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San Diego Corporate Law: 5% Interest in Restaurant Not a “Security”

As we have written here at San Diego Corporate Law, if you are selling and/or offering “securities” in California, you must comply with both federal and California securities laws — the Corporate Securities Law of 1968 (Corp. Code, §§ 25000-25707) and the federal Securities Act of 1933 (15 U.S.C. § 77b). In general, unless an exception applies, compliance is accomplished by registering and otherwise providing the disclosures required under the various laws.

One of the more complicated aspects of securities law is the definition of “security.” A recent case involving a San Diego construction company and a San Diego restaurant gives us an example of what is NOT a “security” — an offered 5% interest in the San Diego LLC that owned the restaurant. See D.R. Mason Construction Co., v. GBOD, LLC, Case No. 17-cv-01779-BAS-WVG (US Dist. S.D. Cal. March 13, 2018). If you are offering or selling or promoting any sort of corporate, LLC, or financial investment, you need the advice and legal counsel of a good San Diego corporate lawyer.

San Diego Corporate Law: What is a “Security?”

In general, under both California statute and federal law, a “security” is stock in a corporation or an investment contract where the investor is making a passive investment, where money is at risk, with the expectation of profit from the efforts of others. See Corp. Code, § 25019. This is the gist of the so-called Howey test articulated by the US Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). With respect to “investment contracts,” there are two additional requirements – that the investment vehicle be offered to more than one person and that there is an expectation of saleability of the investment vehicle. See Marine Bank v. Weaver, 455 U.S. 551 (1982). In general, California state courts follow the definitions used by the US Supreme Court and the other federal courts.

San Diego Corporate Law: Facts of D.R. Mason Construction

The pertinent facts of D.R. Mason Construction are these: The plaintiff, D.R. Mason Construction Co., is a San Diego construction company. D.R. Mason was hired to perform construction work at Meze, a Greek-fusion restaurant in downtown San Diego owned by GBOD, LLC. Construction work began work in November 2014, and D.R. Mason received $40,000 in payments. However, it seems that GBOD, LLC ran out of money, but still needed the work to be completed. Thus, according to the pleadings, GBOD offered — and D.R. Mason agreed — that the work would continue and, in exchange, D.R. Mason would receive a 5% ownership interest in the restaurant. The construction work was completed by New Year’s Eve 2014. The balance due going forward into 2015 was $69,625. Over the next several months, D.R. Mason was supposed to have received “dividend payments” as a 5% shareholder of Meze to cover its outstanding invoices. However, no payments were made.

D.R. Mason sued claiming, among other things, that GBOD, LLC had offered “securities” in violation of federal securities law. However, the US federal court rejected the securities claims.

San Diego Corporate Law: 5% Interest in Restaurant Not “Stock” and Not an “Investment Contract”

In concluding that no “security” was involved, the court discussed two possibilities – that the 5% interest in the restaurant was “stock” and the possibility that the 5% interest was an “investment contract.” With respect to the first possibility, the court noted that GBOD was a limited liability company, not a corporation. The court further noted that, under California law, LLCs distribute “membership interests” not “shares of stock.” As such, the legal tests for whether “traditional stock” is a “security” was not applicable to the case. The court noted that, in general, membership interests in LLCs are evaluated under the test for “investment contracts,” not “stocks.”

With respect to whether the 5% GBOD LLC membership interest was an “investment contract,” the court concluded that it was not. The court noted that D.R. Mason failed to allege that it was a passive investor — Howey prong #3 — or that this “investment contract” was offered to other investors. Indeed, D.R. Mason provided no information on what role it was to have in the management of the restaurant based on it owning a 5% interest. The court could have also noted that there was no information provided on the saleability of the “investment” held by D.R. Mason.

Contact San Diego Corporate Law

As can be seen, offering stock and shares in a corporation or offering membership interests in an LLC can have serious legal implications. You should seek the guidance of a skilled and experienced corporate attorney like Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard provides legal services related to private securities offerings/sales, the sale/purchase of businesses and with respect to mergers and acquisitions. Contact Mr. Leonard by email or by calling (858) 483-9200.

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