One of the biggest mistakes that a securities lawyer can make is fail to recognize a “security”. As a general rule, sale of securities must be registered under federal and state laws unless an exemption from registration is available. Failure to recognize that the deal involves a sale of securities may render the whole transaction invalid and in violation of securities laws.
The term “security” is broadly defined to include the expected stocks, bonds, etc., but also includes interests in pyramid sales schemes and even interests in the development of citrus orchards. The latter two examples are securities because they are “investment contracts”.
In 1946, the U.S. Supreme Court held in SEC v W.J. Howey Co. (328 U.S. 293) that an investment in a transaction or a scheme where a person invests his money in a common enterprise and is led to expect profits solely from the efforts of others is an investment contract, and therefore, a security. This test has been since used and interpreted extensively by the courts. It is this test that a lawyer should use when determining whether an interest in a limited partnership, general partnership, limited liability partnership or a limited liability company is a security.
The Howey test can be summarized as follows: passive investments, where investors do not have any decision-making power and just invest their money, are securities; whereas investments made by the principals, who are actively involved in the management of the enterprise, are not securities. So, limited partnership interests are generally securities because limited partners rely on the general partners to manage the partnership, unless they preserve some veto power, in which case the “investment contract” test would not be met.
Applying the same test to the general partnerships, it appears that generally such interests are not securities because they fail to satisfy the “solely from the efforts of others” part of the test. Although some general partnership or joint venture agreements may vary, usually all general partners exercise full control and decision making power with respect to the affairs of the partnership, they are not passive investors, and therefore, their interests are not securities.
Limited liability partnership interests are typically securities, since, like in limited partnerships, LLP limited interests lack managerial powers and have limited liability. Finally, Howey test also applies to LLC interests to determine whether they are securities. If the LLC is member-managed, then each member is involved in management of the enterprise and has decision-making powers, and therefore their interests would generally not be securities. On the other hand, if the LLC is manager-managed, then members are just passive investors, and their interests are likely to be securities.
Typical exclusions from these rules include gifted limited partnership or LLC interests, where, even though these are securities, there is no sale involved. Also, a grant of a limited liability interest to a general partner in consideration for his or her management of the affairs of the limited partnership, may also not be considered a security.
I have to say that all of the above are not hard rules and depend on a variety of circumstances. A close examination of partnership or operating agreements is necessary in each case. Also, federal circuits may vary in the interpretation of federal laws, and there are also state securities regulations to consider.
This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.