Corporate Governance

Intelligent Digital Systems, LLC v. Visual Management Systems, Inc.: Seller?s Choice of Payment in the Form of Fixed Stock Conversion Ruled Not a Security

By Andrew Podore

In Intelligent Digital Systems, LLC v. Visual Management Systems, Inc., No. CV 09-974, 2010 WL 431472 (E.D.N.Y. Jan. 28, 2010), the District Court for the Eastern District of New York held a sale of assets agreement ('Note') allowing for payment in the form of Visual Management Systems, Inc. ('VMS') stock was not a security under federal securities laws.  Rather, the Court characterized the Note as a commercial sale of assets because the sale price was not speculative, and the transaction did not involve the investing public. 

Plaintiffs Intelligent Digital Systems, LLC and Jay Russ ('IDS') sold proprietary digital video recording technology to VMS in exchange for a Note of approximately $1.5 million.  The Note gave IDS the option of converting any remaining balance due under the Note into VMS common stock at a conversion price of $1.15 per share.  While the Note allowed for conversion, it expressly stated that VMS common stock was not registered under the Securities Act, and that it could not be sold without an effective registration statement.  VMS defaulted and IDS filed suit, naming VMS, its CEO, and its Board as defendants. 

IDS's complaint alleged, among other claims, federal securities fraud under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 ('Securities Claim').  VMS moved to dismiss the Securities Claim on the grounds that the Note was not a security within the meaning of federal securities law, and VMS failed to comply with common law fraud's heightened pleading standards. 

Applying the 'family resemblance' test articulated in Reves v. Ernst & Young to determine whether the Note was a security, the court considered (1) the motivation of the parties; (2) the plan of distribution; (3) the reasonable expectations of the investing public; and (4) the existence of an alternate regulatory regime.

First, the court reasoned that because the Note predetermined the stock conversion price, IDS's motivation was selling proprietary technology to VMS outright, not to invest in VMS's business.  Specifically, the court explained the Note called for payment in the form of a fixed amount, 'whether or not the buyer's business is positively affected by the purchase.'  Second, the court found the plan of distribution weighed against IDS because the Note evidenced a solitary transaction, and was not an instrument of common trading for speculation or investment.  Third, because there was 'only a single seller who expected only to be paid in full for an asset sale,' the reasonable expectations of the investing public factor weighed against finding that the Note was a security.  Finally, the court did not consider the fourth factor because the first three factors weighed heavily in favor of VMS.  Ultimately, the court dismissed the Securities Claim. 

The primary materials for this case may be found on the DU Corporate Governance website.

Full post as published by The Race to the Bottom on April 21, 2010 (boomark / email).