Strictly Business

This post is the third in a series exploring when securities laws impact business transactions.

In my previous posts, I provided a general overview of the definition of a “security” under federal securities laws.  One of the categories of investments that constitutes a “security” under federal law is an “investment contract.”  The term is a rather open-ended one, but under the so-called Howey Test, the term includes any arrangement or transaction that is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  As a result, any transaction which constitutes an investment contract is a security under federal securities law.  In this post, we’ll explore when an interest in a limited liability company (“LLC”) or a partnership constitutes an investment contract, and consequently, a security.

When the Securities Act of 1933 was written, there was no such thing as an LLC or a limited partnership.  The only type of partnership-like entity available was a general partnership, which featured unlimited joint and several liability for the partners.  As a result, it was very rare that someone would invest in a partnership in a passive role.  Therefore, partnership interests were left out of the definition of a “security” under the Securities Act.

Now, with the advent of limited partnerships, limited liability partnerships, limited liability limited partnerships, and limited liability companies, there are a myriad of choices available that allow an investor to invest in a partnership and enjoy limited liability.  Therefore, passive investing in partnerships and partnership-like entities is now common.  But because interests in these kinds of entities are not listed within the definition of a “security” under the Securities Act, a partnership or LLC interest will only be considered a security if it constitutes an investment contract.

That said, interests in many LLCs and partnerships fall under the definition of an investment contract.  For instance, in manager-managed LLCs, the non-managing members are essentially passive owners.  The same also applies to limited partners in a limited partnership.  An investment contract is, quintessentially, an arrangement where a passive owner invests money with another person who promises to use that money to make a profit for the passive owner.  Therefore, in each of these instances, the non-managing member interests and the limited partnership interests would be considered investment contracts and consequently securities.[1]

Conversely, a general partnership interest in a partnership or a managing member interest in an LLC are generally not securities, because the control that the general partner or managing member has over the company causes the general partner or managing member’s interest to fail to meet the final prong of the investment contract definition (that is, profit arising primarily from the efforts of people other than the investor).  Likewise, members in a member-managed LLC are usually not deemed to be holders of securities if they have the ability to participate in management.

However, even if a member of an LLC or a partner in a partnership has management rights on paper, the LLC or partnership interest could still be considered an investment contract, if in practice, there is no expectation that the investor will be active in generating profits.  In securities law, substance often trumps form.  Thus under Williamson v. Tucker, 645 F.2d 404 (5th Cir 1981), the Court of Appeals for the Fifth Circuit held that a general partnership interest could be a security if the investor was dependent on the promoter and could not exercise meaningful control.  Examples of such a situation are (i) where the managing partner cannot be replaced or is very difficult to replace, (ii) where the investors are inexperienced in business affairs and cannot exercise their abilities to participate in management, or (iii) where the promoter has unique managerial abilities which cause de facto reliance on the promoter.  Generally, if one of these situations exist at the time of initial investment, then the investment is likely to be an investment contract.

Whether a partnership interest or an LLC interest is a security often depends highly on context.  The less involved the holder of the interest is in the activities of the company, the more likely that the interest will be considered a security.  In addition, the relative sophistication of the purchaser of the interest as compared with company management also has a role to play.  Interests sold to less sophisticated investors are more likely to be considered a security than those sold to more sophisticated ones.  Unfortunately there is no bright line test that determines whether an LLC or partnership interest is a security, and consequently, the context of the transaction pays a significant role.

Footnotes

[1] It is possible that a limited partnership interest or a non-managing member interest in an LLC could be outside the definition of an investment contract if the economic realities indicate that the limited partner has significant and legal control of partnership management.  See Steinhardt Group v. Citicorp, 126 F.3d 144 (3rd Cir. 1997).

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

This post is the second in a series exploring when securities laws impact business transactions.

In my previous post, I provided a general overview of the definition of a “security” under federal securities laws.  The Securities Act of 1933 provides for a very far reaching definition of a security, including “any note, stock… investment contract…, or, in general, any interest or instrument commonly known as a ‘security’…”  As explained in my prior post, this definition, taken literally, can result in both overinclusiveness and underinclusiveness.  I’ll discuss the issue of overinclusiveness and how it is addressed in future posts; this post will discuss how the inclusion of an “investment contract” within the definition of a security allows the definition to include classes of investments that are not specifically listed, like limited liability company interests and limited partnership interests, which are both concepts that had not even been invented when the Securities Act was passed.

The principal case which defined the term “investment contract” under federal law is SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  In the case, the defendant, Howey was sued by the SEC to enjoin it from selling plots of land that had citrus trees planted on them.  Along with the plots of land, Howey offered management contracts where the purchaser would lease the plots back to Howey and Howey would harvest them.  However, the purchaser was not required to enter into such a management contract and could purchase the land without doing so.  Nonetheless, the Supreme Court held that the land sale together with the management contract collectively constituted an investment contract, and thus a security.

In this decision, the Supreme Court set forth a test, now known as the Howey test, for determining whether a transaction constitutes an investment contract.  Under the Howey test, a contract or transaction is an investment contract if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third-party.”  Please note however that while the Supreme Court in Howey stated that the profit must arise “solely” from the efforts of others, later decisions by lower courts and the Supreme Court[1] have expanded this, so even if the investor has the power to be involved, the transaction may still be an investment contract if the efforts of others predominate.  Therefore, there are three essential components for this test: (1) investing money in a common enterprise, (2) the expectation of profit, and (3) the profit arising primarily from the efforts of people other than the investor.

In future posts, I’ll explore how the Howey test operates in specific situations.  In addition, I’ll also explore situations where some classes of investments are excluded from the definition of a “security” even if they are listed within the federal definition.

Footnotes

[1] More recently in United Housing Foundation v. Forman, 421 U.S. 837 (1975), the Supreme Court stated that an investment contract is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  The word “solely” was conspicuously left out.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Business owners and attorneys without a securities background will often engage in transactions that, while on first blush do not involve securities regulation, but actually are a securities transaction, and thus subject to federal and state securities laws.  For instance, real estate developers often finance projects by bringing in outside investors as limited partners.  They are likely to hire a real estate attorney to complete the deal, who will dutifully draft a limited partnership agreement for the transaction.  What neither of them often realize is that a securities transaction is occurring as part of the deal.  The sale of limited partnership interests is usually a securities transaction under federal and state law.  This means that the interests are subject to registration with the SEC and with the state of each investor’s residence[1], unless an exemption can be found. In addition, all statements made in discussions with limited partners are subject to the anti-fraud rules.

The reality is that the definition of “security” a whole lot broader than many people realize.  In fact, it is a lot broader than what many attorneys realize, at least those without a background in securities law.  In this series of posts, I’ll explore when securities laws apply and when they don’t apply to particular transactions.

The Federal Definition of a Security

Each of the main federal statutes (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940) has a definition of the term “security.”  For the most part, they are all very similar, with only minor differences between them.[2]  So lets start with the definition used in the Securities Act of 1933:

“[U]nless the context otherwise requires… [t]he term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”[3]

That’s quite a lot to digest, but there are a couple of initial important points.  First, a large number of different types to transactions are securities transactions.  For instance, stock in a closely held business or a note evidencing a loan are both potentially within the definition of a “security.”  Therefore, when incorporating your business, the sale of stock to your fellow co-founders can indeed be a securities transaction.  In addition, the issuance of a promissory note, which happens in most loan transactions, can also be a securities transaction.  So there are a lot of transactions that may be subject to securities laws that you would ordinarily not think of as a securities transaction.  I’ve seen many entrepreneurs think that simply issuing notes, rather than equity, to investors gets them out of complying with securities law.  So does this mean that all loans are securities transactions?  No, it doesn’t, as I will explain below.

The second thing that should be pointed out is what the list contained in the paragraph above does NOT include.  Two examples that immediately come to mind are partnership interests and limited liability company interests.  In fairness, limited liability companies weren’t even invented at the time the Securities Act was passed, but Congress has amended the Securities Act several times since then (in Sarbanes-Oxley, Dodd-Frank, and many other instances as well) and it could have added to the definition.  So does this mean that limited liability company interests are never securities?  Again, the answer is no.

The potential overinclusiveness and underinclusiveness of the federal securities definition is ameliorated by the two phrases which I highlighted above in bold.  The phrase “unless the context otherwise requires” allows a court to, for example, treat a note that is issued clearly as part of an ordinary loan as an ordinary loan and not as a security.  Likewise, courts have interpreted the term “investment contract” very broadly, covering some limited liability company interests, partnership interests, and even the sale of citrus trees (though in this instance, what was being sold was more than just citrus trees).  Therefore, courts have wide latitude to exclude specific instances of the items listed within the “security” definition and to also include items that were not listed as well.

In future posts, I’ll explore what the legal standards are for such exclusion and inclusion in specific scenarios.

Footnotes

[1] And the interests are also potentially subject to registration in the states in which the interests are offered but not sold.  This is, if you send out any promotional material to any residents of a state, it is possible that the securities may need to be registered in that state.

[2] It is unclear if, but unlikely that, any of these minor differences actually makes a difference in the end result of whether a particular transaction involves securities.

[3] The bolding of certain phrases is mine, and is not in the statute.  The explanation of why I highlighted these phrases is explained later in the post.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

One of the benefits to using a limited liability company is the flexibility of being able to choose how the entity is taxed.  After a new LLC is formed, its owners must decide the method by which they would like their business taxed.  By default, an LLC is treated as a pass-through entity, which means that it does not pay federal taxes directly, but its income or loss is allocated to the owners, who then pay taxes on that income.  If the LLC has only one member, it files no tax return and all transactions of the LLC are treated as transactions of the owner for tax purposes.  If the LLC has more than one member, the LLC files a partnership tax return, which reports the LLC’s income and how that income is to be allocated to each owner.  Partnership style taxation is governed by Subchapter K of the Internal Revenue Code.  However, the owner(s) of an LLC, whether the LLC has a single member or multiple members, may choose to have their LLC taxed as a corporation.  In this case, the LLC can be taxed as a so-called “C Corporation,” which is governed under Subchapter C of the Internal Revenue Code, or an “S Corporation,” which is governed by Subchapter S.  This ability of LLC owners to elect the company’s means of taxation is called the “check the box” regulations. Below are summaries of the four methods of taxation of an LLC:

• Disregarded Entity – This is the default rule for any LLC that has only one member.  A single member LLC is treated as though it does not exist for tax purposes and thus the owner is treated as if he were running a sole proprietorship.  All transactions — income and expenses — are included on the owner’s tax return.  Therefore, no separate tax return need be filed for the LLC.
• Subchapter K (aka partnership taxation) – This is the most flexible form of taxation for a multi-member LLC.  All income and losses of the LLC are allocated to the owners, who pay taxes on that income regardless of the amount of cash they received from the company.  A distribution of cash to owners is itself a tax-free event.  The owners of the LLC can be compensated for service to the company (called “guaranteed payments”) in which case the payments are treated as an expense to the partnership and income to the owner.  Subchapter K is quite flexible, and allows the owners to allocate the income between themselves in a variety of ways, sometimes in quite complex formulas (subject to certain limited restrictions in the Internal Revenue Code).  One downside to using a partnership taxation structure is that the income of the partners is generally subject to the self-employment tax.
• Subchapter C – If an LLC elects to be taxed under Subchapter C, it is treated for tax purposes, as if it were a corporation.  The company must file a corporate tax return (regardless of whether there is one member or multiple members) and the LLC itself pays taxes.  Any income that is paid to owners in the form of dividends is also taxable income to the owner (so-called “double taxation”), though the dividends are taxed to the owner at the capital gains rate.  Because of this, many C Corporation owners pay themselves a salary or bonus.  Such income is deductible to the corporation, though the compensation must be “reasonable.”  If the IRS were to deem the salaries paid to an owner as higher than what would be reasonable if the owner were just an ordinary employee, it could reclassify part of the salary as a constructive dividend, subjecting the company to additional taxes and potential penalties.
• Subchapter S – If an LLC elects to be taxed under Subchapter S, it is treated for tax purposes, as if it were a corporation that had elected to be treated as an S Corporation.  In this form, the company will still file a corporate tax return but does not itself pay taxes.  Instead, each owner is allocated a portion of profits or losses based on the percentage interest that they each own.  As in a partnership, the owners must then pay the taxes themselves, regardless of whether any cash has been distributed to them.  Any cash payments to owners (called distributions or dividends) are tax-free.  Active owners are considered employees of the company and can also be paid for their services to the company in the form of a salary or other payments, in which case, the payment will be deductible to the company and will be taxable wage income to the owner.  The benefit of taxing an LLC as an S Corporation is that income that is not paid out as a salary is not subject to self-employment taxes.  However, the IRS can scrutinize the salaries paid to owners and if it deems that the owners have been underpaid, it may reclassify some of the LLC’s income as wages, subjecting the LLC and the owners to additional payroll taxes and potential penalties.  Another disadvantage to using Subchapter S is that the designation is very “fragile.” There are a number of requirements the company must adhere to (such as having only one class of stock and no more than 100 owners).  If the company fails to adhere to these requirements, it will automatically be converted to a C-Corp and face double taxation.  The single class of stock requirement is especially easy to violate inadvertently.  If the LLC gives any owners preferred distributions or distributes distributions in any way except through a straight pro rata method, it could be deemed as having more than one class of stock.  In addition, many of the default provisions in LLC statutes violate the single class of stock requirement, which means that the operating agreement of an LLC taxed under Subchapter S must be carefully written to override the default provisions.

As you can see, there are many factors to consider in choosing how to have an LLC taxed.  Your final choice should be based on your own specific situation.  Therefore, before making any decisions on your form of business, you should speak with your attorney or accountant.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previously, I have written about the advantages and disadvantages of incorporating in Delaware or Nevada as a small business owner.  With regards to Delaware, my conclusion was that, for most small companies, the disadvantages outweigh any advantages.  With regards to Nevada, my view was that it is highly uncertain that many of the advertised benefits of incorporation in Nevada, such as greater asset protection and greater liability protection, would actually materialize.  In this piece, I’ll cover my thoughts on another state that is frequently pitched as a good place for forming your business: Wyoming.

Wyoming limited liability companies are heavily marketed on the internet as a great option to form a new business.  Wyoming has the distinction of being the first state to have a limited liability company statute, which apparently was created as special interest legislation for an oil company.  Because of Wyoming’s long history with LLCs, Wyoming LLCs are highly promoted as being superior to the LLCs of other states (usually by companies that offer to do the formation for you…for a fee).  The fact that Wyoming was the first state to have an LLC statute doesn’t really benefit a business owner, of course.  The three major substantive selling points that are used to promote Wyoming LLCs are: (1) superior asset protection, (2) lower taxes, and (3) lower fees.  For the reasons described below, it is highly unlikely that a business owner would actually realize any of these benefits if they were to organize their business as a Wyoming LLC.

The first major substantive selling point is that Wyoming LLCs supposedly have superior asset protections.  Wyoming law provides that the sole remedy available to creditors of owners of LLCs is a charging order.  A charging order is an order by the court directed to the company ordering the company to send all distributions that would have gone to the owner/debtor to the judgment holder instead.  This limitation can make it more difficult for a creditor to collect on their judgment because the creditor will not be able to force the debtor to sell his ownership interest in the company. Usually, after a creditor obtains a judgment against a debtor, the creditor is entitled to sell the debtor’s personal property to satisfy that judgment.  However, if the creditor’s sole remedy is a charging order, then the creditor is entitled to whatever distributions are produced from the ownership interest (if any at all), but the creditor cannot transfer or sell that ownership interest.  Having this protection can give a debtor more leverage in negotiating a settlement. However, the charging order limitation is not unique to Wyoming.  Most states’ LLC statutes provide that the sole remedy to a creditor of a member is a charging order.  It is true that Wyoming has extended the charging order limitation to single member LLCs, whereas many other states do not provide such a protection in the case where an LLC has only one owner.  However, it is important to note that if a lawsuit takes place in your home state or in some other state besides Wyoming, conflicts of laws principles may cause the law of a state other than Wyoming to control whether a creditor may be able to obtain a lien on or a forced sale of a debtor’s interest in a Wyoming single member LLC.  In other words, judges often have a lot of discretion as to which state’s laws apply in multi-state cases and often begin with the assumption that the law of the forum applies, unless a party can show that another state’s laws have greater contacts or interests in the case.  Therefore, you cannot be sure that your own home state won’t go ahead and apply its own law to the situation, notwithstanding whatever Wyoming law states.  Therefore, for people interested in asset protection, I’d recommend taking steps other than forming a Wyoming LLC.  See my post on Nevada corporations and LLCs for links to more information on what steps your should take for asset protection.

Another major selling point that is used in promoting Wyoming LLCs is that Wyoming has no income tax.  Unfortunately, since most LLCs are pass through entities, which pay no taxes themselves, this is of limited benefit.  For instance, if you live in another state that has a personal income tax, and form a Wyoming LLC, all the income would be passed through to you and you would still end up paying state income taxes.  Therefore, forming an LLC in Wyoming is not an effective tax avoidance method.  In addition, if your state does impose an income tax on LLCs at the entity level (which for instance my own state of Tennessee does), and your LLC operates a business in your state, then your LLC would still end up paying the state income tax regardless of Wyoming’s income tax, because it is the entity’s presence in a state which controls whether it is taxed there, not its state of incorporation.

The final major selling point that is used to promote Wyoming LLCs is that the fees to organize them and the ongoing annual fees are lower than other states.  This is certainly true.  But if you live outside of Wyoming, and organize your business as a Wyoming LLC, your business will almost certainly be doing business in your home state.   In that case, your LLC will be required to qualify to do business in your state, which usually involves paying a fee equal to what your company would have paid had it simply been organized in your own home state.  Therefore, you are unlikely to realize any cost savings from organizing your LLC in Wyoming (Nevada and Delaware entities present this same issue as well).

As with Delaware and Nevada entities, I don’t think there is much advantage to using a Wyoming LLC, as opposed to an entity formed in your home state (unless of course, your home state is Wyoming).  You will end up incurring double the fees, because you will have to pay Wyoming’s fees and then pay your own state’s fees to obtain authorization for your Wyoming LLC to do business in your own state.  Despite this additional cost and complication, it is uncertain whether you will see any of the benefits, such as greater asset protection, that are often promised in connection with incorporation in Wyoming, nor are you likely to see any tax savings.  In addition, if there were ever litigation among the owners, you may be forced to conduct that litigation in Wyoming, which could end up being highly inconvenient and expensive.  Therefore, unless there is some specific reason to set up your company in Wyoming, I’d avoid using a Wyoming LLC.

As always, your final choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previously, I wrote about the pros and cons of incorporating in Delaware as a small business owner.  My conclusion was that, for most small companies, the disadvantages outweigh any advantages.  In this piece, I’ll cover my thoughts on another state that is frequently pitched as a good place for incorporation: Nevada.

Like Delaware, Nevada has a special court system for litigating business disputes.  Nevada promotes its so-called “Business Court” as efficient and fast in its case management.  However, Nevada’s Business Court doesn’t issue written opinions or binding precedent, so it does not provide the predictability that Delaware provides.  In addition, as with being incorporated in Delaware, if your business is physically located in a state other than Nevada, the supposed efficiencies are probably outweighed by the hassle of having to litigate cases in a far away state.  Therefore, for most business owners, I do not see Nevada’s Business Court as being a major benefit.

The second big selling point to incorporating in Nevada is that Nevada supposedly has greater protections for shareholders against a “piercing the corporate veil” action.  Piercing the corporate veil involves holding the owners of a corporation or limited liability company liable for the debts of the company. Generally, piercing the corporate veil can only be done in extreme situations such as when the shareholder commits fraud or when the corporation is deemed the “alter ego” of the shareholder.  The standard for successfully piercing the corporate veil in Nevada may be stricter than in your home state.  However, it is important to note that if a lawsuit takes place in your home state or in some other state besides Nevada, conflicts of laws principles may cause the law of a state other than Nevada to control whether a piercing the corporate veil action would be successful.  In other words, judges often have a lot of discretion as to which state’s laws apply in multi-state cases and often begin with the assumption that the law of the forum applies unless a party can show that another state’s laws have greater contacts or interests in the case.  In fact, while Nevada corporations are often promoted as being particularly useful to business owners in California, California has been one of the most aggressive states in applying its own corporate laws to businesses incorporated elsewhere but doing business in California.  Therefore, my recommendation is to use your own state’s incorporation statute and take effective precautions against liability, which includes observing all corporate formalities and making sure that you and your company have adequate liability insurance coverage.

Nevada corporations are also promoted for their asset protection abilities. Nevada law provides that the sole remedy available to creditors of owners of Nevada closely held corporations and LLCs is a charging order.  A charging order is an order by the court directed to the company ordering the company to send all distributions and dividends that would have gone to the shareholder/owner/debtor to the judgment holder instead.  This limitation can make it more difficult for a creditor to collect on their judgment because the creditor will not be able to force the debtor to sell his stock or ownership interest in the company. Usually, after a creditor obtains a judgment against a debtor, the creditor is entitled to sell the debtor’s personal property to satisfy that judgment.  However, if the creditor’s sole remedy is a charging order, then the creditor is entitled to whatever distributions or dividends are produced from the ownership interest (if any at all), but the creditor cannot transfer or sell that ownership interest.  Having this protection can give a debtor more leverage in negotiating a settlement. However, the charging order limitation is not unique to Nevada.  Most states’ LLC statutes provide that the sole remedy to a creditor of a member is a charging order.  It is true that Nevada has extended the charging order limitation to situations that other states have not, namely to closely held corporations and single member LLCs.  However, as in the case of piercing the corporate veil, you cannot be sure that your own home state won’t go ahead and apply its own law to the situation, notwithstanding whatever Nevada law states.  My colleague Jeff Vandrew wrote recently about this issue and has some suggestions for alternative asset protection precautions that can be taken using your own home state’s LLC statute.  These precautions are far more likely to accomplish your asset protection goals than simply incorporating in Nevada and hoping that the judge applies Nevada law.

As with Delaware, I don’t think there is much advantage for most businesses to incorporating in Nevada, as opposed to the business owner’s home state.  You will end up incurring double the fees, because you will have to pay Nevada’s fees and then pay your own states fees to obtain authorization for your Nevada entity to do business in your own state.  Despite this additional cost and complication, it is uncertain whether you will see any of the benefits, such as greater asset protection and liability protection, that are often promised in connection with incorporation in Nevada.  As always, your final choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

One question I frequently receive from people seeking to start a new business is whether they should incorporate that new business in Delaware.  They frequently hear vague notions of the benefits of incorporation in Delaware but haven’t heard any definitive statement on why they should or shouldn’t choose Delaware as their state of incorporation.  My advice most times is to incorporate in the home state of their business (usually the company’s headquarters).

The one major significant benefit to being incorporated in Delaware is that Delaware has a highly developed body of corporate law.  The Delaware General Corporation Law is considered to be well-designed and flexible.  In addition, Delaware has established its own court system (called the Court of Chancery), which only hears corporate cases and is considered to be highly sophisticated and efficient.  As a result of the depth of Delaware’s body of corporate law decisions, boards of directors are able to better predict and understand their fiduciary duties to shareholders.  Delaware also has a reputation of being “management friendly” when it comes to disputes between owners and the company’s management, though whether this is actually true is subject to some debate.

Often when I explain these factors to an aspiring entrepreneur, they respond “that’s it?”  Yes, that is it.  There are little to no tangible or financial benefits for a small business to incorporate in Delaware.  It certainly is not a tax haven; it has some of the highest corporate state income taxes in the nation.  Even if it were a tax haven, this would be of little benefit to the company, because the company will still be required to pay the state income taxes of its home state and any other states it operates within.  In addition, incorporating in Delaware is often more expensive for the business.  It will be required to pay annual fees and franchise taxes to Delaware (which get pretty high for corporations) and it will also need to pay annual incorporation fees to its home state in order to qualify to do business in that state.  So in the end, if a business incorporates in Delaware, but operates in another state, it will be more expensive than if it had just incorporated in its home state.  The “management friendly” nature of Delaware corporate law usually is not of significant interest to a small business owner since small businesses rarely have a large division between ownership and control.

Who should incorporate in Delaware?  Certainly large corporations have a good reason to do so.  Since they have a significant division of ownership and control, the predictability of Delaware corporate law is helpful to directors, giving them clear guidance on what their duties to shareholders are.  In addition, hedge fund, private equity, and venture capital fund managers frequently use Delaware limited liability companies and limited partnerships.  They have good reason to do so because of the clear well-developed fiduciary duties of Delaware law.  Like large corporations, hedge funds have a significant separation of ownership and control.

One category of small business that should consider incorporating in Delaware is those businesses that anticipate unusually fast upward trajectories in their growth.  If a business expects to be receiving venture capital funding within the next couple of years, it may be a good idea to opt for a Delaware corporation, because chances are, when the company does receive funding, the VC fund will insist that it convert into a Delaware corporation.  However, if such funding is far off, be aware that it is not that difficult to change a company’s the state of incorporation (compared with the relative complexity of any corporate financing), so a business does not need to incorporate in Delaware because simply because it may at some point in the future seek outside financing.

As always, your final choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

One of the first decisions new business owners face is what type of entity they should use to form their new company. Most likely, this involves a choice between a limited liability company (LLC) or a corporation.  These two types of entities differ significantly in how they are governed.

Corporations

In a corporation, each owner owns shares of stock and is called a shareholder.  Each shareholder’s portion of ownership is measured in how many shares of stock each shareholder has.  The shareholders elect a board of directors, which has the ultimate management control over the company.  Shareholders may also be directors, but there is no requirement that they be.  In some states, the board of directors is permitted to have only one director, while in others, there must be more than one.   All major decisions of the company must be made by the board and approved by a vote.  These decisions are documented as formal resolutions and minutes of meetings of the board must be taken.  Boards delegate day-to-day management of the corporation to officers, who are responsible for carrying out the decisions of the board.  There is no requirement that someone be a shareholder or a director in order for them to be an officer.  Thus all three groups (shareholders, directors, and officers) could theoretically consist of completely different people, although in practice there is usually some degree of overlap.

Corporations are governed by a certificate of incorporation (sometimes also called a charter or articles of incorporation) and a set of bylaws, which set out board election and voting procedures.  In addition, there can be one or more shareholder agreements, which set forth the rights that shareholders have vis-a-vis each other (e.g. transfer restrictions, options, or rights of first refusal).   Usually, corporations are required to hold annual shareholder and/or board meetings, even if there is no significant business to discuss.

The overarching theme of the way corporations are governed is that they are formalistic and structured.  In some situations, this can be beneficial.  In a company with a significant number of owners or people involved in its governance, the corporate structure provides an established template for decision-making processes.  If the company were to be governed more like a partnership, where each owner is actively involved in making decisions and executing them, company governance and decision-making could get chaotic.  The disadvantages of the corporate form is that the formalities involved may be overkill for a small business with just one or a few active owners.

Limited Liability Companies

In an LLC, each owner is called a member.  Each member’s portion of ownership is often measured in percentage interests, although LLCs can emulate corporations by issuing units of ownership, which are similar to shares of stock.  An LLC may be governed directly by the members, similar to the way a partnership is often governed, in which case the members would vote to approve major decisions.  Generally, a member can act on behalf of an LLC and sign and execute contracts.  It is possible for the members to delegate authority to a non-member, but that is rarely done in a member-managed LLC.

LLCs can also elect to be manager-managed.  In this case, the members will have no governance rights over the company but have the power to elect one or more managers, who are given the ultimate decision-making authority over the company.  Some state LLC acts provide for board-managed LLCs, which approximate the governance structure of corporations.  In a board-managed LLC, the members elect a board of governors (sometimes also called directors or managers), which manages the company like a board of directors would manage a corporation. Even in those states that do not have board-managed LLCs, a corporation-like structure can still be approximated be having a group of managers who act as the board of the company.  The managers can delegate day-to-day authority to officers, just as a board would do in a corporation.

LLCs are governed by a certificate of formation (sometimes also called articles of organization) and an operating agreement.  The operating agreement is a comprehensive contract between the members (and sometimes the managers) which covers economic rights (i.e. division of profits, losses, and cash flow), governance issues such as manager election and voting procedures, and rights between the members such as restrictions on transferability.

The overarching theme of the way LLCs are governed is flexibility.  Generally, the parties can organize an LLC however they would like.  They can run it in the structured manner that a corporation is governed, run it informally, or operate some kind of hybrid of the two.  LLCs permit a high degree of creativity in structuring a company.

Some Rules of Thumb

Below are some general rules of thumb of follow in making your decision on whether to form your business as an LLC or a corporation.  Please note that these suggestions only take into account governance issues and there are other issues to consider, such as taxation and asset protection issues.

• For a company with a single owner, an LLC often is the easiest organization to manage. The owner can operate the business largely the same way as he did as a sole proprietor (except he should take care not to commingle assets and make sure all business is done in the name of the company).  No annual meetings are necessary nor are any formal resolutions.

• For a company with a small number of owners who are active in the business, an LLC is also an excellent option.  The small size of the group lends itself well to the informality of the LLC structure. Major decisions will need to be made at member meetings, but there are no requirements for annual meetings.

• For a company with multiple owners but where only one owner makes the decisions, an LLC is once again the best option.  The company would elect to be a manager-managed LLC and the members would either elect their manager or he or she would be appointed in the operating agreement.  This manager could also be a member (called a member-manager or a managing member).  This structure is very similar to a limited partnership, except that the manager would not be liable for the debts of the company like the general partner of a limited partnership would be.

• For a company with a large number of decision-makers or owners, a corporate structure is often best.  Once the number of “cooks in the kitchen” gets large enough, the structured nature of a corporation begins to make sense.  Please note, the owners may want to consider setting up a board-managed LLC or some other LLC structure that imitates a corporation if they desire that the entity to be taxed as a partnership (which a corporation cannot be) or if they want to take advanced of the asset protection benefits of an LLC.

Please note, your choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney and/or accountant.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

In any business with multiple owners, there is a good chance that at some point, one or more of those owners may no longer be affiliated with the company, whether by choice, death, bankruptcy, or divorce.  It’s important for business owners to plan for this in advance, so that when one of these situations occur, there is a preexisting agreement that sets out an orderly way to handle the situation.  The best way to do this is with a buy-sell agreement.  A buy-sell agreement is a contract between business owners that dictates who can buy a departing owner’s share of the business and establishes a fair price for the owner’s stake. The agreement may also provide procedures to resolve disagreements when a majority of the owners but not all of the owners decide to sell the business.  Here are some reasons why you, as an entrepreneur, don’t want to be in business with other people (even family) without a buy-sell agreement in place:

1. You should be able to choose your partners.  When you made the decision to enter into business with your partners, hopefully you thought extensively about it and did some due diligence on them.  It would be unfortunate to have that diligence and thought go to waste, because if you don’t have a buy-sell agreement in place, your partner’s stake in the business can be transferred to third-parties for a variety of reasons: your partner decides to sell, goes bankrupt and is forced to sell, dies, or gets divorced and his spouse ends up with some or all of his shares.  In this event, you will have new partners that you never counted on having, and this may threaten your business’s ability to continue on its current path.

2. If your partner decides he no longer wants to be involved in the business, you have a way of obtaining his stake in the company so that he can’t continue to influence the business after he is no longer involved.  Buy-sell agreements often provide that if an owner-employee were to become no longer employed by the company, that owner-employee must sell his stake back to the company or the other owners.  Also, since buy-sell agreements provide a mechanism for determining a fair price in the departing partner’s stake, he will be unable to extort an unreasonably high sum on his way out.

3. If you want to leave the business and no longer want to own stock in the company, you have a way of fixing the fair price in your stake.  Again, since a buy-sell agreement sets out a method of determining the fair price of the stake of the departing owner, you can eliminate potential lawsuits and disputes by agreeing in advance what is fair.  This can be of benefit to you if you are the one leaving the company.  Be careful though; if the valuation method is not well thought out, you could end up being unable to get a fair price on your stake in the company on your way out.

4. It could reduce your estate tax burden.  The valuation method contained in a buy-sell agreement is set not only for purposes of an eventual sale, but also for estate tax valuation purposes. Privately owned businesses are difficult to value. An owner’s idea of a business’s worth at his death may be much lower than the IRS’s. However, if you have a buy-sell agreement in place, as long as such agreement is a bona fide arms length transaction, you can use the method contained in that agreement as evidence as to how the business should be valued. But if no process for valuing the business has been put into place, the IRS will be free to determine its own value.

5. It lets the partners set expectations as to the transferability of interests in the company.  Even when a partner does not want to leave the company, he still may want to sell part of his stake in the company to partially “cash out” for any number of reasons.  Putting in place a buy-sell agreement can give the remaining partners a right of first refusal or other protections to give them more control over ownership changes in the company.  In the least, the mere process of writing a buy-sell agreement is beneficial because it gives the partners a chance to discuss and decide these issues at a time when there is often a surplus of good will.

6. It can prevent minority shareholders from vetoing a sale of the business.  If a buy-sell agreement contains a drag along clause, then a majority of owners can force the entire business to be sold.  Without this, it is possible that even a 1% owner could hold up an entire deal, possibly to extort the other owners for a greater portion of the sales proceeds.

7. It can protect minority shareholders from being cheated out of the proceeds of a sale of the business.  Along with point 6 above, if a buy-sell agreement contains a tag along clause, then upon the sale of the business, the minority owners will be entitled to the same price per share as the majority owners.  This prevents majority shareholders from conspiring with a buyer of the business and extracting a control premium from the buyer to the detriment of the minority shareholders.

8. The time when someone leaves a company is not the time to be negotiating the fair value of a business. Often partings are awkward and sometimes downright unpleasant.  Emotions may run high, precluding a careful and thoughtful discussion of how to resolve disagreements. Instead, you should set the mechanism for calculating the value while spirits are high.

9. It can protect your family. One of the most likely reasons why you may need to leave your company or transfer your stake is upon your death or disability. At this point, you will not be capable of negotiating on behalf of your family.  Your family will need and deserves to be paid the fair value for your interest.  If there is no buy-sell agreement in place, the surviving owners may be reluctant to pay a fair amount for your stake and are likely to at least negotiate against your family members.  A buy-sell agreement provides a pre-agreed method of making sure the work you put into your business takes care of the people you care about most.

Buy-sell agreements are a crucial part of business planning for any venture which is owned by multiple parties.  They can be used for corporations, limited liability companies, and partnerships.  Drafting one should not be put off, because if you don’t put one in place at the outset, you are unlikely to do so until issues arise.  You should consult an attorney with experience in business and corporate matters for more information.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

After my recent post regarding exemption from investment adviser registration of venture capital funds and small hedge funds, I had a number of people ask me about the status of real estate funds under the new regime.  Do the managers of real estate investment funds and partnerships need to register as investment advisers either under the pre or post-Dodd-Frank regime?  The answer has always been somewhat ambiguous, but in my view, if the fund is a true real estate fund (i.e. it buys only real estate rather than interests in companies that own real estate), then its manager does not have to register. The Dodd-Frank Act did not change this analysis.

The definition of an “investment adviser” under the Investment Advisers Act is “any person who, for compensation, engages in the business of advising others… as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.”  The key word in that definition is the last one.  If a fund does not invest in securities, then its manager or adviser is not acting as an investment adviser, which means that its activity falls completely outside the scope of the Investment Advisers Act.

So when is real estate a security and when is it not?  The definition of the word “security” is complex, encompassing extensive statutory definitions and a long line of case-law.  If you are interested in the legal reasoning behind what real estate assets are and aren’t securities, Doug Cornelius, a fellow legal blogger, has posted a great discussion of it here, so I won’t reinvent the wheel by repeating it.  However, I will provide some practical guidelines to use in analyzing your own situation.

Here are how I believe each real estate asset type would be classified:

• Direct Real Estate Ownership.  A direct fee simple interest in real estate would not generally be considered a security.  However, a TIC (tenant in common) interest in real estate may or may not be a security depending on the degree of control the fund maintained.  If the fund has control or is active in the management of the real estate, it will likely not be a security, but if the fund is a passive owner, it likely will be considered a security.
• Stock.  Stock in a corporation that owns real estate would always be considered a security. There may be an exception if the corporation is a wholly owned subsidiary of the fund, but it would not be a good idea to test this, since courts have come pretty close to ruling that stock is always a security.
• Partnership and LLC Interests.  A limited partnership interest in a partnership that owns real estate or a non-managing member interest in a limited liability company that owns real estate is likely to be a security.  A general partnership interest in a partnership or a managing member (or a member of a member-managed LLC) generally is not a security.  Fee simple real estate owned by a wholly owned LLC subsidiary of the fund would likewise not be a security.
• Joint Ventures.  With joint ventures, the situation depends on the degree of active participation.  Similar to the discussion above, re: partnerships and LLCs, if the fund is an active participant, generally its interest is not a security, but if the fund is passive, then the interest could be deemed to be a security.
• Commercial Mortgage Loans.  Common sense would say that commercial mortgage loans would not be a security, because if they were, every borrower would also be an issuer of securities.  This is obviously not the case.  However, securities laws provide that any “note” is presumptively a security unless the context would indicate otherwise.  Therefore, a fund that owns a portfolio of commercial mortgages that it purchased from a non-affiliated originator would likely be considered to be holding a securities portfolio.  However, if the fund were to instead make direct commercial mortgage loans to borrowers, then the context would likely dictate that the loan is not a security.

As you can see, determining whether a specific asset is a security can be complex.  In addition, it may often be the case that a fund’s assets may consist mainly of real estate but the fund also owns a smaller amount of its assets in other categories such as limited partnership interests.  The Investment Company Act (a separate statute from the Advisers Act) generally provides that a company will be considered an investment company (i.e. a portfolio of securities), if the securities owned by that company has a value exceeding 40 percent of the value of the company’s total assets.  Arguably, if a fund is not considered to be a securities portfolio, then its manager would also not be considered to be an investment adviser.  This line of reasoning has yet to be tested by the SEC or the courts.

Given the very fact specific nature of these issues, you should consult a qualified attorney in making the decision of whether to register as an investment adviser.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.