Form and Substance in the Definition of a "Security": The Case of Limited Liability Companies

I. INTRODUCTIONThe federal securities laws apply to any investment described by the broad statutory definition of a "security"(1) unless an exemption applies. This suggests that the type of business association and other aspects of the investment's external form should not matter, and that the securities laws should apply whenever appropriate for the protection of investors. Indeed, the Supreme Court often has expressed this view.(2)Yet this "substance-over-form" approach presents serious problems. At its full extension, the approach would require the courts to analyze each investment in the light of the function of the securities laws. Neither investors nor issuers could ever know without litigation or an administrative hearing whether the securities laws apply. This would not only increase litigation, but also would make it difficult for the parties to make and price their contracts with regard to the applicable level of regulation. These problems will become more serious as investment markets develop new types of business associations and "derivative" and other securities.(3)So "form" must matter. The only question is, how much? Courts have, in fact, emphasized form over substance by holding that a general partnership interest is presumptively a nonsecurity, and that corporate stock is per se a security.(4) Thus, current law essentially lets the parties to closely held firms choose whether the securities laws will apply by selecting their business form.The rapid acceptance of a relatively new form of business enterprise--the limited liability company (LLC)--raises new questions about the application of this form-over-substance approach to closely held firms. Like partnerships, LLCs are noncorporate firms whose members commonly participate directly in management and so arguably have less need than public corporation shareholders for mandatory disclosure rules. Yet, unlike partners, LLC members have limited liability and sometimes do not participate directly in management unless the agreement provides otherwise. It is not clear, therefore, whether the general-partnership-as--"security" analysis should be applied to LLC interests. While prominent securities law commentators have discussed the application of the securities laws to LLCs,(5) none have addressed the critical underlying form-over-substance issue.This Article concludes that LLC interests, like partnership interests, should be at least strongly presumed not to be "securities:"(6) This conclusion is based on an analysis of the extent to which courts should rely on investment form rather than substance--that is, "economic reality"--in defining a security.Part I of this Article reviews the reasons for treating general partnership interests as presumptively nonsecurities. Part II discusses potential distinctions between partnerships and LLCs that might justify a different result in the latter situation. Part III undertakes a more detailed analysis of the form-over-substance theory underlying the general partnership cases in order to determine whether the courts should extend the general partnership rule to LLCs. Part III shows why, in the light of this broader form-over-substance theory, LLCs should be treated substantially like general partnerships. Part IV discusses specific issues in applying the theory, while Part V discusses possible qualifications of the analysis. Part VI contains concluding remarks.II. THE BASIC THEORY: GENERAL PARTNERSHIPS AS NONSECURITIESThis Part reviews the starting point for analysis of LLC interests under the securities laws--the law and policy of general partnerships as non-"securities."A. ECONOMIC REALITY VS. PRIVATE ORDERINGThe Supreme Court has stated that "in searching for the meaning and scope of the word 'security' . . . form should be disregarded for substance and the emphasis should be on economic reality."(7) This means that in each case the courts must apply the general test for "investment contracts" articulated in SEC v. …