Lawyers regularly help their clients form business entities. In the modern day, the large majority of entities that are formed are formed as limited liability companies (LLCs).^[1]

While forming an LLC is fairly simple – one simply needs to prepare and file with the Wisconsin Department of Financial Institutions (DFI) a certificate of formation and have an operating agreement (which can be informal and oral, though preferably is in writing) – there is a subsequent step practitioners be alert for, even if the issuance of interests is not to professional investors.

That is, LLC interests can be securities under state and federal securities laws – the issuance of which must be registered unless a relevant exemption applies.

Definition of Security

In Wisconsin, a security includes, among other things,^[2] an investment contract.

An investment contract, in turn, is defined to include “an investment in a common enterprise with the expectation of profits to be derived through the essential managerial efforts of someone other than the investor.” A “common enterprise” is “an enterprise in which the fortunes of the investor are tied to the efficacy of the efforts of those seeking the investment or a third party.”^[3]

Putting all of this together, under this test, an LLC interest is an investment contract and therefore a security if: a party make an investment (usually money), (2) in an enterprise in which the investor’s fortunes are tied to the efforts of those who manage the LLC or to the efforts of a third party, (3) where the investor expects profits (4) from the essential managerial functions of someone else.

The second element of the above test is often referred to as “commonality.” Under the commonality element, there must be some commonality in interest between the investor and those whose efforts generate returns for the LLC – usually management. Thus, where an LLC member expects profits from the success of a manager’s or management team’s efforts, this element is met.

This contrasts with how the U.S. Court of Appeals for the Seventh Circuit applies the equivalent test under federal securities laws. Under the federal test, the “commonality” element can only be satisfied where multiple investors pool their money in a common investment.^[4] This is referred to horizontal commonality, as it focuses on alignment in interests among investors rather than on alignment in interests between managers and the investors.

But again, horizontal commonality is not needed under Wisconsin securities laws, so a security might exist even where an LLC interest is issued to a single investor.

The fourth element of this test focuses on those whose efforts generate the profits. If a person provides the essential managerial functions for an LLC, then that person does not hold a security, as profits do not derive from the essential managerial functions of someone else.

Under this part of the test, Wisconsin courts look at whether the person participates in the essential managerial functions.^[5]

As the Wisconsin Supreme Court has held, “an investor may have a role in the managerial efforts of an investment contract, so long as the investor does not provide the essential managerial efforts for the investment contract.”^[6]

This is often described by courts as being broader than the equivalent test under federal securities laws, which looks at whether an investor expects profits “solely from the efforts of others.”^[7]

LLC Interests as Securities

Under this measure, by and large, the founder who forms the LLC and then works for the LLC does not own an investment contract, nor therefore, a security. While the founder likely invests resources and expects to make a profit, the founder expects profits primarily from the founder’s own efforts – in other words, the founder is not depending on the efforts of others.

But what about where there are multiple founders? Are one founder’s returns “tied to” the efforts of the other founder such that they each hold a security?

Here, the answer depends on whether both founders provide essential managerial functions. If both are actively involved in managing the business, then likely neither holds a security.

Wisconsin even has a safe harbor such that if both founders have authority to bind the business, then they do not hold securities.^[8] However, if one founder has operational control and the other only provides strategic oversight and funding but does not manage, then the latter founder likely holds a security.

And what about when an LLC issues ownership interests to a founder’s friends and family (F&F) – are those interests securities?

By and large yes, those interests are securities, assuming the F&F are not actively involved in managing the business. Even if F&F have some voting rights, whether by virtue of Wisconsin’s LLC Act or additional negotiated voting rights, or the right to receive information, those rights alone do not place them in the role of performing essential managerial functions.^[9] As such, those F&F would likely hold securities.^[10]

Issuing LLC Interests in Compliance with Law

Assuming an LLC is issuing securities to F&F, that issuance must either be registered with the DFI’s Division of Securities unless (1) an exemption applies, or (2) the security is a “covered” security under federal securities laws.^[11]

While this article does not go into depth on available exemptions, there are a number of exemptions that are commonly available for the issuance of LLC interests to F&F.

One frequently relied upon Wisconsin exemption applies where the LLC has its principal office in Wisconsin, after the issuance, will continue to have fewer than 25 nonaccredited investors,^[12] and does not publish an advertisement soliciting investors unless approved by the DFI’s Division of Securities.^[13]

Another exemption is available where the LLC’s interests are offered to no more than 25 nonaccredited investors in Wisconsin, all of whom are reasonably believed to be purchasing for investment (and not to resell).^[14]

A third frequently used exemption is known as the “intrastate offering exemption,” and is generally available where an LLC is organized and doing business under Wisconsin law, has a majority of its employees in Wisconsin, makes offers to 100 or fewer people in Wisconsin, and does not publish an advertisement soliciting investors unless approved by the DFI’s Division of Securities.^[15]

Finally, it is important to note that an issuance of LLC interests must also comply with federal securities laws, assuming the transaction involves interstate commerce. Federal securities laws use a similar definition of security as Wisconsin, other than the differences noted above.

Thus, when an LLC issues ownership interests, it must also ensure there is an exemption from registration under federal securities laws, too. Some of those exemptions require that additional steps be taken, such as to verify the status of the investor or to notify the Securities and Exchange Commission of the exempt offering.

Conclusion

Regardless of a lawyer’s area of practice, a lawyer is likely to encounter a scenario where a client wants to form a legal entity. Oftentimes, that legal entity is an LLC.

The purpose of this article is to flag for lawyers that, while it can be a quick process to form an LLC, the lawyer must always be mindful of state and federal securities laws when forming the legal entity and helping the client issue ownership interests in that entity.

This article was originally published on the State Bar of Wisconsin’s Business Law Blog. Visit the State Bar sections or the Business Law Section webpages to learn more about the benefits of section membership.

Endnotes

[1] While the focus of this post is on LLCs, the content would also apply to other business entities whose ownership interests are analyzed as potential investment contracts, including partnerships. ↩

[2] Most obviously, a security includes stock. ↩

[3] Wis. Stat. § 551.102(28)(d)(1). ↩

[4] Stenger v. R.H. Love Galleries, Inc., 741 F.2d 144, 146 (7th Cir. 1984). ↩

[5] SeeState v. LaCount, 750 N.W.2d 780, 789-90 (Wis. 2008). ↩

[6] Id. at 789. ↩

[7] SeeSEC v. W.J. Howey Co., 328 U.S. 293, 328 (1946). And yet, despite use of the word “solely,” courts interpret this to capture where there is a reasonable expectation of profits from the entrepreneurial or managerial efforts of others. See, e.g., SEC v. Glenn W. Turner Enterprises, Inc. 474 F.2d 476, 482 (9th Cir. 1973) (“we adopt a more realistic test, whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”). ↩

[8] Wis. Stat. § 551.102(28)(e)(2). This applies where an entity has 15 or fewer securities holders, where each holder has authority to bind the LLC. ↩

[9] See Wis. Stat. § 551.102(28)(e)(1). ↩

[10] While this post focuses on the issuance of LLC interests to founders and F&F, the issuance of LLC interests to angel investors, venture capitalists, and other professional investors would also involve the issuance of securities, and therefore need to be registered unless an exemption applies. ↩

[11] Wis. Stat. § 551.301. A “covered” security is one that is exempt from state registration. LLC interests issued to F&F would be covered securities if, for example, they were issued under the exemption in Securities Act Rule 506(b). Note though, that even if a security is a “covered” security and exempt from the requirement of state registration, Wis. Stat. § 551.302 requires a notice filing with the DFI’s Division of Securities. ↩

[12] An “accredited investor” has the meaning given that term in the Securities Act of 1933. Accredited investors includes certain high-level insiders of the issuer as well as individuals who meet either a net-income or net-worth test. See Securities Act Rule 501. ↩

[13] Wis. Stat. § 551.202(24). ↩

[14] Wis. Stat. § 551.202(14). ↩

[15] Wis. Stat. § 551.202(14m). ↩