The U.S. Court of Appeals for the Second Circuit (the “Court”) upheld a jury finding that membership interests in limited liability companies formed to finance the production and distribution of films (the “LLCs”) were securities for the purposes of the federal securities laws despite provisions in the LLCs’ organizational document indicating that members participated in the management of the Company. The issue came before the Court on an appeal of securities fraud convictions related to the marketing of interests in the LLCs. Among other things, the defendants-appellants challenged the sufficiency of the evidence supporting the jury’s determination that the membership interests in the LLCs were securities.
The “Howey” Test. The Court noted that the hybrid nature of limited liability companies made it critical for courts to look beyond the formal terms of a limited liability company membership interest to the reality of the parties’ position in order to evaluate whether there was a reasonable expectation of significant investor control under the test set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”), for determining whether a given financial instrument or transaction constitutes an “investment contract” and, therefore, a security under the federal securities laws. More specifically, Howey defined an investment contract as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” The Court indicated that it had subsequently interpreted “solely” to permit a court to “consider whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.” SEC v. Aqua- Sonic Prods. Corp., 687 F.2d 577 (2d Cir. 1982) (“Aqua-Sonic”). In Aqua-Sonic, the Court distinguished between companies that seek the “passive investor” and situation where there is a “reasonable expectation . . . of significant investor control.”
Analysis of Offering and Organizational Documents. In analyzing the nature of the memberships interests in the LLCs, the Court first looked to the LLCs’ offering and organizational documents, noting that were its review confined to those documents it would likely have concluded that the LLC membership interests were not securities. Testimony at trial indicated that the LLCs were structured so as to minimize the possibility that membership interests would constitute securities. The offering documents indicated that each member was required to participate in the management of an LLC retaining one vote for each membership interest acquired, with each “important decision relating to the business of the company” being submitted to a vote of the members. The offering documents further indicated that each member of an LLC was required to participate in its management by serving on one or more committees established by the members. The operating agreement for one of the LLCs indicated that it would be managed by its Members with each member having a right to act for and bind the LLC in the ordinary course of business.Analysis of Actual Operations. Notwithstanding the offering and organizational documents, the Court concluded that the evidence presented at trial regarding the LLCs’ operations supported the jury’s conclusion that there could be no reasonable expectation of investor control, and that the membership interests were securities subject to the federal securities laws. Evidence presented at the trial emphasized that in actuality members played an extremely passive role in the management and operations of the LLCs. For each LLC, only two member committees were formed with significantly less than 1% of members serving on each committee. The Court also pointed to the fact that members’ managerial rights and obligations did not accrue until the LLCs were “fully organized,” with “interim managers” initially holding legal control rights in deciding almost every significant issue prior to the completion of fundraising. The Court also pointed to the fact that members appear not to have negotiated any terms of the LLCs’ organizational documents. The Court echoed the Fifth Circuit in finding that investors may be so lacking in requisite expertise, so numerous or so dispersed that they become utterly dependent on centralized management, counteracting a legal right of control. Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981). The LLCs’ members had no particular expertise in film or entertainment and therefore would have had difficulty exercising their formal rights under LLCs’ organizational documents. The Court further found that their number and geographic dispersion left investors particularly dependent on centralized management. In conclusion, the Court found that upon consideration of the totality of the circumstances, the jury could have determined that, notwithstanding the offering and organizational documents drafted to suggest active participation by the LLCs’ members, the defendants-appellants sought and expected passive investors for the LLCs, and therefore the membership interests that they marketed were securities subject to the federal securities laws.