When drafting LLC agreements, practitioners ought to remember that LLC interests may be securities subject to both state and federal securities laws. When an LLC interest becomes a security, additional disclosures of “material facts” are required. Without such disclosures, personal liability for securities fraud looms. The recent Washington Court of Appeals case of Freeman v. Fisher, No. 80541-0-I, 2021 WL 423135 (Wn. App. Feb. 8, 2021) reminds us of this very real risk.
Facts
Fisher was the managing member of J&M Capital who sought to purchase, renovate, and operate a boutique hotel in Pioneer Square in Seattle. Fisher solicited Freeman for investment in the venture. The J&M LLC agreement stated initial investors may elect to opt out and receive a “priority return on invested capital of 20% per annum” after the termination of the entitlement process. The entitlement process, according to Fisher, meant the steps required to get the hotel building ready for construction. After reassurances within the LLC agreement about her ability to opt out and receive a return on her investment at the end of the entitlement process, Freeman invested in J&M.
Throughout the process of bringing Freeman on as an investor, Fisher failed to disclose certain material facts. Specifically, Fisher and J&M failed to address the risks that the entitlement process could be delayed for a significant period of time. Who knew?
Over a year after investing in J&M, the venture failed to receive a building permit. Shortly thereafter, the venture defaulted on its various loans. Then, Freeman filed suit against Fisher for various causes of action, including violations of the Securities Act of Washington (WSSA), RCW 21.20. At trial, the court found that Fisher committed securities fraud, and Fisher appealed.
Securities and LLCs
In its analysis regarding whether Fisher violated the WSSA, the court jumps over the first step in WSSA analysis: was a security at issue. This step is the most important step for our purposes as it is where an LLC interest becomes a security.
RCW 21.20.005(17) includes in the definition of security a “certificate of interest or participation in any profit-sharing agreement.” In discussing whether a general partnership interest (not an LLC interest) is a security, courts look to whether the partner has “limited actual control and depends largely upon others’ managerial efforts.” Ito Intern. Corp. v. Prescott, Inc., 83 Wn. App. 282, 291, 921 P.2d 566 (1996). The United States Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) also developed a test to determine whether an investment is an investment contract (which is also within the statutory definition of security under RCW 21.20.005(17)). Under the Howey test, an investment contract exists when a transaction involves 1) an investment of money, 2) in a common enterprise, and 3) there is an expectation of profits that come solely from the efforts of others. In other words, under certain circumstances an LLC interest or an LLC agreement may certainly be a security.
In Freeman, the Court of Appeals certainly seemed to agree. This finding makes sense considering Fisher was the individual with the control over J&M, and, Freeman was merely a passive investor relying on Fisher’s “actual control.” Ultimately, the Court determined that Fisher omitted material facts surrounding the ability to “opt out” that he provided in the LLC agreement, thereby violating the WSSA. Remember, regardless of whether the sale of a security is a public or private offering, the seller must make a full disclosure of all material facts.
Considerations
Practitioners, whether drafting an entity’s governing documents or advising the members, need to consider that LLC interests may be securities. When an LLC interest is a security, the seller of the security must make a full disclosure of all material facts. When the seller fails to make such a disclosure, the seller becomes personally responsible for the success of the venture. When the venture fails, personal liability includes the full return of the investment together with interest at 8% per annum and attorney’s fees. State and federal securities laws are rife with potential pitfalls, especially with overzealous businesspeople and their counsellors. A sound understanding of when an LLC interest becomes a security may help avoid the problems seen in Freeman.