to defraud; (b) made untrue statements of material facts and/or omitted
to state material facts; and (c) engaged in acts, practices and a course
of business that operated as a fraud or deceit upon him in connection
with the Agreement. See Cplt. ¶¶ 132, 138, 143. In order to satisfy
the jurisdictional requirement of the Exchange Act, however, the wrongful
activity alleged in the Complaint must be "in connection with the
purchase or the sale of any security." 17 C.F.R. § 240.10b-5.
Indeed, the main issue arising from the pleadings is whether the Pace
interests and the Weyand Eagle interests are "securities" under federal
securities law. If they are "securities," a second question arises as to
whether Plaintiff Keith, a beneficiary of the Hanover Trust, the legal
"buyer" of the Pace and Weyand Eagle interests, has standing to sue under
Rule 10b-5. To the extent Keith's Complaint raises these questions, it is
neither "plainly insubstantial" nor does it fail to present any issue
worthy of adjudication. See Giulini, 654 F.2d at 192.
Dismissal under Rule 12(b)(1) is inappropriate. However, the next
question is whether the Complaint states a claim under the Rule 12(b)(6)
1. The "Securities" Requirement
(a) Counts 14 and 15: Keith's membership interests in Pace
Keith's interests in Pace are membership interests in a New York LLC.
See Agreement at Exhibit A. LLC membership interests are not "securities"
unless they meet the four criteria of an "investment contract" set forth
in Securities and Exchange Commission v. W.J. Howey Co., 328 U.S. 293, 66
S.Ct. 1100, 90 L.Ed. 1244 (1946). The Howey test defines "an investment
contract [as] a contract, transaction or scheme whereby 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 Id. at 298-99, 66 S.Ct.
1100. Howey requires (1) that a purchaser give up some tangible and
definable consideration in return for the interest obtained; (2) the
existence of either common interests between the investor and managers of
the enterprise or a pooling of interests by members; (3) an expectation
of profit by the investor; and (4) that the expectation of profit be
derived from the entrepreneurial efforts of others. The Supreme Court has
further asserted that in defining the term "security," "form should be
disregarded for substance and the emphasis should be on economic
reality." See Howey, 328 U.S. at 298-99, 66 S.Ct. 1100; see also Reves
v. Ernst & Young, 494 U.S. 56, 61, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990);
United Hous. Found., Inc. v. Forman, 421 U.S. 837, 848, 95 S.Ct. 2051, 44
L.Ed.2d 621 (1975); Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct.
548, 19 L.Ed.2d 564 (1967).
On the face of his Complaint, Keith meets the first three prongs of the
Howey test: (1) the transfer of his Eagle interests constitutes tangible
and definable consideration for the purchase of his Pace membership
interests; (2) a commonality of interest with Milton and Black Diamond
exists, because each has pooled his interests — Milton and Keith
through their Eagle shares, Black Diamond in the form of cash and
promises of "sweat equity" — to create Pace; and (3) it is presumed
that Keith entered into the deal with the intention of making a profit.
The critical inquiry here involves the fourth prong of Howey —
whether Keith invested in Pace with the intention of deriving profit from
the managerial or entrepreneurial efforts of others. It is clear from
Keith's allegations that he intended to maintain some degree of control
in Pace. In particular, Keith acquired an interest in Pace pursuant to
Black Diamond's representations that he would oversee the marketing
operations of the new company and that his interests in Pace would never
be unfairly diluted. Cplt. at ¶¶ 16-18. Furthermore the Agreement
created a "member-managed"
LLC, which, under New York law, is controlled by its members.*fn2 See
New York Limited Liability Company Law ("NY LLC Law") § 401 (McKinney
Under the Agreement and N.Y. LLC Law, Pace members (including Keith)
are endowed with a broad range of rights and powers. Compare Agreement
and N Y LLC Law. In particular, the N.Y. LLC Law grants Keith (a) the
right to manage Pace, along with the other members, see N Y LLC Law
§ 401; Agreement § 5.1.1; (b) the right to vote in proportion to
his holdings, see N.Y. LLC Law § 402; (c) protection from other
members acting individually on behalf of Pace, see Agreement §
5.1.2; (d) protection from calls for additional capital without approval
of two-thirds of the membership interests, see Agreement § 3.2.1; (e)
the right to participate in a detailed cash flow distribution structure,
see Agreement § 4.1.1; and (f) the right to call meetings of Pace
members.*fn4 This level of control is antithetical to the notion of
member passivity required under the fourth prong of Howey.
Keith argues, however, that under an "economic realities" inquiry, this
type of functional analysis merely emphasizes "form" where the focus
should be on the "economic reality." See Howey, 328 U.S. at 298-99, 66
S.Ct. 1100. In Keith's view, the Agreement and the statute should not
trump the economic reality of Keith's involvement with Pace. Keith claims
that the Agreement "was set up to appear as if Black Diamond did not
fully obtain its interest until approximately $30 million was paid out to
Milton and Keith in preference distributions . . . [while], in fact,
[giving] Black Diamond 50% of Pace." Cplt. at ¶ 19. Further, Keith
alleges that Pace stripped him of oversight of marketing, Cplt. at
¶ 22; manipulated him into assigning his option to purchase the
Dysons' Eagle interests to Pace, Cplt. at ¶ 23; took steps to dilute
his interests through a capital call in which it knew he would be
financially unable to participate, Cplt. at ¶¶ 38-43; installed its
newly controlling slate of directors, Cplt. at ¶ 44; and cut off his
salary. Id. On the basis of these allegations, Keith argues that his
investment in Pace resulted in so little control, notwithstanding the
statute and the Agreement, that he deserves to be protected by the
In Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981), the court
recognized that although general partnership interests, in contrast to
limited partnership interests, are ordinarily not securities because of
the level of managerial control exercised by a general partner, in some
limited circumstances a general partnership interest may be a "security."
By analogy, an LLC membership interests may be considered a security if
the Plaintiff can "demonstrate that, in spite of the partnership form
the investment took, [the investor was] so dependent on the promoter or
on a third party that [he was] in fact unable to exercise meaningful
partnership powers." Id. at 424; see also Holden v. Hagopian, 978 F.2d 1115,
1119 (9th Cir. 1992) ("in determining whether interests are investment
contracts, we focus on the economic realities of the underlying
transaction and not on the name it carries"). However, following the
Supreme Court's "repeated directions to consider investment schemes in
light of their economic realities," this Circuit has found that a scheme
that was primarily "a means whereby participants could pool their own
activities, their money and the promoter's contribution in a meaningful
way" was not an investment contract. SEC v. Aqua-Sonic Products Corp.,
687 F.2d 577, 582 (2d Cir. 1982). Indeed, if an investment scheme gives
rise to a "reasonable expectation . . . of significant investor control,
a reasonable purchaser could be expected to make his own investigation of
the new business he planned to undertake and the protection of the
[Exchange Act] would be unnecessary." Id. at 585.
Furthermore, "the mere choice by a partner to remain passive is not
sufficient to create a security interest." Rivanna Trawlers Unlimited v.
Thompson Trawlers, Inc., 840 F.2d 236, 240-41 (4th Cir. 1988). To make
this determination, the Rivanna court found that the critical inquiry is
"whether the powers possessed by the [LLC members] under the [operating
agreement] were so significant that, regardless of the degree to which
such powers were exercised, the investments could not have been premised
on a reasonable expectation of profits to be derived from the management
efforts of others." Id. at 241 (quoting Tucker, 645 F.2d at 419).
In Hirsch v. duPont, 396 F. Supp. 1214 (S.D.N.Y. 1975), a pre-Rivanna
case, this court found that the determination whether a partnership
interest was a security ""does not and should not hinge on the particular
degree of responsibility [a partner] assumes within the firm, '" nor does
the delegation of membership responsibilities, or the failure to exercise
membership powers, "diminish the investor's legal right to a voice in
partnership [or company] matters." Id. at 1220 (quoting New York Stock
Exchange Inc. v. Sloan, 394 F. Supp. 1303, 1314 (S.D.N.Y. 1975)).
Therefore, if at the time of his investment in Pace, Keith did not intend
to be a passive investor, as he clearly did not, the Pace interests could
not be securities. Furthermore, although the degree of control he
actually exercised was less than he expected to exercise, that fact does
not convert his interests into securities.
(b) Count 16: Keith's interests in Eagle acquired from the Weyand
Keith also seeks relief under federal securities laws for the
transaction involving his acquisition of Weyand's Eagle interests.
Defendants argue that because the Eagle interests Keith acquired from
Weyand were shares in a company that Keith founded, promoted, and
participated in as manager, and from which he once drew a salary, he
exercised a degree of control over Eagle inconsistent with an allegation
that he was relying on the entrepreneurial efforts of others to create or
enhance the interests' value. See Howey, 328 U.S. at 298-99, 66 S.Ct.
1100. Defendants further rely on a Supreme Court decision holding that in
order to be a security an "unusual instrument" must be offered to
multiple potential investors, while a private transaction, negotiated
face-to-face between two parties, is not likely to be a security,
particularly if the acquirer retained some degree of management control.
Marine Bank v. Weaver, 455 U.S. 551, 559-60, 102 S.Ct. 1220, 71 L.Ed.2d
Here, Keith's acquisition of the Weyand Eagle interests involved an
"unusual instrument" — the bundled Eagle, Ltd. and Eagle Corp.
interests — and resulted from a negotiated settlement between Keith
and Weyand. The Weyand Eagle interests were not designed to be traded on
a public market, nor were they widely traded. While these interests might
one day be
sold on an impersonal, public market, and thus might warrant giving those
persons who trade in the interest the protection of the securities laws,
this is not yet the case. When Keith acquired the Weyand Eagle
interests, be retained a measure of control over both Eagle and Pace, and
therefore was not a passive investor in them. In short, the Weyand Eagle
interests are not securities as a matter of law.
Finally, since neither the Pace interests nor the Eagle interests are
securities, it is unnecessary to address the question of whether Keith is
a buyer or seller under sections 10(b) and 29(b) of the Exchange Act.*fn5
C. Supplemental Jurisdiction for State Law Claims
For the reasons set forth above, Keith's securities fraud claims are
dismissed for lack of subject matter jurisdiction. Because Keith has no
other ground for federal jurisdiction, I decline to exercise supplemental
jurisdiction over his state law claims. See United Mine Workers of
America v. Gibbs, 383 U.S. 715, 726, 86 S.Ct. 1130, 16 L.Ed.2d 218
(1966); In re Merrill Lynch Ltd. Partnerships Litigation, 154 F.3d 56, 61
(2d Cir. 1998). The clerk is directed to close this case.