controlling the business, this suggests that the business is being run like a partnership and the interests, like partnership interests, should not be considered securities. On the other hand, if the LLC is being managed by a manager or a board, the business is in fact operating like a corporate-LLC.

Under the Williamson test, many courts have refused to consider whether the investors were passive in the actual operation of the partnership. This appears to be based on two arguments. It is asserted that the issue of whether a partnership interest is a security is to be judged at the time of the sale of that interest, rather than at some later time.(390) The argument is that under the Howey investment contract test, an instrument’s character as a security depends on the “expectations” of the investor.(391) The second argument, articulated by Justice Powell in Rivanna Trawlers, is that a partner should not be able to transform his interest into a security by remaining passive in the management of the partnership.(392) Neither argument is persuasive. Although the actual management of a partnership or LLC does not prove what the expectations of the investors were at the time of the sale, the post-sale conduct may either support or contradict assertions as to what those expectations were at that time.(393) The courts have frequently considered the extent to which partners have participated in a partnership to determine whether their interests were securities.(394) Also, if an investor claims that the promoters represented the interest to be a passive investment, one would expect the investor to have “remained” passive. The fact that an investor is passive does not necessarily suggest that the investor is manipulating his conduct in order to create securities law jurisdiction.

Given the importance of the structure of the LLC, the marketing of the LLC interests, the number and geographic dispersion of the members, the dependence of the members on the LLC managers, and the actual operation of the LLC, how should the analytical framework be structured? In line with the traditional Howey test and the Court’s new approach in Reves, we propose a multi-factor, balancing test(395) to determine whether an LLC interest is a security. As with the Reves test for notes, the courts would consider all of the above factors to determine whether the investors had a reasonable expectation of profits to be derived from the efforts of the LLC managers. Such an ad hoc test to resolve the securities law issue is consistent not only with the Joiner-Howey-Reves line of cases, but also with the underlying policy of the securities laws to provide maximum protection to the investing public. Although it is also more flexible and practical than the Williamson approach, an ad hoc test is subject to criticism because it creates uncertainty for those planning LLC enterprises. As a result, it may discourage the use of the LLC form of business in favor of a less efficient and less desirable (from a managerial perspective) form of business, like a general partnership or joint venture. To provide some certainty in the test, we propose a presumption that would differ depending upon the organizational structure of the LLC. The courts would presume that interests in LLC enterprises adopting a partnership model of governance, opting for direct member control of the business, are not securities. This presumption parallels the Williamson presumption that general partnership interests are not securities. In contrast, the courts would presume that interests in LLC enterprises adopting a corporate model of governance, where members elect managers or a board to manage the business, are securities. This presumption is consistent with the limited partnership opinions and the treatment of corporate stock under Landreth. By employing a presumption as to the security status of LLC interests, planners and drafters of LLC operating agreements as well as LLC investors would have some assurance as to the treatment of such interests under the securities laws.

Neither presumption would be conclusive, but the burden would be on the investors or LLC promoters to demonstrate that the identified factors rebut the applicable presumption. For example, a partnership-LLC would usually not be subject to the securities laws. But, if the LLC interests were represented to the investing public as passive investments, mass-marketed to numerous, geographically dispersed investors who took no part in the management of the business’s affairs, the courts may find the interests to be “investment contracts” under the proposed multi-factor test. Similarly, interests in a corporate-LLC would usually be considered securities. However, if such an LLC had a small number of sophisticated investors who purchased in a private sale, and they were involved in a venture where there was minimal dependence on the expertise of the managers, the courts may properly determine that the sale falls outside the broad scope of the securities laws.


The limited liability company has the potential to rival the partnership and the corporation as the preferred form of business organization because it combines the best features of both traditional organizational forms. As limited liability companies become more popular with entrepreneurs, issues will inevitably and increasingly arise concerning the securities law treatment of LLC interests. This article proposes an analytical framework to resolve that emerging issue, one that can be employed at both the state and federal levels. The test strikes a proper balance between the need to protect investors and the interests of business in efficiency. By employing a presumption that interests in a corporate-LLC would be considered securities, while partnership-LLC interests would not be, the framework provides some degree of certainty, enabling lawyers and business persons to structure their LLCs accordingly. At the same time, the rebuttable nature of the presumption and the flexible multi-factor balancing test ensures that the application of the securities laws will ultimately depend on the “economic reality” of the LLC interests. (1) For a good general discussion of LLCs, see Thomas E. Geu, Understanding The Limited Liability Company: A Basic Comparative Primer (pt. 1), 37 S.D. L. Rev. 44 (1992). (2) See John R. Emshwiller, New Kind of Company Attracts Many-Some Legal, Some Not, Wall St. J., Nov. 8, 1993, at B1

(1) a domestic corporation

(2) which is not an “ineligible corporation

(3) with no more than 35 shareholders

(4) that does not have as a shareholder a person who is not an individual (other than an estate or a trust described in I.R.C. [sections] 1361(c)(2)) or a nonresident alien

(5) that has no more than one class of stock. See 26 U.S.C. [sections] 1361(b) (1993). (30) See, e.g., Kan. Stat. Ann. [sections] 17-7618 (Supp. 1993) and Fla. Stat. Ann. [sections] 608.431 (West 1993). (31) See, e.g., Kan. Stat. Ann. [sections] 17-7616(b)(3) (Supp. 1993) and Fla. Stat. Ann. [sections] 608.427(2)(c) (West Supp. 1994). (32) See, e.g., Utah Code Ann. [sections] 48-2b-125 (1994) and Va. Code Ann. [sections] 13.1-1022 (Michie 1993). (33) See, e.g., N.D. Cent. Code [sections] 10-32-69 (1995). (34) See, e.g., Nev. Rev. Stat. Ann. [sections] 86.291 (West 1993). (35) Rev. Model Bus. Corp. Act [subsections] 14.02, 14.03 (1991). (36) See, e.g., Wyo. Stat. [sections] 17-15-123(a)(iii) (1989). (37) For a discussion of interstate recognition of LLCs, see Wayne M. Gazur & Neil 51. Goff, Assessing the Limited Liability Company, 41 Case W. Res. L. Rev. 387, 437 (1991). (38) U.P.A. [subsections] 6, 7 (1992). (39) Id. [sections] 18(e). (40) Id. AS to voting in proportion to contribution, see Fla. Stat. Ann. [sections] 608.422 (West Supp. 1994). (41) U.P.A. [sections] 40 (1992). (42) Unif. Ltd. Partnership Act [sections] 7 (1916)

(1) The 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, fractional 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. Id. [sections] 77b(1). (50) 320 U.S. 344 (19431. (51) Id. at 346. (52) The marketing campaign was targeted at 1,000 prospects throughout the country. The fifty investors were located in 18 different states and the District of Columbia. Id. (53) Id. at 347-48. (54) Id. at 355. (55) Joiner, 320 U.S. at 348-49. (56) Id. at 352-53. (57) Id. at 348 (58) Id. (59) Id. at 350. (60) Joiner relied on the “ejusdem generic” rule of interpretation. Joiner, 320 U.S. at 350. (61) Id. (62) Id. at 351. (63) Id. (64) Id. at 352. (65) Joiner, 320 U.S. at 352. (66) Id. The Court also rejected the argument for a strict construction of the statute because of its penal character. It noted that state courts had generally adopted a liberal construction of Blue Sky laws to effectuate their remedial purposes to prevent fraud in the securities market. It concluded that the law should be liberally interpreted in light of the intent of the legislature. Id. at 353-55. (67) 328 U.S. 293 (1946). (68) During the relevant time period, W. J. Howey Co. planted 500 acres, selling approximately half of the acreage to investors. Id. at 295. (69) Id. (70) The investors were lured by the prospect of substantial profits, represented to be as high as 20% by the company. Id. at 296. (71) The hotel promoted the groves to its guests and, if the guests expressed an interest in them, gave them a sales pitch. Id. at 296-97. (72) The service contracts were for a 10-year period, gave Howey-in-the-Hills exclusive possession of the land, and were not subject to cancellation. Over 85% of the acreage sold during the relevant period was covered by a service contract with Howey-in-the-Hills. Howey, 328 U.S. at 295-96. (73) Id. at 296. (74) Id. at 294. (75) Id. at 297. (76) Id. at 298. (77) Howey, 328 U.S. at 298. (78) Id. (79) Id. (80) Id. at 298-99. (81) It was also the underlying basis of the opinion in Joiner, the Court reasoned. Id. at 299. (82) Howey, 328 U.S. at 299. (83) Id. at 299-300. (84) Id. at 299. (85) Id. at 300. (86) Id. (87) Howey, 328 U.S. at 300. (88) Id. at 301. (89) Id. (90) 359 U.S. 65 (1959). (91) 387 U.S. 202 (1967). (92) 15 U.S.C. [sections] 77c(a)(8) (1988). (93) VALIC, 359 U.S. at 69. (94) Id. (95) Id. at 69-70. (93) Id. at 71. (97) Id. at 71-72. (98) VALIC, 359 U.S. at 76-77. (99) Id. at 77. (100) Id. at 78. (101) Id. at 80. (102) United Benefit Life, 387 U.S. at 204. (103) Id. at 205. (104) Id. at 205-06. (105) The court of appeals read VALIC as requiring that an insurance company must bear only a “substantial part” of the investment risk for the contract to fall within the insurance exemption. Id. at 206-07. (106) Id. at 210. (107) The Court noted that United’s primary advertisement was entitled “New Opportunity for Financial Growth” and that promotional literature emphasized the possibility of investment returns and professional management of the fund. United Benefit Life, 387 U.S. at 211. (108) “The basic difference between a contract which to some degree is insured and a contract of insurance must be recognized.” Id. (109) Id. (110) Id. This conclusion, the Court reasoned, was consistent with the position of state securities regulators that variable annuities are securities. Id. at 211-12. (111) 389 U.S. 332 (1967). (112) The present definition of a security under the Securities Exchange Act of 1934 is as follows:

The term “security” means any note, stock, treasury stock, bond, debenture,
certificate of interest or participation in any profit sharing agreement or in
any oil, gas, or other mineral royalty or lease, any collateral-trust certificate,
preorganization certificate or subscription, transferable share, investment
contract, voting-trust certificate, certificate of deposit, for a security, 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 instrument commonly known as a “security”
or participation in, temporary or interim certificate for, receipt for, or
warrant or right to subscribe to or purchase, any of the foregoing
not include currency or any note, draft, bill of exchange, or banker’s acceptance,
which has a maturity at the time of issuance of not exceeding nine
months, exclusive of days of grace, or any renewal thereof the maturity of

which is likewise limited. 15 U.S.C. [sections] 78(e)(10) (1988). (113) Tcherepnin, 389 U.S. at 335-36. The Court further reasoned that a primary purpose of the Act was the protection of investors through full disclosure and that the Howey economic reality approach should guide its determination of the definitional issue. Id. at 336. (114) Id. at 337. (115) Id. at 338-39. (116) The Court reasoned that the shares were evidenced by a certificate and dividends were contingent upon an apportionment of profits. Thus. the shares fit the definition of “stock” and a “certificate” in a “profit-sharing agreement.” Also, because the shares could be transferred or assigned, they fell within the concept of “transferable shares.” Id. at 339-40. (117) Tcherepnin, 389 U.S. at 340-41. (118) Id. at 341. (119) Id. at 343. (120) Id. (121) Id. (122) Tcherepnin, 389 U.S. at 343. The lower court also noted that the holders of the shares were not entitled to inspect the books of the association, a factor the Court deemed insignificant since not all corporate shares carry such a right of inspection. Id. at 343-44. (123) “This simply reflects the fact that such shares are not a usual medium for trading in the markets.” Id. (124) Id. at 344. (125) Id. at 344-45. (126) Tcherepnin, 389 U.S. at 345. (127) Id. (128) 421 U.S. 837 (1975). (129) The suit involved Co-op City, a massive housing cooperative in New York City. United Housing Foundation, a non-profit corporation, was responsible for the development of Co-op City. It organized Riverbay Corporation, a nonprofit cooperative housing corporation, to own and operate Co op City. Riverbay sold the co-op housing stock to tenants for a set price per room in a unit, the shares entitling the tenant to a unit in Co-op City. The shares were not transferable to a nontenant and could not be pledged or encumbered. Purchasers of the shares claimed that they were mislead by an Information Bulletin circulated by Riverbay and brought a class action, securities fraud lawsuit against United Housing Foundation, Riverbay Corporation, and other defendants. Id. at 840-45. (130) Id. at 846. (131) Id. The district court had dismissed the claim because the sale was not induced by the prospect of profits nor were profits reasonably to be expected. Id. at 845-46. (132) Forman, 421 U.S. at 848-49. (133) Id. at 849. (134) Id. at 850-51. (135) Id. at 851. The Court also noted that the shares did not possess other characteristics typically associated with stock, i.e., voting rights, negotiability, and capital appreciation. (136) Id. at 852. (137) Forman, 421 U.S. at 852. (138) “[W]hen a purchaser is motivated by a desire to use or consume the item purchased … the securities laws do not apply.” Id. at 853. (139) Id. at 855. (140) Id. at 856. The Court reasoned that there was nothing in the record to indicate that tenants were attracted to the housing by the prospect of reduced rentals from the leasing of commercial facilities or that the leasing of commercial facilities ever produced a profit. (141) Id. (142) 439 U.S. 551 (1979) (143) Id. at 559. (144) Id. at 560. (145) Id. at 562. (146) Id. at 561-62. (147) Daniel, 439 U.S. at 562. (148) The SEC had also argued that several actions by Congress indicated Congressional recognition that noncontributory pension plans were covered by the securities laws, but the Court rejected this position. Id. at 563-65. (149) Id. at 569-70. (150) Id. at 570. (151) Id. The Court’s ERISA analysis was similar to the public policy approach it followed in VALIC and United Benefit Life. In the annuity cases, the Court considered the underlying purposes of the alternative regulatory scheme (state insurance law) to determine whether the contracts were exempt from securities regulation. In Daniel, the Court argued that ERISA provided the type of information to plan participants and protection against fraud that the securities laws were designed to provide investors, and, thus, the passage of ERISA rendered regulation of pension plans under the securities laws unnecessary. The Court probably chose not to base its decision on this Congressional action under a public policy rationale because ERISA contained a savings clause providing that other federal laws were not superseded by ERISA. (152) 455 U.S. 551 (1982). For an insightful analysis of the Court’s opinion, see Marc I. Steinberg & William E. Kaulbach, The Supreme Court and the Definition of “Security”: The “Context” Clause, “Investment Contract” Analysis, and their Ramifications, 40 Vand. L. Rev. 489 (1987). (153) The CD had a six-year maturity and was insured by the FDIC. Marine Bank, 455 U.S. at 552-53. (154) Id. at 553. (155) Id. (156) The bank kept $42,800 to satisfy prior loans and to cover an overdrawn checking account. Most of the remaining monies went to pay off other creditors, leaving only $3,800 to be disbursed to Columbus. The bank then refused to allow Columbus to overdraw its account. Id. (157) The district court granted summary judgment for the bank, but the Third Circuit Court of Appeals reversed. Id. at 553-54. (158) The definition of security in the 1934 Act is prefaced by the phrase “unless the context otherwise requires.” 15 U.S.C. [sections] 78(e)(10)(1988). (159) Marine Bank, 455 U.S. at 556. (160) Id. (161) The Court noted that the CD was issued by a federally regulated bank and was insured by the FDIC. Id. at 557-58. (162) “It is unnecessary to subject issuers of bank certificates of deposit to liability under the antifraud provisions of the federal securities laws since the holders of bank certificates are abundantly protected under the federal banking laws.” Id. at 559. (163) Id. at 560. (164) Marine Bank, 455 U.S. at 559. (165) Id. (166) Id. (167) In addition to the fact that the interest was not designed to be publicly traded, the Court believed that the Weavers had a “measure of control” over the Columbus business that was not common in securities and that the agreement relating to the barn was “unique.” Id. at 559-60. (168) See Steinberg & Kaulbach, supra note 152, at 504. (169) Steinberg & Kaulbach, supra note 152, at 504. (170) It has been argued that the Marine Bank opinion “threaten[s] to restrict the scope of the securities laws to large-scale, multi-investor transactions occurring in the ordinary investment markets.” Steinberg & Kaulbach, supra note 152, at 528. (171) Professor Carney has proposed a two-step test for a security that would consider not only the nature of the financial instrument, but also the factual context in which the instrument was sold. William J. Carney, Defining A Security: The Addition Of A Market-Oriented Contextual Approach To Investment Contract Analysis, 33 Emory L.J. 311 (1984). Under his proposed framework, the court would first examine the nature of the instruments sold under the Howey test. The second step would involve an examination of the transaction to determine whether regulation is necessary to protect the investors. This test is based on the premise that the primary function of the securities laws is to protect investors by mandating disclosure when they cannot otherwise protect themselves in the market for information. Id. at 315-16. See also Sue A. Dillport, Restoring Balance to the Definition of a Security, 10 Sec. Reg. L.J. 99, 122 (1982) (arguing that an instrument possessing characteristics commonly associated with one of the instruments enumerated within the definition section should be excluded if it is “not within the spirit of the Act or the intention of the drafters”). (172) Marine Bank, 455 U.S. at 560 n.11. (173) The Marine Bank Court may have been influenced by an article by Professor FitzGibbon proposing a redefinition of a security. The Court cited the article in a footnote to its opinion. Marine Bank, 455 U.S. at 555 n.4. In his article, Professor FitzGibbon proposes that a security be redefined to mean a “financial instrument eligible to move in the public financial markets” based on the primary intent of Congress to regulate the national capital markets. Scott FitzGibbon, What is a Security? A Redefinition Based on Eligibility to Participate in the Financial Markets, 64 Minn. L. Rev. 8Y3 (1980). Under this redefinition, a “unique” instrument is not a security because it cannot be traded in the public financial markets. Id. at 929. Thus, the unique agreement in Marine Bank would not meet this test for a security. The Marine Bank Court’s opinion regarding the uniqueness of the investment may be based on the rationale proffered by Professor FitzGibbon. For another article supporting the notion that the federal definition of security should include the requirement of a significant number of investors such that an instrument could be traded on the national securities markets, see Dennis S. Karjala, Federalism, Full Disclosure, And The National Markets In The Interpretation Of Federal Securities Law, 80 Nw. U. L. Rev. 1473, 1507-15 (1986). (174) For an excellent article proposing the adoption of a “multiplicity” test and the abandonment of the horizontal and vertical commonality tests, see James D. Gordon III, Common Enterprise And Multiple Investors: A Contractual Theory For Defining Investment Contracts And Notes, 3 Colum. Bus. L. Rev. 635 (1988). Professor Gordon’s multiplicity test would require “an enterprise in common among the promoter and multiple parallel investors.” Id. at 667. His thesis is that a requirement of multiple investors is more consistent with the underlying purpose of the securities laws to provide information to investors who otherwise would lack access to that information. (175) The Court denied certiorari in Mordaunt v. Incomco, 469 U.S. 1115 (1985), a case raising the common enterprise issue in connection with a discretionary trading account. Mordaunt v. Incomco, 686 F.2d 815 (9th Cir. 1982) (finding no common enterprise). Justice White, joined by Chief Justice Burger and Justice Brennan, wrote a dissenting opinion in which he urged granting review given the “clear and significant split” among the federal circuits on the commonality issue. Mordaunt, 469 U.S. at 1117. (176) Horizontal commonality is required in the Third, Sixth, and Seventh Circuits. Wals v. Fox Hills Dev. Corp., 24 F.3d 1016 (7th Cir. 1994)

We first review the agreements to determine whether the investors have
the authority to exercise some control over their investment. Second, we
determine (a) whether they have the practical ability (i.e., the sophistication
and expertise) to exercise control over the ultimate success or failure of
their investment and (b) whether, in fact, they exercised control. Id. at *25 (citation omitted). Under this test, the court concluded that the partnership interests were not securities because of the control exercised by the experienced investors. (275) 730 F.2d 99 (3d Cir.), cert. denied, 469 U.S. 831 (1984). Justice Powell did make reference to the “interesting opinion” in Goodwin, but concluded that given the broad powers conferred by the RTU partnership, “we have no occasion to consider the effect of Virginia law.” Rivanna Trawlers, 840 F.2d at 241 n.6. (276) 928 F.2d 1471 (9th Cir. 1991). The Ninth Circuit followed a similar approach in a subsequent decision, Holden v. Hagopian, 978 F.2d 1115 (9th Cir. 1992), in which it found interests in a horsebreeding partnership not to be securities. (277) Koch, 928 F.2d at 1472-73. (278) Id. (279) Id. at 1473. (280) Id. (281) Id. at 1473-74. (282) Koch, 928 F.2d at 1474. (283) The district court granted summary judgment relying on Matek v. Murat, 862 F.2d 720 (9th Cir. 1988), a case in which the court refused to adopt Williamson in its entirety. Subsequently, however, in Hocking v. DuBois, 885 F.2d 1449 (9th Cir. 1989) (en banc), cert. denied, 494 U.S. 1078 (1990), the court adopted the Williamson test. The Koch court held that Hocking was the controlling precedent on the securities law issue. Koch, 928 F.2d at 1478. (284) Koch, 928 F.2d at 1478-81. (285) Id. at 1478. (286) Id. (287) Id. (288) Id. at 1478-79. (289) Koch, 928 F.2d at 1478. (290) Id. (291) Id. (292) Id. at 1479-81. (293) Id. at 1480. (294) Koch, 928 F.2d at 1480. (295) Id. (296) Id. at 1481. (297) 8 F.3d 1079 (6th Cir. 1993). (298) Id. at 1081. Stone had an equity interest in his employer’s coal mining business, and he began to earn hundreds of thousands of dollars when the business became profitable. This was at a time when the top tax bracket was 50 percent. Id. (299) Id. at 1082. (300) Id. at 1082-83. (301) Stone, 8 F.3d at 1083. (302) The jury awarded Stone $430,800 in actual damages and $500,000 in punitive damages. The jury also found that Kirk was liable under RICO, and the court trebled the compensatory damage award. On appeal, Kirk challenged his liability under RICO, as well as the damages awarded to Stone. The Sixth Circuit found that Kirk was not liable under RICO based on the Court’s decision in Reves II. The circuit court also rejected the computation of damages and the award of punitive damages. Id. at 1084, 1091-93. (303) Id. at 1086. He also argued that there was no common enterprise, but the court found horizontal commonality in that each joint venture had three or more investors. Id. at 1085-86. (304) Id. (305) Stone, 8 F.3d at 1085-86. (306) Id. (307) Id. (308) “[A] limited partnership generally is a security because, by definition, it involves investment in a common enterprise with profits to come solely from the efforts of others.” SEC v. Murphy, 626 F.2d 633, 640-41 (9th Cir. 1980) (citations omitted). (309) Youmans v. Simon, 791 F.2d 341, (310) See, e.g., Rodeo v. Gillman, 787 F.2d 1175, 1177 (7th Cir. 1986)

premised on an expectation of profits to be derived from the efforts of others.
One would have to show that the reliance on the manager which forms the
basis of the partner’s expectations was an understanding in the original

transaction, and not some subsequent decision to delegate partnership duties. Williamson, 645 F.2d at 424 n.14 (emphasis added). See also Koch v. Hankins, 928 F.2d 1471, 1477 (9th Cir. 1991) (“inquiry is not directed to what actually transpires after the investment is made”). (391) See Joiner, 320 U.S. at 352-53 (whether instrument is security depends on the “character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect”). (392) Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236, 242 n.10 (4th Cir. 1988). See also Matek v. Murat, 862 F.2d 720, 729 (9th Cir. 1988) (“interest marketed as a general partnership might be transformed into a security simply because its holder is not diligent or knowledgeable in exercising his rights under the agreement”). (393) See Maritan v. Birmingham Properties, 875 F.2d 1451, 1459 (10th Cir. 1989) (“the fact and nature of Maritan’s later participation sheds light on how the parties regarded Maritan’s rights and status under the agreement all along”). (394) E.g., Rivanna Trawlers, 840 F.2d at 242

MICHAEL J. GARRISON, Associate Professor of Business Law, North Dakota State University.

TERRY W. KNOEPFLE, Assistant Professor of Taxation and Business Law, North Dakota State University.