§ 1.04 ESTABLISHING LIABILITY FOR UNLAWFUL OFFERS/SALES/ PURCHASES
Most shareholder litigation under the WSSA arises under RCW 21.20.430(1) or (2), which permit a seller or buyer of a security to sue for violations of RCW 21.20.010 ("Unlawful offers, sales, purchases"). That section provides:
It is unlawful for any person, in connection with the offer, sale or purchase of any security, directly or indirectly:
(1) To employ any device, scheme, or artifice to defraud;
(2) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading; or
(3) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
The language of RCW 21.20.010 has often been referred to as the "anti-fraud" provision of the WSSA and has similarities to the language of SEC Rule 10b-5 (17 C.F.R. § 240.10b-5), promulgated under Section 10(b) of the Securities Exchange Act (15 U.S.C. §§ 78j(b)), which is directed at securities fraud. But while section .010 gives rise to liability for fraudulent conduct, this section differs from Rule 10b-5 and Section 10(b) in that it is not necessary to prove the elements of fraud in order to establish liability for an unlawful offer, sale, or purchase. Rather, RCW 21.20.010, as interpreted by Washington courts, creates primary liability when a plaintiff can show the sale of a security, a misstatement or omission of fact in connection with that sale, and that the untrue or omitted fact was material. Scienter, reliance, and damages—all elements of a securities fraud claim under the federal provisions cited in this paragraph—are not required to establish this liability. See Federal Home Loan Bank ofSeattle, 194 Wn.2d 253, 449 P.3d 1019.
The required elements of a claim under RCW 21.20.010—a security; a sale and a seller; a misstatement or omission of existing fact; and materiality—are addressed in turn below.
[1] Security
[a] Definition of "Security"
RCW 21.20.005(17)(a) defines "security" as follows:
"Security" means any note; stock; treasury stock; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract; investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture; voting-trust certificate; certificate of deposit for a security; fractional undivided interest in an oil, gas, or mineral lease or in payments out of production under a lease, right, or royalty; charitable gift annuity; any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof; or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; or, in general, any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any security under this subsection. This subsection applies whether or not the security is evidenced by a written document.
The statute specifically excludes certain financial interests from this definition:
(i) Any insurance or endowment policy or annuity contract under which an insurance company promises to pay a fixed sum of money either in a lump sum or periodically for life or some other specified period; or (ii) an interest in a contributory or noncontributory pension or welfare plan subject to the employee retirement income security act of 1974.
RCW 21.20.005(17)(b)(i)-(ii).
This list enumerated in the WSSA's "security" definition is not exhaustive. Instead, the concept of a security is "a flexible one emphasizing substance over form." Ito Int'l Corp. v. Prescott, Inc., 83 Wn. App. 282, 290, 921 P.2d 566 (1996) (citing Cellular Eng'g v. O'Neill, 118 Wn.2d 16, 24-25, 820 P.2d 941 (1991)). Courts, therefore, look to the transaction's economic reality to determine whether it involves a security. Cellular Eng'g, 118 Wn.2d at 24-25; see also Hunichen v. Atonomi LLC, No. C19-0615, 2019 U.S. Dist. LEXIS 226147, at *42 (W.D. Wash. Oct. 28, 2019), report and recommendation adopted, No. C19-00615, 2020 U.S. Dist. LEXIS 70175 (W.D. Wash. Apr. 21, 2020) (plaintiff sufficiently alleged blockchain-based utility tokens are securities based on "analysis into the economic realities of the underlying transaction[s].").
Two tests have been recognized to determine whether a transaction involves a security under the WSSA.
[i] The Howey Investment Contract Test
The first test is a modified version of the "investment contract" analysis announced by the United States Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293, 298-99, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946), which defined a security as "a contract, transaction or scheme whereby a person invests his [or her] money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party." Washington courts apply a modified version of the Howey "investment contract" test, under which profits are primarily, rather than solely, expected from the efforts of the promoter or third party. Under the modified Howey test, a security is defined as (1) an investment of money (2) in a common enterprise and (3) the efforts of the promoter or a third party must have been fundamentally significant ones that affected the investment's success or failure. Cellular Eng'g, 118 Wn.2d at 25-32; Ultimate Timing, L.L.C. v. Simms, 715 F. Supp. 2d 1195, 1208 (W.D. Wash. 2010).
In International Brotherhood of Teamsters v. Daniel, 439 U.S. 551, 99 S. Ct. 790, 58 L. Ed. 2d 808 (1979), the Supreme Court clarified that the first prong of the Howey test—an investment of money—does not confine an investment to "take the form of cash only," but can instead consist of an investment of goods and services. Id. at 560 n.12. The Ninth Circuit has also held that the first Howey prong only requires that the investor commit his assets to the enterprise in a manner that could subject him to financial loss. Hector v. Wiens, 533 F.2d 429, 432 (9th Cir. 1976).
The second prong of Washington's version of the Howey test requires that an investment be made in a "common enterprise." Cellular Eng'g, 118 Wn.2d at 29-31. Both the Washington Supreme Court and the Ninth Circuit have held that vertical commonality is required to establish this element. McClellan v. Sundholm, 89 Wn.2d 527, 532, 574 P.2d 371 (1978); United States v. Jones, 712 F.2d 1316, 1321 (9th Cir.), cert. denied sub nom. Webber v. United States, 464 U.S. 986, 104 S. Ct. 434, 78 L. Ed. 2d 366 (1983). Vertical commonality denotes " 'an interdependence of fortunes, a dependence by one party for his profit on the success of some other party in performing his part of the venture.' " Cellular Eng'g, 118 Wn.2d at 29 (quoting McClellan, 89 Wn.2d at 532). The Ninth Circuit has defined vertical commonality to mean that "the fortunes of the investors are linked with those of the promoters." SEC v. R.G. Reynolds Enters., Inc., 952 F.2d 1125, 1130 (9th Cir. 1991) (internal quotation marks omitted).
The final prong of the modified Howey test requires that the efforts of the promoter or a third party "must have been the undeniably significant ones that affected the success or failure of the investments." Cellular Eng'g, 118 Wn.2d at 31-32 (quoting Philips, 108 Wn.2d at 635). Where the investor's profits from the enterprise are expected to be generated primarily from the efforts of others—i.e., that the investment is passive—the investment is a security. See, e.g., Cellular Eng'g, 118 Wn.2d at 31. Thus, it is the extent of the investor's contribution to the profitability of the enterprises, or lack thereof, that governs this prong. Demonstrating such contribution is often a fact-intensive inquiry dependent on the nature of the enterprise. See, e.g., Cellular Eng'g, 118 Wn.2d at 31 (third prong satisfied where promoter organized investors into pools intended to design cellular phone networks and performed the associated technical, financial, and legal tasks); Ultimate Timing, 715 F. Supp. 2d at 1209 (third prong satisfied by promoter's marketing activities, managerial decision-making, and substantial efforts to ensure that the venture becomes profitable).
[ii] The "Risk Capital" Test
The statute itself supplies a second test to define a security under the WSSA—the "risk capital" test at RCW 21.20.005(17). That section provides that "security" includes:
investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture.
The Washington Legislature added this language to the WSSA's definition of security in 1979, in specific response to the Washington Supreme Court's decision in Sauve v. K.C., Inc., 91 Wn.2d 698, 701, 591 P.2d 1207 (1979), in which the court refused to apply the "risk...
