Can a Software Agreement be a Security Under Oregon Law?

The situation is confusing because the "buyer/investor" is the seller of the software. (XYZ in our hypothetical) The seller/promoter is the buyer of the software. (ABC in our hypothetical) This reversal of traditional roles occurs because the software buyer is offering the royalty agreement in exchange for the software and it is the issuance of the royalty and not the sale of the software, which creates the security.

A security claim gives the selling company a claim which is easier to prove than common law fraud because its reliance on the misrepresentation of the other party does not have to be proven and the materiality standard for such representations is easier to satisfy.

Hence, the company giving the royalty in exchange for the purchase of the software must be concerned not only with the usual contract issues, but also must satisfy the disclosure requirements of the securities laws and avoid any material omissions. (This duty in turn may cause the attorney for the purchaser of the software to conduct a "due-diligence" investigation of his or her client in order to determine what facts a reasonable person would consider important to be disclosed in the subject transaction.)

The central securities concept is that a company, which sells its software in exchange for royalty payments over time, is similar to an investor who gives a promoter money and expects a return on his money through the efforts of an issuer.

1. General Securities Rules. Oregon securities law generally requires that all sales of securities comply with the following: (a) the securities transaction must be registered unless exempt; ORS 59.055 (b) the person effecting the sale must be licensed unless excluded; ORS 59.165 and (c) no material misrepresentation or omission can occur; ORS 59.1154 (b).
   1. Registration. There are basically two categories of registration exemptions available in Oregon: exempt securities (ORS 59.025) and exempt transactions (ORS 59.035). The first category examines the instrument itself, e.g., a government savings bond is exempt. The second category focuses on the sales aspects of the transaction, regardless of the security, e.g., sales to a limited number of purchasers, wealthy individuals and institutions may be exempt. Also, certain security-type instruments used to protect creditors have been excluded from coverage by the Oregon securities laws.

      The royalty granted in our hypothetical does not fit into the categories of exempt securities contained in ORS 59.025. Therefore, we must look to ORS 59.035 to see if the transaction itself is exempt from registration.

      The most promising exemptions in ORS 59.035 for our hypothetical transaction include the exemption from registration of the sale of a security to ". . . a bank, a savings institution, trust company, insurance company, investment company, pension or profit sharing trust or other financial institutions or institutional buyer...broker dealer, mortgage broker or mortgage banker," ORS 59.035(4); the exemption for sales to accredited investors where there is no public advertising or solicitation, ORS 59.035(5). (The term "accredited investor" includes entities with assets in excess of $5,000,000, natural persons with net worths in excess of $1,000,000 and certain other persons. See OAR 815-30-042); and the exemption for sales of securities to not more than 10 purchasers within the state of Oregon during any 12 month consecutive period, ORS 59.035(12) (No commissions, advertisements, or public solicitation are allowed). Also, the exemption offered by ORS 59.035(12) cannot be used if a finder's fee or closing transaction fee is paid.

      Since ABC does not appear to be one of the entities in ORS 59.035(4), we need to look at ORS 59.035(5) and (12). IF ABC has over $5,000,000 in assets, the exemption offered by ORS 59.035(5) would apply, however, even if it did not, ORS 59.035(12) appears to apply to the given facts because there was no public solicitation or payment of commissions and there are fewer than 10 buyers.

   2. Licensing Persons Effecting Securities Transactions. Licensing the companies' representatives by the state of Oregon should not be a problem in our hypothetical. Persons representing the issuer (directors, officers, and employees) are generally exempt from the requirement that they be licensed to sell securities in sales involving both exempt securities and exempt transactions. See generally, ORS 59.015(1) and ORS 59.015(15). However, if someone receives an outside sales fee for an exempt transaction, he or she generally must be licensed. Therefore, outside persons assisting in sales must be properly licensed with the Director of the Department of Insurance and Finance if they are paid fees for finding the buyer.

   3. No Material Misrepresentation or Omission May Occur - Full Disclosure
      1. Common Law Fraud. The legal requirements for securities fraud are considerably easier to establish than those under common law fraud. The following are the nine elements of common law fraud required under Oregon law:
         1. A representation;
         2. Its falsity;
         3. Its materiality
         4. The speaker's knowledge of its falsity or ignorance of its truth
         5. The speaker's intent that it should be acted on by the person and in the manner reasonably contemplated;
         6. The hearer's ignorance of its falsity;
         7. The hearer's reliance on its truth;
         8. The hearer's right to rely thereon; and
         9. The consequent and proximate injury.

1. Securities Fraud. In contrast to requirements of proving common law fraud, under Oregon securities law any person who sells a security is liable to a purchaser of a security if the person sells by means of an untrue statement of a material fact or omits to state a material fact necessary to make the statements made, in light of the circumstances under which made, not misleading. (The buyer must not know the untruth of such statement or of the omission of material facts at the time of the sale.) An affirmative defense of lack of knowledge is available to the maker of the statement, if such person sustains the burden of proving that such person did not know and in the exercise of reasonable care could not have known of the subject untruth or omission. See ORS 59.015.

In Everest, the court found that a fact is material if there is substantial likelihood that a reasonable [person] would consider it important. See also Myers v. E. M. Adams and Co., 268 Or 91, 102, 511 P2d 841, 519 P2d 375 (1974).

1. Attorney Liability.
   1. Oregon Law. Once a sale of a security is established, an attorney may be liable as a non-seller who materially aids in the unlawful sale of securities under ORS 59.115(3). A drafter's knowledge, judgment and assertions reflected in the context of sales documents are "material" to a security sale for the purposes of liability for a sale of an unregistered security. Prince v. Byrdon, 303 Or 146, 764 P2d 1370 (1988). Whether one's assistance with an unlawful sale of a security is "material" does not depend on one's knowledge of the facts that make it unlawful; it depends on the importance of the contribution to the transaction. Id.

      In Prince, the court found that an attorney for an Idaho partnership that sold unregistered limited partnership units in Oregon "materially" aided the sale of unregistered units, where the attorney drafted the limited partnership agreement and major portions of the partnership's offering circular and gave an opinion on the partnership's tax status which was included in the information provided to prospective investors. The court found that the attorney could be held liable to the buyers under ORS 59.115 unless he could prove the affirmative defense of lack of knowledge. However, mere lack of knowledge is not enough to establish such defense. The showing by the non-seller must not be only that he did not know, but also that he could not have known by exercising reasonable care, the existence of facts that made the sale of securities unlawful. Id.

   2. Federal Securities Law. Under the federal securities laws, attorneys may be found liable under Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act"). Such liability is based upon a material misrepresentation or wrongful failure to disclose material facts in connection with the purchase or the sale of a security or that the attorney engaged in a manipulative practice with an intention to mislead investors by artificially affecting the market activity and that the attorney knew or should have known of the fraud. Ernest v. Hochfelder, 425 US 185 (1976).

Depending upon the attorney's role in the transaction, liability may also appear under Section 12 of the Securities Act of 1933 ("1933 Act"). The attorney would have to have played a substantial role in the process leading to the sales transaction at issue. Ahern v. Gaussoin, 611 F Supp 1465, 1485 (D Or 1985). Merely preparing offering materials is normally not enough to incur liability under this section of the 1933 Act.

1. Definition of a Security.

   Oregon securities law defines a security as follows:

   "Security" means a note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in a pension plan or profit-sharing agreement, collateral-trust certificate, reorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, certificate of interest or participation in and oil, gas, or mining title or lease or in payments out of production under such title or lease, real estate paper sold by a broker-dealer, mortgage broker or a person described in paragraph (b) of subsection (1) of this section to persons other than persons enumerated in ORS 59.035(4), or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificates for, receipt for, guarantee of, or warrant or right to subscribe to or purchase any of the foregoing." [Emphasis supplied]. ORS 59.015(17)(a).

   Hence, investment contracts are securities under Oregon laws.

2. Definition of an Investment Contract.
   1. Elements of an Investment Contract. Oregon requires four elements to be present in the creation of an investment contract under its securities laws. Such four elements are as follows: (1) an investment of money (or money's worth); (2) in a common enterprise; (3) with an expectation of profit; and (4) to be made through the management and control of others. Pratt v. Kross, 276 Or 483, 555 P2d 765 (1976).

   2. The Investment of Money or Money's Worth. It is clear from ORS 59.015(17)(a) and Oregon cases that securities law encompasses investments of cash. However, non-cash or "money's worth" was added to permissible consideration for securities by the Oregon Supreme Court in Pratt v. Kross, supra. In determining what the court meant by adding the phrase "money's worth," it in Instructive to look at the court's discussion of the subject in Pratt. The discussion appears to find its roots in a law review article by Joseph C. Long entitled "Partnership, Limited Partnership, and Joint Venture Interests of Securities," 37 Mo. L. Rev. 581 (1972) which was quoted with approval by the Pratt court at p. 771.

      In his article, Professor Long answered the question of what is money in footnote 75 on page 600 of such article by stating: "Money here means value or money's worth. A corporation may issue stock in exchange for property, goods or services previously performed. §351.16(1), RSMO (1969)." He submits that the same principle for consideration should apply to an investment contract.

      Oregon has a statute, similar to the Missouri statute, which states what consideration can be given in exchange for a corporation's stock. ORS 60.147(2) states: "The board of directors may authorize shares to be issued for consideration consisting of any tangible or intangible property or benefit to the corporation, including cash, promissory notes, services performed, contracts for services to be performed or other securities of the corporation." The inclusion of intangible property demonstrates that the scope of consideration in securities matters may extend beyond cash and includes copyrights and the licensing of such copyrights.

   3. A Common Enterprise. The requirement of a common enterprise was recently examined in the case of Computer Concepts, Inc. v. Brandt, 310 Or 706, _____ P.2d _____ (1990) decided by the Oregon Supreme Court on November 26, 1990. In Computer Concepts, the court found that the federal court cases are instructive on the issue of common enterprise. The court then went on to find that federal courts have two different views of what constitutes a common enterprise, known as "horizontal" and "vertical" commonality.

      Horizontal commonality requires more than one investor and a pooling of investments. Hart v. Pulte Homes of Michigan Corporations, 735 F2d 1001 (6th Cir 1984); Milnarik v. M's Commodities, Inc., 457 F2d 274, 276 - 277 (7th Cir 1972), cert den 409 US 887 (1972).

      In our hypothetical, like in Computer Concepts, there was no pooling of investments where two or more investors invested in the same scheme. Instead, in our hypothetical as in Computer Concepts, there is one investor in one project. Such circumstances do not satisfy the requirements of horizontal commonality and therefore require an examination of vertical commonality.

      Vertical commonality is subject to numerous definitions. A few courts have found that investors can prove vertical commonality by merely proving dependence on promoter expertise. Taylor v. Bear Stearns & Co., 572 F Supp 667, 671 (ND Georgia 1983); Alvord v. Shearson Hayden Stone, Inc., 485 F Supp 848, 853 (D Conn 1980). Other courts require that the investment be interwoven with a dependence on the fortune of others so that the investor and promoter can be said to conduct a common enterprise. Brodt v. Bache & Co., Inc., 595 F2d 459 (9th Cir 1978). Additionally, other courts have found that the commonality test requires that the fortune of the investor and the promoter be intertwined as they both profit and loss. Kaplan v. Shapiro, 655 F Supp 336, 341 ( SD N Y 1987); Mechigian v. Art Capital Corp., 612 F Supp 1421, 1427 (SD N Y 1985).

      In Pratt v. Kross, supra, the court took the view that a one-on-one arrangement could qualify as a security. In Pratt, the court found that the fraud provisions of the Oregon securities law applied to "purchasers in isolated transactions where there is no public sale of solicitation," so long as the transaction otherwise fits the definition of an investment contract. 276 Or at 495. In Computer Concepts v. Brandt, supra, the court expressly held that in Oregon a plaintiff may prevail by showing vertical commonality as an alternative to showing horizontal commonality.

      In our hypothetical, ABC, the seller of the Solve-it-All software, who takes back a royalty is dependent upon the management of XYZ, the buyer, in order to receive any money for its software or in securities parlance "a return" on its investment. Furthermore, XYZ, the promoter, cannot generate any cash flow and achieve a profit, without a payment also being made to ABC. If XYZ does not successfully license the software, ABC will receive nothing and lose the entire value of Solve-it-all. Likewise, without licensing, XYZ will receivenothing for its efforts. Hence, ABC's investment of its software with XYZ is interwoven with and dependent on the fortune of XYZ. Also, ABC is relying on XYZ's expertise.

      The facts in our hypothetical satisfy the commonality tests of Taylor v. Bear Stearns, Co., supra, and Brodt v. Bache & Co., Inc., supra.

      The most restrictive commonality test, requiring that the fortunes of both profit and loss be intertwined, is contained in Kaplan v. Shapiro, supra, and requires further examination ("Kaplan Standard"). The court in Computer Concepts looked favorably upon the facts where the profits and losses were apportioned between the parties, although the plaintiffs' losses were limited to his contributions. In our hypothetical, the royalties are not generated by XYZ, the promoter-buyer. If the software is generating license fees, ABC would receive its royalties and XYZ would keep the balance of such payments. Although our facets are not identical to those in Computer Concepts or Pratt v. Kross, they are similar and therefore an argument could be made that our facets satisfy even the Kaplan Standard. The Supreme Court declined to rule as to which of the commonality tests would be applied by it in Computer Concepts.

   4. With the Expectation of Profit. Although many cases present an issue of whether or not a benefit is equal to a profit, we do not have such an issue here. Our hypothetical presents the situation where the seller clearly expects a profit, in this instance in the form of a royalty, from the promoter-buyer's efforts in licensing its software. Oregon is among the more liberal states in defining profit. In Black v. The Corporation Commissioner, 54 Or App 432, 634 P2d 1383 (1981), the court found that an investor's expectation of a reduction in his taxes alone could constitute a "profit".

   5. To be Made Through the Management and Control of Others. The standard for "management of others" which has been adopted in Oregon arises from SEC v. Glenn W. Turner Enterprises, Inc., 474 F2d 476, 482 n. 7 (9th Cir), cert den 414 US 821 (1973). In that case, the court set the standard of management of others as "whether the efforts made by those other than the investor are managerial efforts which affect the failure or success of the enterprise." That standard was quoted and adopted by the court in Jost v. Locke, 65 Or 704, 714, 673 P2d 545 (1983).

1. Royalties are Securities.

   A "percentage of receipts" is a royalty". See Black's Law dictionary, p. 1195 (5th Ed. 1979) as cited in Computer Concepts v. Brandt, 98 Or App 618, 780 P2d 249, 253, n. 8 (1989).

   Furthermore, royalties are securities because they satisfy the definition of an "investment contract" as set forth in IV above and are a "participation in a . . .profit sharing agreement" as such term is used in the definition of a security. ORS 59.015(17)(a).

   The Oregon Supreme Court in Computer Concepts found it unnecessary to examine the question of whether or not a royalty is a security under ORS 59.015, because the court decided there was enough evidence to permit a trier of fact to find that the subject contract was an "investment contract" without examining the royalty questions and therefore the Oregon Supreme Court found that the trial court erred in granting summary judgment to the defendants. However, the appellate court in Computer Concepts v. Brandt, supra, did discuss the concept of a royalty as a security. It noted that: "Federal courts have found the sale of a royalty interest of as little as one percent to be a security under federal securities laws" and cited United States v. Schaefer, 299 F2d 625 (7th Cir 1962), cert den, 370 US 917, 82 S.Ct. 1553, 8th Led 497; Trostle v. Nimer, 510 F Supp 568 (SD Ohio 1981); Nicewarner v. Bleavins, 244 F Supp 261 (D Colo 1965). In each of those cases, all of the money exchanged was used to purchase a royalty, while in Computer Concepts a royalty was only one component of a larger transaction. However, that distinction does not alter the fact that the plaintiffs were purchasing a right to a share of profits, making this aspect of the transaction an investment. Both the option and royalty aspects of the agreement show that it satisfies the "investment" and "expectation of profit" elements of the investment contract test, which also requires that an expected profit be made through "the management and control of others." Computer Concepts, 310 Or at 713, _____ P2d at _____.

   The federal cases above are of special interest because the interpretation of federal law is persuasive in analyzing the definition of an "Investment contract" under ORS 59.015. See Karsun v. Kelley, 258 Or 155, 161, 482 P2d 533 (1971).

   In addition to the federal cases discussed in Computer Concepts above, the court in S.E.C. v. Goldfield Deep Mines Co. of Nevada, 758 F2d 459 (9th Cir 1985) found a security existed for interests in an ore interest program where the promoter was to receive 25% royalty fee for processing the investor's ore. The fortunes of both the investor and the promoter were dependent on the success of the promoter's unique ore processing technique. If the processing technique was to prove faulty, then both the investor and the promoter would suffer financial losses. If successful, the investor would obtain the sums received from the sale of the ore, less a 25% royalty to the processor.

   Finally, in addition to the federal cases, various state courts outside of Oregon have found royalties to be securities. Voss v. Friedgen, 141 Cal2d 135, 296 P2d 424, 427 (Cal App 1956); State of Washington v. Williams, 17 Wa App 368, 563 P2d 1270 (1977). All courts that have ruled on the issue of whether or not a royalty is a security have found that royalty interests are securities.