Saturday, October 21, 2017

Blockchain: Recordkeeping in the 21st Century

Since our last post on cryptocurrency, the price of Bitcoin has risen nearly $1,500. This rapid rise in the value of cryptocurrency is representative of the extreme volatility that has given many investors pause. While cryptocurrency still yearns for acceptance, the backbone of cryptocurrency has already garnered favor with financial intermediaries. The blockchain and distributed ledger technology have indeed vaulted cryptocurrencies to the forefront of the entrepreneurial frontier, but it has greater potential and ramifications for the entire economy.

The blockchain is a record of peer-to-peer transactions categorized into blocks on a distributed ledger. Despite the terms “block” and “distributed ledger,” the blockchain functions similarly to a local bank authorizing and recording a transaction; but instead of only one party holding the entire ledger book, the transactions are recorded communally by member nodes (peer-to-peer network of computers). The blockchain can confirm a transaction almost instantaneously instead of several banks trying to reconcile and audit separate ledgers and transactions. Whenever a transaction takes place on the blockchain, the member nodes of the blockchain develop a new hash and digital signature to update the ledger and create a new “block.” This block, or recorded transaction, is time-stamped and encrypted and will remain with the currency for life. Therefore, cryptocurrencies are made up of a chain of recorded transactions (i.e. blocks) that create the blockchain.

As with other financial technology (“Fintech”), the blockchain is subject to cyber security threats and technical glitches. However, blockchain technology is designed differently than other Fintech. In order for hackers to change the distributed ledger, they would have to infiltrate the specific block they are targeting as well as all preceding blocks in the chain. The individual hash marks in each block ensure that any attempt to change the chain would have to be approved by the other member nodes. Such a change in the historical transaction ledger would be rejected because it would conflict with existing entries. However, the blockchain is still a digital technology and it has not been free of its technical difficulties. For example, Mt. Gox, a former Bitcoin exchange, lost nearly $450 million worth of Bitcoin in 2013 due to a technical glitch. Digital disasters can be avoided or mitigated with proper insurance and cybersecurity policies by the exchanges.  Also, cryptocurrencies and the blockchain will likely see an increase in regulation.

U.S. regulators, central banks, and major financial institutions have already seen great potential in the distributed ledger technology. Chairman Chris Giancarlo of the U.S. Commodity Futures Trading Commission stated in the spring of 2016 that blockchain and the distributed ledger technology “has the potential to link networks of legal recordkeeping the same way the Internet connects networks of data and information.” The U.S. Federal Reserve and its Chair Janet Yellen expect the blockchain to significantly affect current payment systems. Meanwhile, the central bank of Singapore has already hired a consulting firm to manage and develop a blockchain-based platform for interbank payments. While major financial players remain hesitant to accept cryptocurrency, they are more willing to accept the possibilities of blockchain. Financial Intermediaries have participated in the R3 consortium, which recently built a distributed ledger platform specifically for financial services, and have explored the possibility of using the blockchain for interbank settlements.

The blockchain’s use extends beyond cryptocurrencies and indeed has already been used in other industries, including agriculture, health care, and even insurance. In health care, for example, the blockchain can be used to track medical supplies and secure patients’ medical records. The blockchain is also the basis for “smart contracts” which are cryptographic contracts that execute as soon as a condition is met. In the case of insurance, for example, rather than requiring a traveler to contact the insurer once travel plans go awry, a smart contract would be triggered as soon as the traveler’s flight is cancelled.

While the blockchain technology can be used in various industries, its use as the basis for cryptocurrency has stirred the greatest controversy. Despite its general acceptance, the blockchain is just one piece to the cryptocurrency puzzle. More controversial than the blockchain technology is the initial coin offering (“ICO”). Many ICOs have already launched during the latest cryptocurrency craze. These offerings of coins and tokens are not only the subject of much debate, but are also the subject of our next post in this series on cryptocurrency.

This article is not legal advice, and was written for general information purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Andrew Silvia and Arina Shulga of Ross & Shulga PLLC.  We are a New York-based law firm specializing in advising individual and corporate clients on various aspects of corporate and securities law, including initial coin offerings.

Thursday, October 12, 2017

Are Real Estate Syndications Available to Non-Accredited Investors (NY perspective)?

A real estate syndication, although a fancy term, simply means pulling money and expertise together to invest in real estate properties.  It often so happens that some people possess the wealth of knowledge about the real estate market and are great at spotting investment opportunities but don't have the money to invest, while others have the required cash but no real estate expertise or time.  Bringing the first group (sponsors) and the second group (investors) together allows them to purchase and manage far bigger properties than each group could manage on their own.

In a (simplified) real estate syndication transaction, typically an LLC or an LP gets formed, which conducts an offering of its securities and then purchases the property using the proceeds of the offering.  The Sponsor acts as the Manager or the GP of the entity.  Investors can expect to receive two types of income: one from the rental income, usually payable on a monthly or a quarterly basis, and the other one due to the appreciation of the property value at the time of its sale, about 5-10 years down the road.  Investors usually receive a preferred return (about 8%) on their investment, then their money back, with the remainder of the proceeds being shared with the Sponsor (usually 80-20%).

As I mentioned before, real estate syndications involve an offering of securities of the property purchasing entity, which means that it must qualify for a federal and state exemption from registration under the applicable securities laws.  It is relatively straight forward to conduct such an offering if the deal has only accredited investors.  Such transaction can meet the requirements of Rule 506(b) or Rule 506(c) and then be exempt from state regulation pursuant to the federal legislation enacted in 1996 (NSMIA) that preempts state regulation of Rule 506 offerings.  States can only require a notification of the offering and a filing fee along with such notification.  For example, in New York, issuers must file a notification form 99 and submit other documentation, as I previously explained on this blog. 

But which exemptions are available to non-accredited investors?  Here are some of them:

1.  Rule 506(b) and State Notification.  Offering and sale of securities can be made to up to 35 non-accredited investors using Rule 506(b) of Regulation D.  However, these investors have to be sophisticated (either alone or with their representative).  This means that they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.  Such offering has to be made pursuant to an offering memorandum that contains an enhanced level of disclosure (i.e., it costs more and takes longer to prepare it).  On the state level, Rule 506(b) offerings are not regulated by the states, so a simple notification and filing fee are enough (although in New York it is not that simple).  Remember that the issuer relying on a Rule 506 offering must file Form D with the SEC.

2.  Intrastate Offerings and NY Policy Statements 101 or 105.  If the sales are made only to investors who are residents of a single state where the property is located, the purchasing entity can qualify under Section 3(a)(11) of the Securities Act for an exemption from registration for intrastate offerings.  The Rule 147 and the new Rule 147A were promulgated by the SEC to serve as safe harbors for Section 3(a)(11) exemption.  Rule 147A intrastate exemption, that became effective in April 2017, allows the issuer to rely on the intrastate exemption even if it was organized in a different state (so, a Delaware LLC that is purchasing a property in NY and has all NY investors may qualify).  I previously wrote about the new Rule 147A here.    The issuer does not have to file Form D, but compliance with state securities laws is required.

In New York, the issuer could rely on a Policy Statement 101 (offerings to no more than 40 people) or 105 (no filing required) for an exemption from registration, although some disclosure would still need to be made.  Although investors in these small offerings do not have to be accredited, they still must be sophisticated, have sufficient means for the investment, and have a pre-existing relationship with the principals of the issuer.  The "no filing" required exemption described in Policy Statement 105 may be used only for offerings to no more than nine investors in total, each of whom is sophisticated, has sufficient means, and a pre-existing relationship with the principals of the issuer.

3.  Rule 504 and NY Policy Statement 100Rule 504 was amended effective in January 2017 to allow companies to raise up to $5,000,000 in any given 12-month period but without the use of general solicitation and advertising.  Such offerings must be registered with the states or comply with applicable state securities law exemptions.  In certain circumstances, companies may use general solicitation and advertising, such as when they conduct the offering "exclusively under one or more state laws that require registration, public filing and delivery to investors of a substantive disclosure document before sale".  Form D has to be filed.

In New York, companies can rely on Policy Statement 100 to apply for a  corresponding exemption from state registration. The application asks for very detailed disclosure.  The current filing fee is 2/10th of 1% of the amount of the offering of securities, with the minimum fee of $750 and the maximum fee of $30,000.  The use of general solicitation and advertisement is not permitted.

4.  Regulation A+ and NY Policy Statements 101 or 105Regulation A+ (Regulation A was amended in 2015 and became known as Regulation A+) allows companies to raise up to $50 million, and is divided into Tier 1 and Tier 2 offerings.  In a Tier 1 offering issuers can raise up to $20 million but must comply with the registration procedures in every state where the company plans to sell its securities.  Any investor can participate in these offerings.  A Form 1-A that requires detailed disclosures and financial statements must be filed with the SEC.

Tier 2 offerings (up to $50 million) are exempt from state regulation, but have limits on how much non-accredited investors may invest.  Tier 2 offerings are very involved, and are considered like "mini-IPOs".  They are significantly more expensive and time consuming to prepare than a Rule 506(b) private placement.

5.  Section 4(a)(6) of the Securities Act / Regulation CF and State Notification.

As you know, the SEC adopted Regulation Crowdfunding (or Regulation CF) to implement Title III of the JOBS Act.  It became effective on May 16, 2016.  (Side note: have you noticed how many of these rules/regulations have been updated just recently?? The securities law is probably one of the fastest developing areas of law nowadays.  Just wait for regulations relating to crypto-tokens).  I will not bore you with all the details here because you can read about it in detail in my other blog post.  Although non-accredited investors can participate, the overall size of the offering is limited to $1,000,000, which is probably too small for a typical real estate syndication deal.  Also, there are limits as to how much individual investors can invest based on the investors' income and net worth.  Just like with Rule 506(b), states are preempted from regulating Section 4(a)(6) offerings.

In conclusion, as you can see from this (simplified) analysis of current securities laws, it is quite possible for non-accredited investors to participate in real estate syndication deals, but participation of non-accredited investors requires extra legal and other fees and time to complete the deal.  Each of the rules mentioned above contains a myriad of exceptions, provisos, special circumstances and requirements, all of which have to be accounted for in order to complete a successful real estate syndication transaction.  Sometimes, inviting just a few non-accredited investors may not be worth the extra expense.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Monday, October 2, 2017

Cryptocurrency: the Origin and Growth of Coinopoly

Mired in the aftermath of the U.S. financial crisis, the year 2009 may have started one of the largest financial revolutions since the birth of paper currency in 1690. Much like its predecessors, cryptocurrency faces an uphill battle of understanding, trust, and proper regulation. Eight years since its inception, cryptocurrency has maintained its allure with startups and financial intermediaries, but is still a misunderstood concept to many. We hope to clarify this misunderstanding in a series of posts, beginning here with the basics of cryptocurrency and later discussing blockchain, initial coin offerings, and the current laws and regulations applicable to this industry.

Cryptocurrency is, by any other name, a currency—a medium of exchange used to purchase goods and services. Or, as some have suggested, cryptocurrency is a “peer-to-peer version of electronic cash.” However, this currency has two qualities that distinguish it from traditional bills and coins. First, cryptocurrency is a virtual currency that is created through cryptography (i.e. coding) and developed by mathematical formulas through a process called mining. Secondly, unlike traditional bills and coins that are printed and minted by governments around the world, cryptocurrency is not tied to any one government, and thus is not secured by any one government. This is often referred to as being decentralized.

Cryptocurrency is based on a cryptographic code that can be created (as described by Ethereum here) or based on existing open source software available through platforms like GitHub. Open source software is freely accessible code intended to be shared and improved. We discussed it in more detail in one of our previous blogs. The readily available open source software is what makes cryptocurrency decentralized—no one person or entity has the ability to control how many types of cryptocurrency are out there. According to, currently, there are close to 900 different cryptocurrencies. In comparison, there are about 180 currencies in the world that are recognized legal tender, and virtual currency is not among them.

As a decentralized currency, cryptocurrency is not subject to the inflationary pressures of legally recognized tender. For example, the cryptocurrency Bitcoin has a finite number in circulation, meaning the 21 million outstanding Bitcoins are all there will ever be. Because it cannot be reprinted or minted, like government backed bills and coins, its value is determined by basic economic principles, including supply and demand and allocation of scarce resources. A finite number of Bitcoins means that when the demand for Bitcoins increases and the supply stays the same, then the price of Bitcoin would increase, and vice versa.

Being a decentralized currency comes with flaws, especially as it relates to value. Giving someone a $20 bill has immediate and apparent value because it is backed by the full faith and credit of the U.S. Treasury. A cryptographic code on the other hand has initially little value. This is where the term “mining” comes in. The owner of the original code of the cryptocurrency works with miners to build the currency’s value. In other words, the original coin holder—the developer of the code—needs to exchange the coin for something. The original coin holder will provide coins to miners and, in exchange, the miners will process transactions by confirming and writing them into the distributed ledger. These transactions are recorded as blocks in a long list on the ledger, which creates the blockchain (which will be discussed in detail in the next post). Whether it is an ordinary bank account to withdraw cash from or it is cryptocurrency’s distributed ledger, both function as a historical record of value based on entries (i.e. transactions) from the third-party servicers—banks when dealing with cash or miners when dealing with cryptocurrency.

Of course, the virtual coin only has value if it can be exchanged for traditional goods and services, like the $20 bill. This heavily relies on marketing the cryptocurrency as a valid form of payment; not unlike paper money back in 1690. As described by Chris Ellis, developer of Feathercoin, “Money is a ledger, it is a tool that people will use as a way of achieving their goals and satisfying their needs.”

Various cryptocurrencies have developed into household names, such as Bitcoin, Ethereum, Feathercoin, and many others because of the potential use now available to cryptocurrencies. Cryptocurrencies can be stored and carried around in different types of wallets, including physical wallets that look like paper money, flash drives, and online wallets, and can be exchanged for goods and services at restaurants, online retailers, television providers, and even donated to charitable organizations. Our law firm, for example, accepts Bitcoin payments. As opposed to concerns from critics that this is just Tulipmania and we are ascribing value to an otherwise valueless item, the potential for cryptocurrencies as a medium of exchange is enormous.

The growth in cryptocurrencies begs the questions regarding security, rules and regulations, and ultimately how to utilize the blockchain and cryptocurrencies in other sectors or the financial industry. The following posts in this series will cover these issues and more in depth.

This article is not legal advice, and was written for general information purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Andrew Silvia and Arina Shulga of Ross & Shulga PLLC.  We are a New York-based law firm specializing in advising individual and corporate clients on various aspects of corporate and securities law, including initial coin offerings.

Tuesday, September 19, 2017

Endorsement Guidelines for Social Media Influencers

Social media influencers have become an essential component of many marketing campaigns.  Influencers have audience that listens to what they say.  Building a relationship with an influencer enables the brand to reach the influencer's audience that is more likely to buy the brand's offerings based on a peer review rather than ads. Many big brands ask influencers to partner with them and offer them compensation for posting blogs, tweets or videos about their products.

All this is legal so long as influencers clearly disclose what, if anything, they get from the brands in return for their posts as well as any relationships that exist between them and the brands.  In March 2017, the Federal Trade Commission ("FTC") issued more than 90 letters to brands and influencers warning them about appropriate disclosures.  Some of these letters are available here.  

In the letters, the FTC reminded both endorsers (influencers) and marketers (brands) that endorsers must disclose any "material connection" that exists between them because such connection can influence the weight or credibility that consumers give to the endorsement.  A "material connection" may consist of a business or family relationship, monetary payment, or the provision of free products to the influencer.   

The FTC letters refer to the Endorsement Guides that apply to both marketers and endorsers.  There is also a helpful FTC staff publication "The Endorsement Guides: What People are Asking" that describes the Guides in a Q&A format.  The publication explains that if an endorser is acting on behalf of an advertiser, then what the endorser is saying becomes commercial speech that may violate the FTC Act if it is deceptive.  

It doesn't mean that endorsers have to disclose everything.  The test here is whether knowing about the gift, the incentive or the special relationship would affect the weight or credibility the viewers give to the recommendation.  There is no needed disclosure if the influencer bought the product herself.  There is also no needed disclosure if the store was giving out free samples to all its customers and the influencer received one of them.  However, disclosure would be warranted if the brand / advertiser gave something of value to the influencer in exchange for posting a review.  For example, a reviewer of restaurants would need to disclose if she received any free meals at the places she reviewed.  Or, in my case, I would need to disclose in this blog if I wrote a review of a book that the publisher sent to me for free.  Or, according to the FTC letter, Sean Combs would have had to disclose that he is the owner and director of AQUAhydrate when he posted on Instagram a picture of two bottles of AQUAhydrate water and wrote "Let's GO!!! @aquahydrate #balance #hydrate #tryIT."

So, to summarize: 
  • Endorsers must disclose all material connections, including financial, family or friendship ties to the brands;
  • Such disclosures must be clear and conspicuous, such that they appear above the "more" button in an Instagram post and are not hidden among the hashtags; and
  • Endorsers should avoid unclear and confusing hashtags.
This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Sunday, September 17, 2017

Why Small Businesses Need Buy-Sell Agreements

One of the agreements that comes up time over time in my practice is a buy-sell agreement.  These are contracts between shareholders of a corporation, partners of a partnership or members of a limited liability company and the business entity itself (although, as you will see, this is optional).  The buy-sell agreements ensure that the business interest of either deceased, disabled or departing owner is transferred to the entity or the co-owner(s) according to the predetermined and agreed upon guidelines.

Why Do You Need a Buy-Sell Agreement

In the absence of a buy-sell agreement in the case of death, the decedent's business interest will pass by the terms of his or her will or the laws of intestacy. This means that the remaining owner could become business partners with people who have little or no interest in running the business or the necessary skills to do so.  Alternatively, the heirs could sell the decedent's interest in the company to an unknown outside buyer who may not unfriendly to the remaining owner.  A buy-sell ensures business continuity while providing the needed cash to the deceased partner's family to handle estate tax and funeral expenses.

A buy-sell agreement can also resolve issues surrounding a business owner's disability.  Imagine a business owner who is critical to the business' operations but becomes disabled.  This could potentially be devastating for the business.  The remaining owner would be left alone to handle business operations while trying to figure out for how long to pay the disabled partner and from what source.  The disabled partner may want to be bought out, or his or her spouse and children may want to step in to run the business instead.  The disability buy-sell addresses the issue of the purchase of the disabled owner's interest, continued salary payments and management continuity.

Buy-sell agreements are also used in the cases of:
  • termination for cause (such as when the owner stops performing his or her duties or becomes convicted of a crime)
  • personal bankruptcy 
  • divorce
  • voluntary retirement
  • loss of professional license.
Funding Buy-Sell Agreements

There are four different ways to fund a buy-sell.

One way is to put aside cash from earnings and create a savings plan, often referred to as the sinking fund.  The danger here is that the fund could get diverted to pay for urgent business-related expenses, leaving the buy-sell underfunded.

Another way is to borrow the money.  However, not all businesses can obtain good terms on a loan.  Also, loan repayment would decrease the company's cash flow and impact credit availability.

The third way is to pay the buyout price over an installment period that is agreed to ahead of time in the buy-sell agreement.  Here, it is the departing owner who faces most of the risk.  He or she risks not getting the full buyout price if the business fails, since the ability to grow the business is now in the hands of the remaining partner(s).

The fourth and final way is to buy life or disability insurance on the lives of the owners.  A permanent insurance policy can also be used for retirement buyouts. However, insurance is not available for all types of buyout scenarios outlined above.  So, some combination of the payment methods is needed to fund a  comprehensive buy-sell agreement.

Entity or Cross-Purchase Buy-Sell

One last thing that I'd like to mention is that sometimes it makes more sense for the owners to buy insurance on each other (a cross-purchase arrangement) than for the company to do so (stock redemption).  In such cases, the company itself is not a party to the agreement.  Each individual partner is the owner, beneficiary and premium payor of the policy on the life of the co-owner.  This may make sense from the tax planning perspective.  I am not a tax specialist, so I encourage to consult with one about this.

If, for example, there are two owners, each of whom has invested $100,000 in the business and holds 50% of its stock.  The company is currently valued at $700,000.  Owner A dies.  The company uses its death insurance proceeds to buy out A's shares.  A's shares become treasury stock.  B remains the sole owner of the corporation.  B's shares are now valued at $700,000 - the full value of the corporation.  B's basis in the stock is $50,000.  When he sells his shares, he realizes taxable gain of $650,000.  On the other hand, if A and B cross-insured each other, then upon A's death, B would pay $350,000 to A in insurance proceeds to purchase A's stock.  B's basis in the stock would then be $400,000.  So, his realized taxable gain on the sale of this stock would be much smaller, $250,000.  In this oversimplified scenario, using a cross-over arrangement results in significant tax savings for the surviving partner.

In conclusion, I recommend for all small and closely held businesses to consider entering into buy-sell agreements or including buy-sell provisions in their shareholder, partnership or operating agreements.  Drafting buy-sell agreements requires not just legal, but also financial and tax expertise.  It is worth the investment of time and money to ensure successful business continuation.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Monday, March 13, 2017

SaaS Contracts vs Software License Agreements

Just like technology itself, technology contracts are becoming more and more complex.  Yet, the legal theories that apply to them remain the same. Understanding the technological aspects of the transaction allows attorneys to apply correct legal terms.  Here is an example that I have encountered in my practice.

Software license agreements are used when a proprietary software is being licensed by the licensor to a licensee.  The licensor has an interest in copyrights, patents, trade secrets and other IP rights in the software and related documentation.  A license is a limited grant of those rights.  A software license can be exclusive or non-exclusive, may be limited to a specific geographic territory, with or without a right to sublicense and transfer, with or without a right to make and store copies, and with a limited scope of access and use.  All this assumes that the software needs to be downloaded or installed on the licensee's platform/network/computer.

A traditional software license described above does not apply to software-as-a-service (SaaS) contracts because the customer does not download or install copies of the software.  The customer remotely logs into the vendor's system to access and use the software, usually through the Internet.  The vendor (or its provider) hosts the software either on its server or in the cloud.  So, essentially the vendor provides a service to the customer, which consists of hosting its software and performing services to support the hosted software and granting access to the hosted software.  This is the reason why SaaS contracts do not typically have a license grant, but talk about authorization to access.  There is very limited, if any, customer customization because the software configuration is mostly uniform throughout the vendor's customer base.  Maintenance and service of the software become very important.  Typically, there are multiple service levels that are carefully negotiated.  Fees are based either on a subscription model or the volume of customer's use.  

So, why would a SaaS vendor prefer to grant a license rather than an authorization to access the SaaS services?  One reason is because in the case there is unauthorized access or use of the SaaS services, the vendors will not be able to claim an IP infringement unless there was a previous license grant.  It could still have a claim for theft of service, trespass to chattels, or a violation of the Computer Fraud and Abuse Act, but not an IP infringement.

However, a grant of an IP license creates an additional risk which probably outweighs the point I just made.  In the case of bankruptcy, the vendor may stop performing its contractual obligations, including SaaS services.  However, the Bankruptcy Court may compel the vendor to keep on performing the services if they are provided under an IP license because Section 365(n) of the Bankruptcy Code protects the right to continue to use "licensed intellectual property" but not the services.  The customer could also get a copy of the software's code and self-host it.

Now, let's complicate things a bit.  If the customer hosts the software (as opposed to the vendor or a third-party provider), the customer would need a software license (not an authorization) because it would need to make copies of the software.

As you can see, the only way to draft a correct agreement is to understand the technological aspects of the deal.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.

Saturday, March 11, 2017

Deconstructing Open Source Software Licenses

When drafting and negotiating software license agreements, I frequently come across open source licenses.  This blog post is to clarify some of the myths that exist around the definition and use of open source software.

First, I want to distinguish open source software from software that is in public domain.  Public domain software is absolutely without any copyright or other intellectual property restrictions.  Anyone can modify it, distribute it, and use as they see fit.  Open source software, on the other hand, is licensed.  It may, but doesn't have to be free. Typically, licensors of open source software charge for providing support, consulting, and other professional services in connection with their open source software.  They cannot charge royalty for the source code itself or the right to modify and redistribute it.

Next, let's investigate the reasons for licensing software under one of the open source licenses.  The main reason for opting to license software under an open source license is the opportunity to get the software noticed, used, improved, and revised by developers anywhere on a continuous basis.  The result is software of high quality that is free of bugs, frequently used, and is current.  Of course, it comes at a price. Since developers can download, modify and redistribute open source software, licensor of such software is unlikely to get rich of the software license fees.  It needs to be able to provide support, consulting, maintenance and other related services to compensate for the loss in license royalties.

And now let's zero in on the terms of the open source software licenses.  They generally fall under two categories: copyleft (restrictive) and permissive.  The existence of copyleft open source licenses is probably the main reason why software developers are suspicious of open source software in general and may be reluctant to use it in their own software.  A copyleft license requires all software recipients to redistribute it under an open source license.  So, if a developer incorporates a part of copyleft open source software into its own larger software program or creates a derivative work based on it, then the entire program or derivative work would have to be distributed under an open source license (i.e., a copyleft open source license "infects" the entire work).  This is the reason why, when negotiating software license agreements on behalf of a licensee that has the right to create derivate works and redistribute the software, it is important to understand whether the licensor has used any open source software and if yes, then under which license.  It is then a good idea to ask for a warranty from the licensor that it has not used any copyleft open source software and for indemnification.  On the other hand, if licensee does not intend to redistribute the software but only intends to use it, then having a copyleft open source software should not be a big concern.

The best-known copyleft license is the GNU General Public License (the "GPL"), provided by the Free Software Foundation.  The current version 3 is available here.  The key terms are in Sections 2, 4-6, and 10.  Version 2 is still widely used (actually more so than the recent version 3).  The key provision in Version 2 is Section 2(b) that says:
"2. You may modify your copy or copies of the Program or any portion of it, thus forming a work based on the Program, and copy and distribute such modifications or work… provided that you also meet all of these conditions:....
b) You must cause any work that you distribute or publish, that in whole or in part contains or is derived from the Program or any part thereof, to be licensed as a whole at no charge to all third parties under the terms of this license."
Other copyleft licenses include GNU Lesser General Public License (LGPL) versions 2.1 and 3.0, GNU Affero General Public License, Artistic License (Pearl), Mozilla Public License (MPL) 1.1 (requires modified versions of the software to be distributed using open source model but doesn't apply to all derivative works, just to the modifications of original code), and Eclipse Public License (EPL).

Overall, according to an open source software provider Black Duck, the use of copyleft or restrictive licenses is declining.  In 2010, about two-thirds of open source software was under copyleft licenses.  In 2017, no more than 37% of open source software use was under copyleft licenses, with GPL version 2 use declining from 48.5% in 2010 to only 18% in 2017.    

Permissive open source licenses let the licensee include open source software into their larger program and then distribute the program under any license it wants.  Most frequently used permissive open source licenses are Apache License 2.0, and Open Source Initiative's MIT License and BSD 2.0.  Sections 2 and 4 of the Apache license allow licensee to reproduce, prepare derivative works of, publicly display, perform, sublicense, and distribute the open source software so long as a copy of the Apache license and certain notices are included.  The licensee may provide additional or different license terms governing the use, reproduction or distribution of any derivative works, provided it continues to comply with the Apache license.  Apache license is the preferred open source license for Android.  The MIT and BSD licenses are probably the least restrictive of all open source licenses because they do not have any IP-specific restriction on redistribution of software.  

According to Black Duck Software, the use of Apache license rose from 4% in 2010 to 14% in 2017.  The use of the MIT license rose from 4% to 32% in 2017, while the use of the BSD license remained at approximately 6% during the same period of time. Currently, MIT license is ranked as #1 open source software license in use.

In conclusion, it is important for software developers and their attorneys to understand the different open source licenses.  Using open source software is beneficial to all, but the license for it needs to correspond to the intended use of the software in the hands of the licensee.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.


Monday, February 6, 2017

Are Terms of Use and Other Online Agreements Real and Binding Contracts?

It used to be that people would enter into binding agreements by manually signing them. A signature manifested the two required aspects of forming a binding contract: a notice and an assent, i.e., the signatory has read the agreement and agrees to its terms.  No matter that the signatory didn't really understand what he or she has read: the signature created a presumption that the person read the terms and agreed to them.

The Internet, of course, changed all that by enabling people to enter into agreements online, without the use of signatures to show notice and assent.  So, are the online agreements really binding and enforceable?

Types of Online Agreements

First, let's take a look at some types of agreements that do not require a signature.

You have probably heard about a shrinkwrap agreement.  It is a printed form that typically appears on the outside of a box containing software.  Opening the box typically means that you have agreed to the terms of the agreement.  You don't really have ways to negotiate it, but you should be able to return the software if you disagree with the terms and have not yet opened the box.  Sometimes, the software provider cannot fit all of the terms on the outside of the package.  Then, opening the package does not mean that you consent to the terms, but installing the software does.

An online version of a shrinkwrap agreement is a clickwrap agreement.  It is an online contract that typically requires the user to click the "I Agree" button to show consent with the terms of the agreement.  The user cannot download the app or install the software until he or she clicks the "I Agree" button.  Some agreements require the user to scroll down to the end of the agreement before they can click the "I Agree" button.  These are sometimes referred to as scrollwrap agreements and are a subset of clickwrap agreements.

Some internet contracts do not require the user to click the "I Agree" button to show acceptance.  The users are notified of the existence of these contracts and the applicability of the website's terms of use when they proceed through the website's sign-in or login process.  These contracts are referred to as sign-in-wrap contracts.

Online agreements that do not have the "I Agree" button are called browsewrap agreements.  A good example of a browsewrap agreement is a website terms of use or privacy policy.  It typically begins with something like this:

This Terms of Use (together with our Privacy Policy, incorporated herein by reference, the “Agreement”) is a legal agreement between you and [ ] (“[ ]” or “we”). By accessing our website [ ].com (the “Site”), you agree to comply with and be legally bound by the Agreement. If you do not agree, please do not access our Site.      
Users do not have to take any affirmative steps to show their acceptance of a browsewrap agreement.  They give assent by simply continuing to use the site.   However, it is much more difficult to prove notice and assent in a browsewrap agreements because users of a website might not notice the terms of use policy that is hidden in the bottom of the screen.  For this reason, courts have not always deemed them to be enforceable.

A hybrid version of a clickwrap and a browsewrap agreement may be used by some websites if they have two types of users: those who use the information on the website without creating an account, and those who create an account to access enhanced features.  So, a clickwrap terms of use would be used for those creating an account (by asking to click "I Agree" button before the users can create it) and also placing the browsewarp version of same terms of use on the website for those users who chose not to create accounts.

Enforceability of Online Agreements

Now, let's discuss some of the legal issues involved with the enforceability of browsewrap and clickwrap agreements.  As I mentioned before, the two things that courts look at are (i) whether the user had sufficient notice of the terms and (ii) whether the user really consented to these terms.

Clickwrap agreements.  The main problem here revolves around the consent requirement.  Recently, courts have been paying particular attention to the potential of altering terms in the clickwrap contracts.  So, be ready that the court may ask to prove that the user clicked "I Agree" button to a particular version of the agreement or terms of use.  To avoid any problems, companies need to keep records of all versions of their online policies or agreements and be able to prove when each user actually consented to the terms.  The best way would be to have the users consent again after each modification of the agreement.   Recent cases about clickwrap contracts include Dillon v. BMO Harris Bank, N.A., 2016 WL 117513  (M.D.N.C. Mar. 23, 2016)Handy v. LogMeIn, Inc., 2015 WL 4508669 (E.D. Cal. July 24, 2015); Resorb Networks, Inc. v., 30 N.Y.S.3d 506 (Sup. Ct. 2016) and Berkson v. Gogo LLC, 97 F. Supp. 3d 359 (E.D.N.Y. 2015).

Browsewrap agreements.  Enforceability of browsewrap agreements is much more difficult to establish because they don't require any particular action on the part of the user to manifest assent.  So, here the courts have been battling with both issues of whether the users were put on sufficient notice of the terms and whether they actually agreed to them.  Because of the passive nature of "assent", courts focus on the circumstances of customers' use and the question of whether the user had actual or constructive knowledge of the website's policies.  The Court in Nguyen v. Barnes & Noble Inc., 763 F.3d 1171 (9th Cir. 2014) said "Whether a user has inquiry notice of a browsewrap agreement, in turn, depends on the design and content of the website and the agreement’s webpage."  In the past, browsewrap contracts have not been enforced where the link to them was buried at the bottom of the page, or put somewhere in a corner where it was hard to find, or was visible only if you had to scroll down to the next screen, or could access it only after a multi-step process of clicking though non-obvious links.  On the other hand, courts liked websites that had "explicit textual notice that continued use will act as a manifestation of the user's intent to be bound" by the online agreements".

Sign-in-wrap agreements.  These contracts will generally be held enforceable so long as the users have clear unambiguous notice of the terms and an effective opportunity to access those terms at the time they are signing in / logging into the site.

Practical Steps

To summarize, below is my list of recommendations regarding online contracts:

1.  It is best to use clickwrap / scrollwrap / sign-in-wrap agreements rather than browsewrap ones.  This means adding an "I agree" or "I accept" button.

2.  Have users agree to any change to your online policies when they next log in / sign into your website.  For browsewrap version, clearly state in bold on the first page the date when the agreement was last modified.

3.  A hyperlink to the terms of use and other policies should be in large font, all caps or in bold (i.e., not hidden, clearly visible).

4.  A hyperlink to the policies should appear on every page of the website.  As the court in Berkson v. Gogo said, it should not be "buried at the bottom of a webpage or tucked away in obscure corners of the website."

5.  The online policies should be easy to download and print.

6.  It is a good idea to have the users scroll through the agreement before accepting it.

7.  A website with a browsewrap terms of use should have a conspicuous notice appearing on every screen that by using this site, user agrees to the site's term of use.

8.  For clickwrap contracts, - keep records of all versions of the online agreements and policies, and know when each user consented and to which version.  It is best to ask users to consent to each modification of the policies.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.