IS MY INVESTMENT IN A REAL ESTATE LLC A SECURITY?

By D. Joe Rockett

Your friend, Gump, organized a real estate development company with a view to developing a tract of land as a golf resort. Gump, being your friend, offered you the opportunity to join in the LLC and contribute to the equity of the deal. You and Gump presented the opportunity to a mutual friend, and golfing buddy, Darrell Duffer, who liked the idea and invested the same amount as you invested. A construction loan was arranged with a friendly bank and your newborn venture was off and running.

Before the development could be completed, the market declined and the development was struggling to stay on track. No additional bank financing was available and you stepped forward with a substantial unsecured loan to the LLC to keep it afloat. In an effort to right the ship, you and Duffer removed Gump as the president and manager of the LLC and the three of you became member-managers.

Even with your injection of capital, the project could not survive and ultimately the bank foreclosed on the property.

With no chance of recovery from the LLC, you are left with a note and an equity interest in a defunct LLC. With the able help of a knowledgeable securities attorney, you sue Gump for securities fraud and seek to recover all of your investment, both your equity investment and your loan to the LLC.

The securities argument is that your investment in the equity of the LLC through the operating agreement is an investment contract and therefore a security under federal and state securities laws, including the Securities Exchange Act of 1934, Section 10(b) and Rule 10(b)(5).

In the U.S. Supreme Court case of SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Court held that an investment of money or other consideration in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others constitutes an investment contract and therefore a “security”. According to federal and state securities laws, a purchaser of a security, in a transaction that involves material fraudulent misrepresentations or omissions, is entitled to recover his or her investment, plus interest and the promoter may be subject to civil penalties and in some cases criminal prosecution.

An essential element of an investment contract is the investor’s reasonable expectation of profit based on the efforts of another. In the hypothetical case above, you and Duffer exercised your powers under the LLC operating agreement to control the efforts of Gump, even to the point of removing him as president and sole manager of the LLC. Your exercise of control is inconsistent with the position that you had an expectation of profits to be derived from the efforts of another.

Such was the outcome of a February 2018 case in the United States District Court for the District of Kansas (Foxfield Villa Associates, LLC v. Robben, CCH 100,024). Plaintiffs, two members of a real estate development LLC, sued the third member, who also was the founder and original president of the LLC, for securities fraud. When the LLC encountered financial difficulty, one of the members loaned the LLC $400,000 to finance short term cash flow interest. The loan was unsecured. Half of the loan was repaid before the venture went under and the plaintiffs sued.

The Court rejected the plaintiffs’ argument that the members’ interests in the LLC and the one member’s loan were securities. Before the suit was filed, the two plaintiff members removed the defendant member as president and the three members became member managers of the LLC pursuant to authority granted in the operating agreement. They held 75% of the equity of the LLC which represented a super majority for voting purposes, including the power to remove the president.

The Court found that the plaintiffs were not passive investors, that they were “business-savvy investors” with real estate experience and under the language of the operating agreement, were expected to devote as much time as necessary to manage the affairs of the LLC. Accordingly, the profits of the venture were not to be derived solely from the efforts of others and therefore, the investments were not investment contracts and were not securities.

Further, the Court held that the member’s $400,000 loan to the LLC was made to finance short-term cash flow interest with a view to seeing the venture succeed, or at least survive. The Court rejected the plaintiff’s argument that his investment was for profit from the loan. As a result, there was no security.

So, if your investment is to be considered a purchase of a security, with the attendant remedies if the business fails, it is essential that any profits are to be derived from the efforts of others. Investors who share in control of the venture risk losing the argument that they relied on the efforts of others.

If you are in need of a lawyer with expertise in the areas of corporate and securities law, please contact Joe Rockett at Andrews Davis, P.C.

Our blogs are for general information purposes and are not intended to be, and should not be taken as, legal advice. The views expressed in this blog are those of the author and do not necessarily reflect the views of the firm.


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