Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Sunday, June 15, 2008

Second Circuit Finds that LLC Interest is a Security

The Second Circuit addressed the definitional question of a "security" in a recent criminal case, U.S. v. Leonard (June 11, 2008), and held that an interest in a limited liability company organized to produce a movie was an "investment contract," despite the promoters' efforts to structure the LLCs so that they were not passive investments.  The court acknowledged that if it were to confine itself to a review of the organizational documents, it would likely conclude that the interests could not be securities because, according to the documents, every member was expected to play an active role in the management of the company.  The court, however, reaffirmed that in applying the Howey "investment contract" test the courts should look beyond the formal terms of the relationship to evaluate whether "the reasonable expectation was one of significant investor control."  Here the court found this was not the expectation since in reality the members played an extremely passive role in the management and operation of the companies: they did negotiate the LLC agreements, they had no experience or expertise in the move business, and they did not, in fact, exercise meaningful managerial control.  The court vacated the sentences and remanded for resentencing, however, since the district court had erred in its loss calculation by assuming that the securities were worthless.  While recognizing that illiquid securities in private investments are extremely difficult to value, the district court was required to exercise its sound discretion in determining their valuation.

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