Avoiding Securities Law Liability Exposure When Authoring A Business Plan


When authoring a new venture’s business plan, transaction startup, management control system, or capitalization structure, the business consultant needs to be cognizant of federal and state securities laws considerations. It is important not to discount the study of whether federal or state securities laws apply to each and every venture participant. Securities laws may protect one investor in the same venture where others are not so protected.

The freelance websites are awash in people seeking business plans for one venture or another.[1] Most are compiling a business plan on a shoestring budget for the purpose of raising funds for the venture of their dreams. Unfortunately, awareness of whether envisioned transactions involve the issuance of securities for federal or state purposes is very low.

When things don’t turn out as planned, securities law problems can emerge. While federal laws usually require scienter as an element of a claim, some state laws impose strict liability. Such transaction causation can lead to rescissory relief at a minimum. In some cases, material misrepresentation or omission shifts the loss causation burden to the defendant as an affirmative defense. As a result, the business consultant needs to exercise reasonable care when undertaking any business plan or financial forecasting engagement where the end product will be used to solicit venture funding.

Savvy practitioners also know section 469 passive activity loss limitations coalesce with transactions afforded securities law protection. On the other hand, the same set of experienced accountants, attorneys, and business advisers understand structuring a business venture to avoid protection of federal and state securities laws goes hand in hand with active income and loss recognition. The dichotomy is an important one.

As a non-attorney business consultant, as many of you are, I strive to recognize when transactions involve the issuance of securities and when they do not. If I discern federal or state securities laws may apply to one or more investors, I preempt the business plan engagement and refer the client to a securities attorney. In the worst case, your preparation of a business plan can be deemed the unlawful practice of law involving the preparation of a substantive private offering memorandum. As a result, your errors and omissions insurance may not protect you.

In preparing business plans, we should assist our clients in formulating business ventures to avoid application of federal and state securities laws. In doing so, we are also taking a step toward protecting the client’s active trade or business status for income tax planning purposes. With this important distinction in mind, let’s review some securities law basics.

First, recognize SEC v. W. J. Howey Co., 328 U.S. 293 (1946), is still good law in determining when an investment interest amounts to an investment contract. Howey holds an investment contract involves 1) an investment of money, 2) in a common enterprise, and 3) where profits are derived solely by the efforts of others. Some courts do not strictly enforce the “solely” criterion. Rather, relying on a substance over form doctrine, courts now view minimal investor managerial participation as substantively invoking Howey’s third criterion. As a result, an investor’s managerial participation must materially and significantly contribute to either the venture’s revenue maximization or cost minimization functions to be regarded as active in the trade or business for securities law purposes.

Courts have also concluded limited liability company interests may amount to an investment contract inasmuch as, generally speaking, neither federal or state laws define such membership interests as securities. It is recognized that a limited liability company has some characteristics of a general partnership while also being endowed with characteristics like a corporation. The more the LLC’s characteristics are similar to a general partnership the more likely it is such interests will be concluded as not invoking the protection of federal or state securities laws.

The converse is true as well. The more a limited liability company’s characteristics are akin to a corporation the more likely it is such membership interests will be concluded to be protected by federal or state securities laws. Other factors are considered by the courts as well when distinguishing when partnerships and limited liability company interests may invoke securities law protection.

Limited partnership interests are usually endowed with a conclusive presumption they involve the issuance of securities. General partnership interests are usually endowed with a rebuttable presumption that they do not involve the issuance of securities. However, general partnership interests may be so restricted in right, power, and authority they are substantive limited partnership interests afforded securities law protection.

Manager-managed limited liability companies are usually endowed with a rebuttable presumption they involve the issuance of securities. Member-managed limited liability companies are usually endowed with a rebuttable presumption that they do not involve the issuance of securities. Again, if a member-managed limited liability company interest is so restricted as to invest substantive management in other member-managers then securities law protection will be afforded the restricted member-manager.

A general partnership or limited liability company interest can be designated a security if the investor can establish—

• An agreement among the parties leaves so little power in the hands of the investor that the arrangement in fact distributes power as would a limited partnership;
• The investor is so inexperienced and unknowledgeable in business affairs that he or she is incapable of intelligently exercising his or her venture powers; or
• The investor is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he or she cannot replace the manager of the enterprise or otherwise exercise meaningful venture powers.

The critical difference between LLCs and general partnerships is that the general partners’ personal liability necessarily gives the partner an incentive to be highly informed about the business. At the same time, personal liability discourages involvement by unsophisticated investors. Usually general partners and joint venturers have enough control over their business entities that the third prong of the Howey test does not apply to them. It follows, then, LLCs may have greater securities law exposure than general partnerships.

A member-managed limited liability company interest may involve a large number of geographically dispersed investors where substantial dilution of limited liability company management prevents members from exercising effective control over venture revenue and cost processes. That is, when the number of investment units sold so dilute individual member-manager power it creates an appearance none could exercise any meaningful venture control. Securities law protection may inure to investors not exercising meaningful control over venture revenue and cost processes while such protection is not afforded to substantive managers in the same venture.

Investors must have meaningful operational knowledge of the specific venture. An investor’s knowledge of the business revenue and cost processes provides one of the most reliable indicators of an investor’s ability to exercise control over the investment. When the investor does not possess specialized operating knowledge of the business, he or she is far more likely to expect profits based on the efforts of the promoter, manager, or others.

As consultants we must be vigilant when securities laws apply and when they do not. Some state securities laws carry strict liability. As a result, authorizing a business plan, including the formulation of financial forecasts, may engender unsuspecting exposures for the client and consultant alike.

One tool the consultant may use to manage exposure to securities law liabilities is to require the client to warrant and represent certain facts that lead to an inescapable conclusion the venture is not afforded federal or state securities law protection. I recommend you make it a part of the business plan document itself. A sample version of such a document I use when formulating a business plan follows.

 Sample Business Plan Principal Representations and Warranties

NEWCO LLC, Principal-A, Principal-B, and Principal-C hereby warrant and represent to Consultant the following material and significant business venture characteristics, to wit:

1. NEWCO LLC is a member-managed limited liability company and is not a manager-managed limited liability company.

2. The member-managers of NEWCO LLC, including Principal-A, Principal-B, and Principal-C have been each assigned managerial responsibilities and duties material and significant to fulfilling NEWCO LLC’s profit objectives and such responsibilities and duties in the case of each of the foregoing individuals exceed those an investor would perform including, but not limited to, studying and reviewing financial statements, compiling financial analyses for the individual’s own use, and monitoring finances or operations in a non-managerial capacity.

3. The NEWCO LLC member-managers have elected the limited liability company form of organization to protect their respective members from unknown exogenous catastrophic loss events as would the corporate form of organization but recognize the willingness of the limited liability company members-managers, including Principal-A, Principal-B, and Principal-C to personally guarantee the foregoing limited liability company commercial financing arrangements is more typical of general partnership arrangements.

4. NEWCO LLC, Principal-A, Principal-B, and Principal-C acknowledge NEWCO LLC will be treated as a general partnership for federal and state income tax purposes and, as such, will be required to file federal and state returns of partnership income.

5. Principal-A, Principal-B, and Principal-C acknowledge not all material and significant NEWCO LLC strategic and operating business decisions are vested in any one limited liability company member-manager but that certain material and significant strategic and operating business decisions require more than 51% of the limited liability company members to be an approved limited liability company course of business conduct.

6. Principal-A, Principal-B, and Principal-C acknowledge, represent, and warrant necessary and sufficient management controls have been or will be implemented to allocate unique or sophisticated product or service attributes to those experienced business managers who will manage in an effort to fulfill NEWCO LLC’s operational profit objectives.

[1]The freelance websites, such as Elance, O-Desk, Thumbtack, and Freelancer, should recognize the contingent liaiblity exposure incurred when their venues are used to promote the sale of unregistered securities. Attorneys looking for deeper pockets when matters don’t turn out well may sue the more well-heeled website promoter as an inextricable and necessary participant in the unlawful sale of unregistered securities.

*David Randall Jenkins, Ph.D., received his doctorate in accounting and a master’s in accounting with an emphasis in tax from the University of Arizona. He has taught financial, managerial, and tax accounting courses at both the graduate and undergraduate levels. Dr. Jenkins is an AACSB academically qualified business school and tax professor owing to his peer reviewed journal article publications. His company, Algorithm LLC (, is an IRS Approved Continuing Education Provider. Dr. Jenkins may be contacted at

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One comment

  1. Kat Jennings says:

    Excellent! Thank you sincerely for an extraordinarily blog post on Securities Law and Business Plans.Looking forward to reading more of your posts on TaxConnections Worldwide Tax Blogs.

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