The real estate developer client asks for the “usual LLC” investor letter; it’s the one that says that the undersigned desires to purchase a member’s interest in the limited liability company is an “accredited investor” and can afford to lose his entire investment. I pull up the form and ask myself, “does anyone today know if their status is ‘accredited’ anymore? And in this environment, is the client (promoter) smart to rely on those representations?” If the wheels come off this deal, is a letter that was generated as a form by the promoter of the LLC and signed by the investor without the least bit of editing (or, likely, reading) going to trump the reality of the circumstances of the investor parties?

Is the sale of a member’s interest in a limited liability a sale of a security that requires registration of an offering—unless, of course, there is an applicable exemption? In Arizona, that question was answered by our Court of Appeals in the abstract, in the 1998 decision of Nutek Information Systems v. Arizona Corporation Commission, 977 P.2d 826, 30 Sec.Reg. & L. Rep. 1665, 1998 WL 767167 (App. 1998). The court reviewed the analytical standards set forth for an “investment contract,” found that the sales before them were indeed subject to state regulation of securities, and applied the Howey “reliance test” in reaching its decision. (In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court 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.”) While the number of investors in Nutek was significant (920), the essential fact was investor dependency on the promoters for return on investment. The LLC was formed to own and operate specialized mobile radio networks, a very technical field of communications. In context, even a very intelligent and sophisticated investor, lacking specialized knowledge, might be highly dependent on promoters to successfully operate the business.

These factors were viewed by the Nutek court as indicative that dependency was inevitable: (a) so little power resided in the hands of the investor that the arrangement was functionally like a limited partnership; (b) the investor did not have the background to be capable of exercising his member powers in the operation of the company; and (c) the investor was “so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or exercise meaningful . . . powers.” The Court of Appeals did not create a per se rule that all LLC interests in Arizona companies are securities, but stated that case by case analysis is obligatory.

Does Nutek stand up today as the state of Arizona law? And how far removed from federal court analysis is that decade-old opinion? The answer is “yes” to the first inquiry and “not much,” to the second question, if the decision of USA v. Leonard (Silver), 529 F.3d 83, US APP LEXIS 12409 (2nd Circuit, 2008) holds up. In Leonard, the court said that the promoters of the company had done their best to create the appearance of investor engagement in the management of the companies in question Little Giant, LLC and Heritage Film Group, LLC:

“were we to confine ourselves to a review of the organizational documents, we would likely conclude that the interests in Little Giant and Heritage could not constitute securities because the documents would lead us to believe that members were expected to play an active role in the management of the companies.” This is similar to the documents that have been prepared by “real estate” sponsors. The investor documents provided:

Each Member is required to participate in the management of the Company retaining one (1) vote for each Unit acquired. Each important decision relating to the business of the Company must be submitted to a vote of the Members. The purchase of interests in the Company is not a passive investment. While specific knowledge and expertise in the day to day operation of a film producing and distributing company is not required, Members should have such knowledge and experience in general business, investment and/or financial affairs as to intelligently exercise their management and voting rights[.] Further, each Member is required to participate in the management of the Company by serving on one or more committees established by the Members.”

In addition, the operating agreements for the LLCs indicated “that the Company shall be managed by the Members. . . . [E]ach Member shall have the right to act for and bind the Company in the ordinary course of its business.” Thus, the court stated, “on the face of the documents, [the LLC Interests] appear to provide for too much investor control to allow a jury to conclude that the units were securities.”

The Leonard court indicated that, when determining whether an LLC member’s interest was a security, a “case-by-case analysis” into the “economic realities” of the underlying transaction was necessary. The court noted that one of the original promoters of the LLC Interests testified at trial that the LLCs were structured to minimize the possibility that the investment units would constitute securities – “to get into . . . the gray areas of the securities laws.”

The real management of the LLCs was very different from the language set forth in the operating agreements, however. The court indicated that in reality, LLC members holders played an extremely passive role in the management and operation of the LLCs. At trial, members testified that they voted, at most, “a couple of times.” Although the organizational documents provided for the formation of a number of committees, only two committees were formed for each of the LLCs – a financial committee and a management committee. Of the 250-300 investors in one of the LLCs, five served on the management committee and seven served on the financial committee. Of the 350-400 investors in the other LLC, ten served on the management committee and seven served on the financial committee. Thus, the court concluded that the vast majority of investors in both LLCs did not actively participate in the venture, exercising almost no control.

The circuit court stated that “evidence allowed the jury to conclude, notwithstanding the language in the organizational documents suggesting otherwise that there could be no ‘reasonable expectation’ of investor control.” at 90. Such consideration of the reality of the transaction is consistent with the U.S. Supreme Court’s instruction to value substance over form in the evaluation of what constitutes a security. The court indicated that it was not bound by legal formalisms, but instead was required to take account of the economics of the transaction. The court stated, “[I]n searching for the meaning and scope of the word ‘security’ in the Act, form should be disregarded for substance and the emphasis should be on economic reality.”

The Leonard court also reviewed the management rights of the members of the LLCs during the syndication period. The investors’ managerial rights and obligations did not accrue until the LLCs were fully organized; interim management had control of the LLCs until the completion of the fundraising. The movies that were to be produced by the LLCs were pre-produced, and the court felt that the jury could reasonably conclude that the post-subscription managerial rights of the admitted members were hollow and illusory.

Likewise, “real estate” sponsors have complete managerial control prior to and during the syndication period. They usually establish a temporary manager to operate the property until all of the members are admitted and have made the most important decisions with respect to the offering, i.e., what property is to be acquired and how the property will be financed.
For contrast, consider a recent development in Arizona’s Mortgages, Ltd. bankruptcy. On January 21, 2009, the investors’ committee in the Mortgages Ltd. Chapter 11 bankruptcy (Court file number 2:08-bk-07465-RJH) filed a plan for reorganization. A portion of that plan calls for establishing a new LLC for each loan that the debtor had agreed to fund. Each new LLC under the reorganization plan would have a manager who could make recommendations on how to handle each loan. Members of the LLC, however, would vote on major decisions concerning the loans, such as whether to foreclose on a borrower, negotiate workouts of outstanding loan principal amounts or sell a loan. While I haven’t studied the plan, the member control over major decisions appears to illustrate how to structure management of an LLC so that a company’s members would not depend for their survival on the efforts of third parties—and, therefore, would pass the muster of a federal or Arizona court applying the Howey “reliance” analysis.

The Leonard court further noted that the LLC investors did not appear to have any ability to negotiate any terms of the operating agreement to which they were required to become a party. Rather, the investors were presented with the agreement on a take-it-or-leave-it basis. Thus, the court concluded that, because the investors played no role in shaping the organization agreements themselves, there was doubt as to whether the members were expected to have significant control over the enterprise.

The circuit court looked at the experience of the LLC investors and the realistic ability of the members to manage the LLC. The Leonard court echoed Nutek 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.” The court went on to say that “notwithstanding the organization documents drafted to suggest active participation by members, the defendants sought and expected passive investors for [the LLCs], and therefore the interests that they marketed constituted securities.”

Similarly, in syndicated TIC transactions, the sponsor identifies the property to be purchased, obtains and negotiates the terms of the financing for the property and presents the investor with a completed set of documents to acquire and manage the property, usually including a tenants in common agreement and management agreement. The investors have no input into the initial structure of the transaction. TIC owners may not have experience with the property types that they buy into through a TIC investment. Not surprisingly, the typical TIC investor has no knowledge of the property’s marketplace and no ability, therefore, to make independent, informed decisions regarding the property’s management. As a result, input from the TIC owners regarding the management of the property is extremely limited, and the TICs rely on the property manager’s expertise to make all consequential decisions related to the investment property. TIC investors usually are also geographically dispersed, which makes active, group management an unrealistic prospect.

Arguing that such a syndicated TIC interest is not a security is head-in-the-sand thinking. Seriously, how can 35 investors, solicited from across a wide swath across the United States, actively manage a property when they do not know anything about the area in which the property is located or each other, and when they live thousands of miles apart? Add to that a lack of expertise with the type or location of the property they have purchased as a group. These investors rely on the sponsors to actively arrange and manage their properties. They expect to be “passive investors,” because they don’t know how otherwise to behave.

In a market where there are “bargain” buying opportunities but individuals aren’t holding enough cash to buy in on their own, alliances for group purchases through TIC arrangements or LLCs. Folks won’t want to sweat the small details of organization like whether they are making a securities offering in joining together investors in these structures. Promoters, beware. Same message for their legal counsel—watch yourselves; perhaps more on legal representative complicity in a future post.

-MNW