A Five Percent Interest Is Not Necessarily Stock

As Professor Joshua Fershee has often noted, many judges fail to distinguish between corporations and limited liability companies.  See, e.g., LLCs Are Not Corporations. Be Vigilant. Respect the Entity.  Therefore, it is nice to see that some judges do recognize that LLCs are not corporations.

The plaintiff's claim in  D.R. Mason Constr. Co. v. GBOD, LLC, 2018 U.S. Dist. LEXIS 41236 was straightforward: the defendants had fraudulently induced it to invest in securities in exchange for work completed at a restaurant.  The plaintiff claims it completed the work but never received the five percent ownership interest it was promised.  The question for U.S. District Judge Cynthia Ann Bashant was equally uncomplicated: should the plaintiff's complaint be dismissed for lack of subject matter jurisdiction?

The potential source of federal subject matter jurisdiction was Section 10(b) of the Securities Exchange Act of 1934.  However, Section 10(b) is not a federal breach of contract statute nor is it a general fraud statute.  A violation of Section 10(b) must be in connection with the purchase or sale of security.  The question for the court was wehther plaintiff's claim to a "five percent interest" involved a "security" within the meaning of Section 10(b) of the Exchange Act.

Judge Bashant concluded that it did not.  Noting that the plaintiff had not used the term "stock" and had alleged that the defendant was an LLC, she applied the "investment contract" test enunciated in SEC v. Howey, 328 U.S. 293 (1946) to determine whether a security was involved.  Citing Mace Neufeld Prods., Inc. v. Orion Pictures Corp., 860 F.2d 944, 946 (9th Cir. 1988), she also ruled that the plaintiff must show that the investment scheme was offered to several potential investors, not just to the plaintiff.  Judge Bashant concluded that the plaintiff had not alleged the existence of a security because it failed to allege: (i) that the defendants had offered the investment scheme to other investors, and (ii) what managerial responsibilities, if any, it was to have in the restaurant.
Obviously, this case does not stand for the proposition that a membership interest never meets the definition of a "security" under the Exchange Act.  Nor does the case deal with the issue of whether a membership interest constitutes a security under state law.  It does demonstrate that some courts recognize the fact that LLCs are not corporations.