Potential Security Laws Issues
When bringing in New Members to an LLC

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When a limited liability company (LLC) brings in new members, several potential security law issues can arise under both federal and state regulations. This is because membership interests in an LLC can, under certain circumstances, be considered "securities."¹

Here's a breakdown of the key issues:

1. Is the LLC Membership Interest a Security?

The primary question is whether the new membership interests being offered to the incoming members qualify as securities. The definition of a security is broad and includes instruments beyond traditional stock.² For LLC interests, courts often apply the Howey Test, derived from a Supreme Court case, to determine if an investment contract exists.³ Under this test, a security exists if there is:

• An investment of money: The new member typically contributes capital or other assets to the LLC.
• In a common enterprise: The LLC is the common enterprise where the fortunes of the investors are interwoven.
• With the expectation of profits to be derived solely from the efforts of others: This is the most critical factor for LLCs. If the new members are passive investors who do not actively participate in the management and operations of the LLC and expect profits primarily from the efforts of the existing members or managers, their membership interests are more likely to be considered securities.⁴

Member-Managed vs. Manager-Managed LLCs:

• In a member-managed LLC, where all members actively participate in the business's day-to-day operations and management, the membership interests are less likely to be considered securities. This is because the profits are not solely derived from the efforts of others.
• In a manager-managed LLC, where some or all members are passive investors and rely on appointed managers to run the business, the membership interests are more likely to be classified as securities.

2. Registration Requirements

If the membership interests are deemed securities, they must be registered with the U.S. Securities and Exchange Commission (SEC) and the relevant state securities agencies unless an exemption from registration is available. Registration is a complex and costly process that requires extensive disclosure about the LLC, its business, management, and the securities being offered.

3. Exemptions from Registration

Most small businesses, including LLCs bringing in new members, rely on exemptions from the registration requirements. Several exemptions are available under federal and state securities laws.⁵ Some of the most common include:

• Regulation D: This SEC regulation provides several exemptions for private placements, including:
• Rule 506(b): Allows the sale of an unlimited amount of securities to an unlimited number of "accredited investors" and up to 35 non-accredited⁶ but sophisticated investors. General advertising and solicitation are not permitted. Specific disclosures are required for non-accredited investors.⁷
• Rule 506(c): Allows general advertising and solicitation but requires that all purchasers be accredited investors, and the issuer must take reasonable steps to verify their accredited status.
• Section 4(a)(2) of the Securities Act of 1933: Exempts "transactions by an issuer not involving any public offering."⁸ Rule 506(b) is a safe harbor under this exemption.⁹ The key here is the private nature of the offering, the sophistication of the investors, their access to information, and the absence of public solicitation.
• State-Specific Exemptions: Many states have their own exemptions for small offerings within their borders. For example, Florida has a Limited Offering Exemption (Section 517.0611) and an Invest Local Exemption (Section 517.0612) with specific requirements related to the issuer's presence and operations in the state.¹⁰

4. Compliance with Exemption Requirements

If an LLC relies on an exemption, it must strictly comply with all the conditions of that exemption. Failure to do so can result in severe consequences, including:

• Rescission rights: Investors may have the right to get their investment back.
• Damages: Investors may sue for financial losses.
• Regulatory actions: The SEC or state securities agencies may bring enforcement actions, including fines and injunctions.
• Criminal penalties: In cases of fraud or willful violation, criminal charges can be filed.

Key Compliance Considerations:

• Accredited Investor Verification: If relying on exemptions that require accredited investors, the LLC must take reasonable steps to verify their status.¹¹
• Disclosure: Even if exempt from registration, adequate disclosure of all material information about the LLC, its business, risks, and the terms of the investment must be provided to investors, especially non-accredited ones in certain offerings.
• Limitations on Number of Investors: Some exemptions limit the number of non-accredited investors.
• Restrictions on Resale: Securities acquired through private placements are typically "restricted securities" and cannot be freely resold to the public without registration or another exemption.¹²
• Filing Requirements: Some exemptions require filing a notice with the SEC (e.g., Form D for Regulation D offerings) and state securities agencies.¹³

5. Anti-Fraud Provisions

Regardless of whether the membership interests are registered or exempt, the anti-fraud provisions of federal and state securities laws still apply.¹⁴ This means the LLC and its members cannot make material misstatements or omissions in connection with the offer or sale of membership interests.

6. Due Diligence

LLCs should conduct thorough due diligence on potential new members, and the new members should also conduct their own due diligence on the LLC. This helps ensure that all parties have a clear understanding of the investment and the associated risks.

7. Operating Agreement

The LLC's operating agreement should clearly outline the rights, responsibilities, and obligations of all members, including new members.¹⁵ It may also contain provisions related to the transfer of membership interests and compliance with securities laws.¹⁶

Practical Steps and Considerations

• Legal Counsel: It is crucial for an LLC considering bringing in new members to consult with experienced securities counsel to determine if the membership interests are likely to be considered securities and, if so, to ensure compliance with federal and state securities laws and identify the appropriate exemptions.
• Understand the Management Structure: The management structure of the LLC (member-managed vs. manager-managed) will be a key factor in determining whether the membership interests are securities.
• Know Your Investors: Understand the sophistication and financial status of potential new members, as this will impact the availability of certain exemptions.
• Proper Documentation: Maintain thorough documentation related to the offering, including subscription agreements, investor questionnaires (if verifying accredited status), and disclosure documents.
• State Law Variations: Be aware that state securities laws (often referred to as "blue sky" laws) can vary significantly, and compliance with the laws of each state where the offering is made is necessary.¹⁷

By carefully considering these potential security law issues and taking appropriate steps to ensure compliance, LLCs can navigate the process of bringing in new members while minimizing legal risks.