A security is a financial instrument or a tradable asset of some type. The Federal Securities Act defines a “security” as a laundry list of items which can be boiled down into three broad categories:
- Debt securities (banknotes or bonds).
- Equity securities (stocks or interests in partnerships or limited liability companies (LLCs)).
- Derivative securities (futures or options).
For the purposes of this discussion, the focus will be on whether ownership in a corporation or limited liability company constitutes a security, thereby requiring compliance with U.S. securities laws in its sale or purchase. Usually, an offering of securities must be registered under the Securities Act of 1933, unless it falls under an exemption. The standard as to whether stock is a security in any given circumstance was set forth nearly forty years ago in the U.S. Supreme Court cases of United Housing Foundation v. Forman, 421 U.S. 837 (1975) and Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).
In Forman, the stock at issue was that of a non-profit corporation that allowed its holders to rent a dwelling within a housing cooperative. The Court concluded that this stock was not a security because it did not have any of the traditional indicia of investment stock, specifically: (1) the right to receive dividends; (2) transferability; (3) voting rights; and (4) the capacity to appreciate in value.
In Landreth, the holders of stock in a corporation sold 100% of it to the buyers, thus giving control over the corporation to the purchasers. Nevertheless, the Supreme Court applied the Forman test, ultimately deciding that, unless the sale of stock involves selling shares where there is no investment motive, the stock must be considered a security.
The holdings of Forman and Landreth and provisions of the Securities Act are of particular importance to owners of close corporations and limited liability companies that want to sell or transfer their interests while avoiding being subject to securities laws. The sale or transfer of stock in close corporations are automatically exempt from securities law when the following requirements are met:
- The transfer or sale is limited to ten or less people who are organizers of the company or who invested through direct solicitation.
- The transfer or sale did not involve any use of the mails, telephones or the internet.
- The transfer or sale was limited to one state.
The determination as to whether the sale or transfer of stock in a close corporation or the sale or transfer of an interest in a limited
liability company is a security is subject to a number of complex laws
and statutory provisions which can be difficult to navigate for those
unfamiliar with their requirements. However, in the simplest terms, the sale or transfer of an ownership in a business (whether shares of
stock, a membership interest in a LLC or a partnership interest) to a
passive investor is considered the sale of a security. The idea is to
protect nonparticipating investors. Thus the Close Corporation receives the treatment described above because the owners of stock enter into
shareholder’s agreements defining their active participation in the
corporation. The same is true for sales of a membership interest in a
member managed LLC where the members manage the affairs of the
business. Because the LLC members actively participate in the operation of the business, the sale is not generally considered a security. In
fact, the SEC’s default position in the past with respect to
partnerships was that the sale of a partnership interest wasn’t the sale of security because partners typically played an intimate role in
running the business. The SEC now looks closer at the sale of
partnership interests given that it is now more common for partnerships
to sell ownership to limited partners who are passive investors.
this matters because those wishing to sell an ownership in their
business would prefer not to have to deal with SEC and similar state
regulations even if all they have to do is apply for a securities
exemption. Given the complexities, it is best to consult a corporate attorney if you have any doubts as to whether the sale of an interest in your business would be considered the sale of a security.