By: Arthur S. Beeman, Joel T. Muchmore and Molly A. Jones
September 26, 2019
FEDERAL COURT WILL RULE ON WHETHER FORMER EMPLOYEE STATEMENTS CONFIRM ORACLE’S FRAUDULENT AUDIT TACTICS
As we have previously (and extensively) commented on, Oracle increasingly has a reputation for hardline licensing and auditing tactics that transform “audit reconciliation” into a primary revenue driver for its legacy software business. While this dubious reputation has been circulating through the tech community for years, many companies continue to find themselves unprepared for how to respond to an Oracle audit. Commentators have long speculated that Oracle’s audit revenue strategy serves the practical purpose of expanding the Oracle licensing footprint, along with the adoption of software upgrades and upgraded support packages with revenue streams that provide long-term stability in Oracle revenue expectations.
Based on our extensive front-line experience over the last few years, we have started to see evidence that Oracle’s auditing tactics have been deployed to boost the company’s performance in the cloud technology sector. In particular, we have observed Oracle increasingly pushing audit resolution packages that bundled the purchase of Oracle cloud licenses. Due in part to the strict confidentiality provisions in which Oracle enshrouds its license agreements and audit proceedings, marshaling evidence to establish a systemic connection between Oracle audits and cloud sales has been elusive.
Until now. A recently amended class action complaint against Oracle for securities violations contains whistleblower statements that, if true, appear to confirm what we have suspected for years: Oracle intentionally initiates questionable audits with the intent of coercing its licensees to purchase cloud products that they neither wanted nor needed.
The putative class alleges that Oracle’s optimistic statements concerning the factors driving improvement in its cloud market share are false and misled investors. In a nutshell, the class alleges Oracle engaged in securities fraud, in that:
“Oracle’s use of coercion and ‘financial engineering’ to boost its cloud revenues was highly misleading to investors. Purported ‘cloud’ revenue generated through these deals was artificial and unsustainable. Rather than truly purchasing cloud products through these transactions, as [Oracle] led investors to believe, customers were simply purchasing a discount on audit penalties or a discount on the on-premises products that they actually wanted. Although these transactions were not true sales of cloud products, Oracle nevertheless touted the inflated ‘cloud’ revenues and growth metrics stemming from these tactics as proof of its seminal [cloud] transformation.”
First Amended Complaint (“Complaint” or Compl.”) at ¶ 17. The class seeks damages related to Oracle’s material misstatements under Sections 10(b), 20(a), and 20A of the Securities Exchange Act, 15 U.S.C. §§ 78j(b), 78t(a), 78t-1, and Rule 10b-5 promulgated thereunder by the SEC, 17 C.F.R. § 240.10b-5.
THE WHISTLEBLOWER ALLEGATIONS OF NOTE FOR ORACLE LICENSEES
While the class action securities litigation ultimately concerns harm to Oracle shareholders, these same allegations are highly relevant to licensees and potential litigants who are confronted with a coercive Oracle audit. The Complaint contains quotes from nine unnamed (but otherwise identified with specificity) former Oracle employees who have allegedly confirmed that Oracle audits were initiated and carried out with the sole intent of increasing sales of Oracle cloud products.
Among some of the more alarming potential revelations, the Complaint alleges the following:
- “Audit, Bargain, Close.” Despite touting “astonishing” cloud growth, Oracle engages in “improper and extortionate tactics to coerce customers to buy short-term cloud subscriptions they did not want and would not renew.” (Compl. at ¶ 82.) These tactics are known internally within Oracle as “Audit, Bargain, Close,” or “ABC” deals. (Compl. at ¶ 83.) In a typical ABC deal, Oracle’s License Management Services (“LMS”) initiates an audit and presents a steep bill for the customer’s alleged violation of its software license, such as for possessing an insufficient number of licenses. The Oracle sales team then intervenes and offers a steep discount on audit penalties if the licensee agrees to purchase cloud subscriptions. These cloud subscriptions are then reported as evidence of “supposedly explosive cloud growth,” despite the fact that Oracle’s sales and customer success teams are well aware that the cloud licenses were not needed and would most likely not be renewed. (Compl. at ¶¶ 82-85.)
- Oracle Audits are Driven by Oracle’s Sales Division. The Complaint alleges a disconcertingly tight interplay between Oracle sales and LMS. According to one whistleblower, rather than initiate audits based on a potential “use” case, LMS waited for the sales teams to “identify large clients they thought they could get more money out of and threaten them with audits.” (Compl. at ¶ 89.) In many instances, the Oracle sales team would draft threatening audit letters for LMS to send, and, frequently, “neither sales nor LMS had real evidence that customers targeted for audits were noncompliant, but  the mere threat of an audit would put the licensee under so much pressure, because of the enormity of the potential penalties, that customers had no choice but to agree to Oracle’s demands that the client purchase cloud products.” (Compl. at ¶ 89.)
- Awareness and Approval of these Tactics Went Straight to the Top. Another former Oracle employee allegedly stated that LMS would never send a letter to a customer without approval by the sales manager or account executive handling the customer and that approval for steep discounts went as high as Oracle’s co-CEOs, Defendants Mark Hurd and Safra Catz. (Compl. at ¶¶ 90, 110-111.)
- Oracle Intentionally Targeted Licensees that had Previously Declined to Purchase Cloud Products from Oracle. One whistleblower allegedly stated that it was a “regular practice” for sales representatives to contact LMS to initiate an audit when the customer was not going to buy a cloud product, stating that the licensee was “not going to buy anything from me so let’s just audit them.” LMS then found and alleged compliance violations, and “the representative would start negotiating from there.” (Compl. at ¶ 92.) The Complaint further alleges Oracle “also went after customers who hadn’t purchased any licenses in two years. If a customer was audited and they had not paid for a license, [Oracle] would forget about the audit if they bought cloud.” (Compl. at ¶ 109.)
- Oracle’s Installation Practices Virtually Guaranteed Audit Findings of Under-licensing. The Complaint’s allegations also appear to confirm what many licensees have learned the hard way: certain Oracle software is installed in a way that increased the likelihood of a customer’s off-license usage. The Complaint cites former Oracle executives who stated that “Oracle installed its main on-premises products with extra options and management packs enabled by default, but did not inform its customers that these features had been installed and must be disabled in order to avoid license overages.” (Compl. at ¶ 88.)
CURRENT PROCEDURAL POSTURE
Oracle has filed a motion to dismiss that is fully briefed and currently pending. In its motion, Oracle argues that: (1) the Complaint does not adequately allege that any of its statements were actually untrue or intentionally misleading; (2) there is nothing actionable about its aggressive sales tactics and “applying such tactics would not make Oracle’s revenues illusory or fake”; and (3) the whistleblower allegations are untrue and based on statements by low-level employees whose conduct cannot be imputed to Oracle. The Court has scheduled oral arguments for October 17, 2019, in the San Jose Division of the Northern District of California. The court also ordered a case management conference for the same day.
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Regardless of the outcome of the securities litigation, the whistleblower allegations (which, given their specificity, seem credible), this filing may represent the first step in what could ultimately prove to be a seismic change in the way Oracle conducts its software audits. In the interim, the savvy licensee undergoing an Oracle audit is advised to retain counsel knowledgeable in the worst aspects of an Oracle audit and how to counter them.
Molly Jones is Counsel at Crowell & Moring, LLP.