Passive Investors in an LLC: Your Membership Interest is Likely a Security

Owners who organize new LLCs, or bring passive investor members into existing LLCs without obtaining the advice of counsel, may expose their businesses and themselves to risk.  

Here at Smith Shapourian Mignano PC, one of those most frequent questions we receive from LLC members/managers is whether a particular member of an LLC who merely provided investment funds to the LLC but does not actively manage the LLC’s daily operations and/or activities, has, in fact, received a "security" and needs to file a securities exemption.  

To that end, we discuss a few general principles below.

Definition of a “Security”

A “security” is a contract, transaction, or scheme involving:

1. an investment of money or other consideration;
2. in a common enterprise;
3. with the investor having an expectation of profits, whether from income or from capital appreciation of the investment;
4. derived primarily from the managerial or entrepreneurial efforts of others.

See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

Based on the foregoing test, an LLC investor member’s interest may constitute a security.  The first three criteria are easily satisfied where a member of an LLC contributes capital investment shortly after the formation of an LLC, and will reap a certain percentage share of the profits based on his membership interests in the LLC.

Furthermore, for those investors in an LLC who do not manage the LLC and/or are not designated “managers” pursuant to the Operating Agreement of the LLC, it is likely that any profits will be derived primarily by the managerial effort of the LLC’s manager(s), which fulfills the fourth criteria of the test.

Exemption

If the investor’s membership interest in the LLC is in fact a security, then the general securities laws apply.  The United States Securities Exchange Commission (“SEC”) and authorities in every state, including California, regulate the issuance or sale of securities.  

Securities issued in California must either be exempted or qualified.  A passive investor in an LLC may rely on the limited offering exemption provided by Corporations Code section 25102(f) if:

1. The sales of securities are limited to no more than 35 unaccredited investors, including those located outside California,
2. He or she has a pre-existing business or personal relationship with the LLC (the issuer of the securities), or, in the alternative, can be demonstrated to be a sophisticated investor,
3. The LLC (or the issuer of the securities) did not advertising of the sale of the securities, and
4. At the time of purchase, the investor does not intend to resell the securities.

To claim this exemption, a Limited Offering Exemption Notice (LOEN) must be filed with the Department of Business Oversight.  The filing fee is $25, and may be done online.1

Smith Shapourian & Mignano, PC is available to answer any questions or concerns you may have regarding your membership interests in an LLC, including whether you qualify for an exemption.  

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.

​1. See http://www.dbo.ca.gov/Licensees/Corporate_Securities_Law/faqs.asp#b1