What is a Security? Even the SEC Can’t Always Tell
On February 27, 2015, an Administrative Law Judge (ALJ) determined that, contrary to claims by the SEC, interests in an LLC that invested in conservation easements as a tax deduction mechanism were not “securities” within the meaning of the Securities Act of 1933.
Paul Edward “Ed” Lloyd, Jr. is a CPA and, at the time in question, was also a registered representative of LPL Financial, LLC, a broker-dealer and investment adviser. Lloyd established LLCs and sold interests in those LLCs to tax planning clients – four of whom were also investment advisory clients of LPL Financial. The LLCs formed by Lloyd were used to bundle the investor funds, then the funds were invested in a second set of LLCs, whose promoters had identified real estate that was suitable for the creation and donation of conservation easements. When the conservation easements were donated to an eligible conservation organization by the land-investment LLCs, a tax deduction was generated and passed through to the individual owners.
The SEC instituted proceedings in September 2014 alleging that Lloyd’s clients agreed to purchase $632,500 in LLC interests, but only $502,500 of that money was actually invested; the rest was misappropriated by Lloyd. Notably, the SEC chose to pursue the action through an administrative proceeding rather than through federal court — a tactic that arguably gives the SEC a significant “home court” advantage. The SEC claimed Lloyd violated numerous fraud-related provisions of the securities laws, including Section 17(a) of the Securities Act, Sections 10(b) and 15(a) of the Exchange Act, Rule 10b-5 under the Exchange Act, Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940, and Rule 206(4)-8 under the Advisers Act. Many of these claims require that the LLC interests be treated as “securities” within the meaning of the Securities Act.
Under Section 2(a)(1) of the Securities Act, one of the categories of “securities” is “investment contracts.” The 1946 case of SEC v. W.J. Howey Co. established the classic test (known now as the Howey test) for determining whether an instrument is an investment contract. The Howey test requires that there be 1) an investment of money, 2) in a common enterprise, 3) with the expectation of profits, 4) solely from the efforts of a promoter or third party.
Lloyd’s lawyers have contested the SEC’s jurisdiction from the outset, claiming that the LLC interests did not meet the Howey test because the availability of a tax deduction is not the equivalent of the expectation of a profit. The SEC, of course, disagreed. An October 1, 2014 article from the Charlotte Observer quotes Bill Hicks, the SEC’s associate regional director in Atlanta: “I think at the end of the day the facts will establish it as a security.”
The ALJ sided with Lloyd, finding that prongs 3 and 4 of the Howey test were not met by the LLC interests. Those portions of the SEC’s claims alleging violations of the Securities Act, the Exchange Act, Rule 10b-5, and Advisers Act Rule 206(4)-8 were dismissed. However, the portions of the SEC’s proceeding against Lloyd relating to alleged violations of Sections 206(1), 206(2), and 206(4) of the Advisers Act (which do not require a sale of securities) will proceed.
Lloyd isn’t out of the woods yet and may ultimately be found to have violated the securities laws, but for now the SEC is left with the indignity of being corrected by an ALJ regarding a fundamental question under the Securities Act.
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