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Highlights from SCO's 10K
Saturday, April 02 2005 @ 01:51 AM EST

I have now read through the tardy 10K SCO filed yesterday, and here is my overarching impression: they are killing themselves with litigation. They would more likely say that they are gambling the farm on the IBM case. Here's how they put it:

If we do not prevail in our action against IBM, or if IBM is successful in its counterclaims against us, our business and results of operations would be materially harmed and we may not be able to continue in business.  The litigation with IBM and others will be costly, and our costs for legal fees have been and will continue to be substantial and may exceed our capital resources.

Of course the nuggets of information are scattered about, as is typical for a 10K, so I've collected the scattered bits into categories, so you can see it all of a piece. I've also marked some in red, the parts that I found significant. The bottom line, to borrow a phrase, is that they seem to be running out of money, and while Unix products are now cash-flow positive, they still expect that the Unix business will continue to decline:

The decrease in revenue in the UNIX business of $11,428,000 for fiscal year 2004 compared to fiscal year 2003 and the decrease of $10,833,000 for fiscal year 2003 compared to fiscal year 2002 was primarily attributable to continued competition from other operating systems, particularly Linux.  We anticipate that for fiscal year 2005 our total UNIX revenue will decline from UNIX revenue generated in fiscal year 2004. . . .

For fiscal year 2004, we incurred a net loss from operations of $28,573,000 and our accumulated deficit as of October 31, 2004 was $224,216,000.  If we do not receive SCOsource licensing revenue in future quarters and our revenue from the sale of our UNIX products and services continues to decline, we will need to further reduce operating expenses to generate positive cash flow.  We may not be able to further reduce operating expenses without damaging our ability to support our existing UNIX business.  Additionally, we may not be able to achieve profitability through additional cost-cutting actions.



They don't seem to expect new business, and are just trying to hang on to the ones they have already:

Sales of our UNIX products and services during fiscal year 2004 were primarily to pre-existing customers.  Our UNIX business revenue depends significantly on our ability to market our products to existing customers and to generate upgrades from existing customers. 

They reduced costs in part by reducing their employees from 340 in October of 2002 to 193 as of October of 2004.

There are intriguing bits that I want to read again. For example, I thought the law firms never got paid any stock. But I see an entry for stock paid to a law firm in 2003. You will find it under the category, "CONSOLIDATED STATEMENTS OF CASH FLOWS", where it lists "Issuance of common shares as compensation to law firms" -- 7,956 in 2003. I also note that the legal agreement between SCO and Boies Schiller to cap their legal fees covers up to the end of the IBM litigation only. Since Red Hat and AutoZone are stayed pending that outcome, it seems reasonable to believe that AutoZone will have nothing to worry about unless SCO somehow gets a settlement or favorable ruling in the IBM action, because SCO itself tells us that they have enough capital to make it through another 12 months. That wouldn't cover protracted litigation with AutoZone post IBM:

We intend to use the cash and equivalents and available-for-sale securities as of October 31, 2004 to maintain our UNIX business and pursue our SCO Litigation.

We believe that we will have sufficient cash resources to fund our current operations for the next 12 months. . . . Our working capital decreased from $37,168,000 as of October 31, 2003 to $15,413,000 as of October 31, 2004.

As for Red Hat, they are the plaintiffs and can certainly go forward, no matter what, but as far as any damages are concerned, it looks to me like they can't collect much of anything in money damages, unless SCO beats IBM somehow, something Red Hat isn't likely to be rooting for. Of course, SCO has assets. Unix is an asset.

Another piece that caught my attention is that the $8+ million paid to Boies Schiller in 2003 as a contigency fee ($8,956,000 to be exact) is listed very specifically as not being paid as legal fees: "This fee was not for attorney’s fees for legal services. . . " It would seem that the legal cap, therefore, would not in any way cover any future such contingencies:

With the completion of the Engagement Agreement with the Law Firms representing us in our SCO Litigation as described elsewhere in this filing, we anticipate that the dollar amount of our cost of SCOsource licensing for fiscal year 2005 will be lower than fiscal year 2004.  However, future legal fees may include contingency payments made to the Law Firms as a result of a settlement, judgment, certain licensing fees or a sale of our company, which could cause cost of SCOsource licensing revenue for fiscal year 2005 to be higher than fiscal year 2004.

But it's the compensation plans that draw the eye, particularly after the Canopy-Yarro litigation revelations. The company is sinking, and while the executives seem, with one exception, to be getting less this year than last, it's also clear they got quite a lot from this whole saga. The folks that are taking it on the chin, as the 10K candidly portrays, if I've understood it all, are the common shareholders.

Another thing we learn is that SCO is now an accelerated filer. And their version of the legal proceedings is interesting. They seem to be blaming Novell (and Linux proponents) for their failing SCOsource business:

We believe and allege revenue and related revenue opportunities for fiscal year 2004 were adversely impacted by our outstanding dispute with Novell over our UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

And we learn that their request to amend the complaint again in the IBM litigation has to do with adding a copyright infringement claim.

And there are some details about the Vintela deal (which seems to be over), and payments to Novell, and monies paid to Santa Cruz Operation. And then there is this riveting sentence:

In addition, regulators or others in the Linux market and some foreign regulators have initiated or in the future may initiate legal actions against us, all of which may negatively impact our operations and future operating performance.

I'd love to hear more about that. Here, then, are some highlights, collected into categories.

Re Novell:

Restricted Cash and Payable to Novell, Inc.  

Pursuant to the 1995 Asset Purchase Agreement and the Company’s acquisition of assets and operations of The Santa Cruz Operation, the Company acts as an administrative agent in the collection of payments from a limited number of pre-existing Novell, Inc. (“Novell”) customers who continue to deploy SVRx technology.  Under the agency agreement, the Company collects payments from such customers and receives 5 percent as an administrative fee.  The Company records the 5 percent administrative fee as revenue in its consolidated statements of operations.  The accompanying consolidated balance sheets as of October 31, 2004 and 2003 reflect amounts collected related to this agency agreement but not yet remitted to Novell of $3,283,000 and $2,025,000, respectively, as restricted cash and payable to Novell.  The Company’s obligation to act as an administrative agent for Novell is unrelated to the Company’s SCOsource initiatives related to its intellectual property rights or the Company’s lawsuit against Novell for slander of title alleging Novell’s bad faith effort to interfere with the Company’s copyrights in its UNIX source code and derivative works and its UnixWare product. . . . .

Novell also claims that it has a license to UNIX from us and the right to authorize its customers to use UNIX technology in their internal business operations.  Specifically, Novell has also claimed to have retained rights related to legacy UNIX SVRx licenses, including the license with IBM.  Novell asserts it has the right to take action on behalf of SCO in connection with such licenses, including termination and waiver rights.  Novell has purported to veto our termination of the IBM, Sequent and SGI licenses. We have repeatedly asserted that we obtained the UNIX business, source code, claims and copyrights when we acquired the assets and operations of the server and professional services groups from The Santa Cruz Operation (now Tarantella, Inc.) in May 2001, which had previously acquired all such assets and rights from Novell in September 1995 pursuant to an asset purchase agreement, as amended.

So, I gather they owe Novell $5+ million, and I wonder whether their prediction that they can last about 12 months depends on not paying Novell that money owed.

RE: Daimler:

The appellate court has dismissed our appeal of the July 21, 2004 ruling finding that the order was not a final, appealable order; we are evaluating our options regarding the appellate court’s ruling.

Re AutoZone:

Our lawsuit alleges copyright infringement by AutoZone by, among other things, running versions of the Linux operating system that contain proprietary material from UNIX System V.  The lawsuit, filed in United States District Court in Nevada, requests injunctive relief against AutoZone’s further use or copying of any part of our copyrighted materials and also requests damages as a result of AutoZone’s infringement in an amount to be proven at trial.  . . .

The court denied without prejudice AutoZone’s motion for a more definite statement and its motion to transfer the case to Tennessee. 

Re Miscellaneous Legal Matters:

We are a party to certain other legal proceedings arising in the ordinary course of business including legal proceedings arising from our SCOsource initiatives.  We believe, after consultation with legal counsel, that the ultimate outcome of such legal proceedings will not have a material adverse effect on our results of operations or financial position.

Legal proceedings arising from their SCOsource initiatives? Like what, exactly? They don't specify.

Re the Legal Fees:

On October 31, 2004, we entered into an engagement agreement (the “Engagement Agreement”) with Boies, Schiller & Flexner LLP, Kevin McBride and Berger Singerman (the “Law Firms”).  The Engagement Agreement supercedes and replaces the original engagement agreement that was entered into in February 2003.  The Engagement Agreement governs the relationship between us and the Law Firms in connection with their representation of us in our current litigation between us and IBM, Novell, Red Hat, AutoZone and DaimlerChrysler (the “SCO Litigation”), through the end of the current litigation between us and IBM . . . .

The other expense in fiscal year 2003 of $8,956,000 was attributable to a contingency fee payable to the Law Firms incurred in connection with the October 2003 issuance of our now retired Series A Convertible Preferred Stock.  This fee was not for attorney’s fees for legal services which fees have been recorded as cost of SCOsource licensing revenue. . . .

During fiscal year 2003, we incurred contingency fees of $8,956,000, or 11 percent of revenue, related to our arrangement with the Law Firms representing us in the SCO Litigation in connection with the issuance of shares of our now retired Series A Convertible Preferred Stock.  All payments to the Law Firms for legal fees incurred in connection with the SCO Litigation have been classified as cost of SCOsource licensing revenue. . . .

Our Engagement Agreement with the Law Firms will require us to spend a significant amount of cash during fiscal year 2005 and could harm our liquidity position.

  As of October 31, 2004, we had a total of $31,449,000 in cash and cash equivalents and available-for-sale securities and an additional $5,000,000 as restricted cash to be used in our operations and pursue the SCO Litigation.  As a result of the Engagement Agreement between us and the Law Firms, as described elsewhere in this filing, we anticipate using cash of approximately $27,000,000 in the defense of our intellectual property litigation during fiscal year 2005, which would leave us approximately $9,449,000 in cash for our business operations.  We expect that our UNIX business will generate sufficient cash in fiscal year 2005 to cover our internal costs related to our SCOsource initiatives and intellectual property litigation.  However, if our UNIX business does not generate cash or we spend additional cash on the SCO Litigation or additional matters, our cash position would be negatively impacted, and our ability to pursue our UNIX business objectives and our SCO Litigation would be harmed. . . .

Factors that may affect our results include: . . .

   * the contingency and other legal fees we may pay to the Law Firms representing us in our efforts to establish our intellectual property rights; . . . .

Our Engagement Agreement with the Law Firms representing us to enforce our intellectual property rights may reduce our ability to raise additional financing.

  Our Engagement Agreement with the Law Firms could inhibit our ability to raise additional funding if needed.  Although under the Engagement Agreement our obligations to the Law Firms are limited to approximately $26,000,000 related to certain previously accrued and all future attorney fees and the escrow of $5,000,000 for the payment of any expert, consulting and other expenses to pursue the SCO Litigation, the agreement provides that the Law Firms will receive a contingency fee that may range from 20 to 33 percent of the proceeds from specified events related to the protection of our intellectual property rights.  Events triggering a contingency fee may include settlements or judgments related to the SCO Litigation, certain licensing fees, subject to certain exceptions, and a sale of our company.  Future payments payable to the Law Firms under this arrangement will be significant.  The Law Firms’ right to receive such contingent payments could cause prospective investors to choose not to invest in our company or limit the price at which new investors would be willing to provide additional funds to our company.

  Re Bay Star:

Fair Value of Derivative Financial Instrument and Our Retired Series A-1 Convertible Preferred Stock.  In October 2003, we issued 50,000 shares of our redeemable Series A Convertible Preferred Stock.  The terms of the preferred stock included conversion and a number of redemption provisions that represented a derivative financial instrument under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended.  We determined that the conversion feature was an embedded derivative financial instrument.

  As of October 16, 2003, through the assistance of an independent valuation firm, we determined the initial fair value of the derivative was classified as a current liability $18,069,000 and the value of the preferred stock was $29,671,000.  We were required to account for the conversion feature as an embedded derivative since the preferred stock instrument did not entitle the holders to equity features such as voting rights and board representation.  As of October 31, 2003, the fair value of the derivative was $15,224,000 and the decrease in fair value of $2,845,000 was recorded as income as a change in fair value of derivative in other income in the statement of operations for fiscal year 2003.  During fiscal year 2004, the fair value of the derivative decreased and we recorded a total of $5,924,000 as income as a change in fair value of the derivative in other income.

  On February 5, 2004, we completed an exchange transaction in which each outstanding Series A share was exchanged for one share of redeemable Series A-1 Convertible Preferred Stock.  We received no additional proceeds in the exchange.  The exchange transaction eliminated the derivative related to the Series A shares that was initially recorded as a current liability on our balance sheet and eliminated the charge in our quarterly statements of operations for the change in the fair value of the derivative related to the Series A shares.

  Through the assistance of an independent valuation firm, we determined the fair value of the Series A-1 shares to be $45,276,000 as of February 5, 2004.  We recorded a dividend in the second quarter of fiscal year 2004 of $6,305,000, which reduced earnings available to common stockholders, related to the difference between the fair value of the Series A-1 shares and the carrying value of the previously issued Series A shares and related derivative.  This dividend was only one component of the total dividends recorded in fiscal year 2004.

  The estimated fair value of the Series A-1 shares as of February 5, 2004 was calculated using a binomial model.  Specific assumptions used included:  2.7 years to maturity, 11 percent equivalent bond yield, risk-free rate of 2.4 percent and volatility of 130 percent.  Had different assumptions been used, the valuation result could have been different than reported, and that difference could have been material.  As described elsewhere in this filing, we repurchased all outstanding Series A-1 shares on July 21, 2004.  As of October 31, 2004, no Series A-1 shares remain outstanding. . . .

Dividends Related to Series A and Series A-1 Convertible Preferred Stock

  In October 2003, we issued 50,000 shares of our Series A Convertible Preferred Stock for $1,000 per share.   In connection with completing the February 5, 2004 exchange of shares of Series A-1 Convertible Preferred Stock for outstanding Series A shares, we removed the carrying value of the Series A shares and related derivative and recorded the fair value of the Series A-1 shares issued in the exchange transaction.  The difference between these two amounts was $6,305,000 and was recorded as a non-cash dividend in fiscal year 2004.

  With the completion of the repurchase transaction with BayStar Capital II, L.P. (“BayStar”) during fiscal year 2004, as a result of which no Series A-1 shares remain outstanding, we will not be required to continue to accrue or pay any dividends on the Series A-1 shares.  As a result of completing the repurchase transaction with BayStar, we recorded a capital contribution in the amount of $15,475,000, which represented the difference in the carrying value of the Series A-1 shares and accrued dividends less the fair value of the 2,105,263 shares of common stock and the $13,000,000 in cash.

If the repurchase had not occurred, dividends on the Series A-1 shares would have been paid after October 16, 2004, the first anniversary of the original Series A private placement, quarterly at a rate of 8 percent per annum, subject to annual increases of 2 percent per annum, not to exceed 12 percent per annum.  We will no longer accrue dividends on preferred stock because the Series A-1 shares were repurchased.  No dividends were paid on the Series A or Series A-1 shares. . . .

The resale of common shares by BayStar may have an adverse impact on the market value of our stock and the existing holders of our common stock.

  We previously had an effective registration statement on Form S-3 relating to the sale or distribution by BayStar as a selling stockholder of the 2,105,263 shares of common stock issued to BayStar in connection with our repurchase completed in July 2004 of all Series A-1 shares previously held by BayStar.  When we failed to file this Form 10-K in a timely fashion, we became ineligible to use Form S-3, our registration statement ceased to be effective and BayStar’s ability to resell shares pursuant to that registration statement terminated.  We are currently in the process of preparing a new registration statement for the resale of BayStar’s shares on Form S-1.  Upon that registration statement being declared effective by the SEC, BayStar will again be able to resell its shares.  We will not receive any proceeds from the sales of the shares covered by such registration statement.  The shares that may be sold or distributed pursuant to such registration statement, upon being declared effective by the SEC, will represent approximately 8 percent of our issued and outstanding common stock.  The sale of the block of stock to be covered by such registration statement, or even the possibility of its sale, may adversely affect the trading market for our common stock and reduce the price available in that market. . . .

Our stock price could decline further because of the activities of short sellers.  

Our stock has attracted the interest of short sellers.  The activities of short sellers could further reduce the price of our stock or inhibit increases in our stock price.

I don't remember seeing mention of short sellers before, do you?

Re Good Will and Vultus:

Impairment of Long-lived Assets.  We review our long-lived assets for impairment when events or changes in circumstances indicate that the book value of an asset may not be recoverable.  We evaluate, at each balance sheet date, whether events and circumstances have occurred which indicate possible impairment.  The carrying value of a long-lived asset is considered impaired when the anticipated cumulative undiscounted cash flows of the related asset or group of assets is less than the carrying value.  In that event, a loss is recognized based on the amount by which the carrying value exceeds the estimated fair market value of the long-lived asset.

  We performed an impairment analysis as of April 30, 2004 in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and determined that the goodwill and intangible assets related to the Vultus technology, which we acquired from Vultus, Inc. (“Vultus”) in June 2003, had been impaired.  We concluded that an impairment-triggering event occurred during the second quarter of fiscal year 2004 as we had a reduction in force that impacted our ability to move the Vultus initiative forward on a stand-alone basis and an anticipated partnership that would have solidified the Vultus revenue and cash flow did not materialize.  Consequently, we concluded that no significant future cash flows related to our Vultus assets would be realized.  As a result of these analyses, we wrote-down the carrying value of our goodwill related to the Vultus acquisition from $1,166,000 to $0 and wrote-down intangible assets related to our Vultus acquisition from $973,000 to $0.

Based on continued declines in our operating results, we performed an additional impairment analysis as of October 31, 2004 and determined that the fair value of our remaining intangible assets was in excess of the current carrying values and that no impairment had occurred.  Judgment from management is required to determine if a triggering event has occurred and in forecasting future operating results.

Write-downs of intangible assets may be necessary if the future fair value of these assets is less than carrying value.  If the operating trends for our UNIX or SCOsource businesses continue to decline we may be required to record an impairment charge in a future period related to the carrying value of our long-lived assets. . . .

(3) ACQUISITIONS

  Vultus

  Under the terms of an Asset Acquisition Agreement (the “Vultus Agreement”) dated June 6, 2003, the Company acquired substantially all of the assets of Vultus, Inc. (“Vultus”), a corporation engaged in the web services interface business.  As consideration for the assets acquired, the Company issued approximately 167,000 shares of the Company’s common stock, of which The Canopy Group, Inc. (“Canopy”), the Company’s principal stockholder as of October 31, 2004, received approximately 37,000 shares.  The Company also assumed approximately $215,000 in accrued liabilities of Vultus.  In addition, the Company assumed the obligations of Vultus under two secured notes payable to Canopy totaling $1,073,000.  In connection with the assumption of the notes payable to Canopy, Canopy agreed to accept the issuance of approximately 138,000 shares of the Company’s common stock in full satisfaction of the obligations.  Canopy was a stockholder and significant debt holder of Vultus.  Neither Canopy nor any of its officers or directors participated in the Company’s approval of this transaction. . . .

The impairment loss related to goodwill and intangible assets acquired in connection with the acquisition of Vultus in June 2003.  The Company concluded that an impairment-triggering event occurred during the three months ended April 30, 2004 as the Company had a reduction in force that impacted the Company’s ability to move the Vultus initiative forward on a stand-alone basis and because an impending partnership that would have solidified the Vultus revenue and cash flow opportunities did not materialize.  Consequently, the Company concluded that no significant future cash flows related to its Vultus assets would be realized.  The Company performed an impairment analysis of its recorded goodwill related to the Vultus reporting unit using a present value of future cash flows model.  Additionally, an impairment analysis of the intangible assets was performed in accordance with SFAS No. 144.  As a result of these analyses, the Company wrote-down the carrying value of its goodwill related to the Vultus acquisition from $1,166,000 to $0 and wrote-down intangible assets related to its Vultus acquisition from $973,000 to $0.

They mention writeoffs for Vultus and Lineo here too, and I can imagine muckrakers digging deeper into those stories:

Management routinely assesses our investments for impairments and adjusts the carrying amounts to estimated realizable values when impairment has occurred.  During fiscal year 2004, we did not have any write-offs of investments.  During fiscal year 2003, in connection with the restructuring of our investment in and relationship with Vista.com, Inc. (“Vista”), we recorded a write-off of our Vista investment and incurred a charge of $250,000.  We had been accounting for our investment in Vista under the equity method of accounting.  

During fiscal year 2002, we determined that the current carrying value of $1,180,000 related to our investment in Lineo, Inc. (“Lineo”) would not be recovered and was written off.  This write-off was due to a significant deterioration in the operating results of Lineo and declines in general economic conditions.  This investment had been accounted for under the cost method.

Re Santa Cruz:

During fiscal year 2002, cash provided by investing activities was $5,287,000, which was primarily generated from the sale of $5,943,000 of available-for-sale securities, offset by an investment in a non-marketable security of $350,000, cash paid for the purchase of equipment of $206,000 and payment of $100,000 to The Santa Cruz Operation. . . .

Our financing activities used $8,998,000 of cash during fiscal year 2002 and consisted primarily of a $5,000,000 payment to retire the note payable to The Santa Cruz Operation and $4,584,000 for the purchase of shares of our common stock held by two investors.  These payments were offset by $291,000 of proceeds received from the exercise of stock options and $295,000 received from employees who purchased shares of our common stock through our employee stock purchase program. . . .

On May 7, 2001, Caldera International, Inc. (“Caldera”) was formed as a holding company to own Caldera Systems and to acquire substantially all of the assets, liabilities and operations of the server and professional services groups of The Santa Cruz Operation, now known as Tarantella, Inc.  The acquired operations from The Santa Cruz Operation developed and marketed server software related to networked business computing and were one of the leading providers of UNIX server operating systems.  In addition, these operations provided professional services related to implementing and maintaining UNIX system software products.  The acquisition provided Caldera with international offices and a distribution channel with resellers throughout the world.  Subsequent to this acquisition, the Company has primarily sold UNIX based products and services. . . .

Stock Buyback from The Santa Cruz Operation and MTI Technology Corp. (“MTI”)  

During the year ended October 31, 2002, the Company bought back an aggregate of 3,615,000 shares of its outstanding common stock from The Santa Cruz Operation in two transactions.  The Company paid an aggregate of $3,514,000 for these shares, or an average of $0.97 per share.  In connection with the repurchase, the Company received and accepted a resignation letter from one of the directors representing The Santa Cruz Operation on the Company’s board of directors.

 

During the year ended October 31, 2002, the Company purchased 1,189,000 shares of its outstanding common stock from MTI for $1,070,000, or $0.90 per share, which represented a premium from the quoted market price.

  The Company has elected to retire the acquired shares and has accordingly reflected the amounts paid as a reduction to stockholders’ equity.    

Re the Compensation Plans:

As discussed elsewhere above in Part II, Item 7 of this Form 10-K and in the section entitled “Recent Sales of Unregistered Securities” above in Part II, Item 5 of this Form 10-K, we issued shares and granted options under our Equity Compensation Plans without complying with registration or qualification requirements under federal securities laws and the securities laws of certain states.  As a result, certain plan participants have a right to rescind their purchases of shares under the Equity Compensation Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations, and we may make a rescission offer to certain of such plan participants subject to obtaining required regulatory approvals.  Additionally, regulatory authorities may require us to pay fines or they may impose other sanctions on us, and we may face other claims by participants other than rescission claims.  

If our potential rescission offer is made and accepted by plan participants holding shares acquired under the Equity Compensation Plans or otherwise entitled to recover damages from us in respect of such shares they have sold, or such plan participants otherwise make rescission claims against us, we could be required to make aggregate payments to these plan participants of up to $528,000 in the aggregate, excluding interest and other possible fees, based upon shares outstanding under the Equity Compensation Plans as of October 31, 2004.

  We may also face additional rescission liability to plan participants holding unexercised stock options in California, Georgia and possibly other states.  Regulatory authorities may require us to pay fines or impose other sanctions on us.  Although we believe that it is reasonably possible that some plan participants holding unexercised options may accept a rescission offer or potentially attempt to enforce a rescission right, we are unable to estimate the number of participants who might pursue rescission or the potential rescission liability we may have to them.  Since any loss is considered reasonably possible but not estimable, we have not recorded a liability for this contingency.  

We may also be required to pay interest and penalties up to statutory limits in connection with Plan participants making rescission claims or in connection with any rescission offer.  We believe that it is reasonably possible that we may be required to pay interest and penalties, but are not able to estimate an amount.  

In the event that cash required to fund operations and strategic initiatives exceeds our current cash resources and cash generated from operations, we will be required to reduce costs and perhaps raise additional capital.  We may not be able to reduce costs in a manner that does not impair our ability to maintain our UNIX business and pursue our SCOsource initiatives.  We may also not be able to raise capital for any number of reasons including those listed under the section “Risk Factors” below.  If additional equity financing is available, it may not be available to us on attractive terms and may be dilutive to our existing stockholders.  In addition, if our stock price declines, we may not be able to access the public equity markets on acceptable terms, if at all.  Our ability to effect acquisitions for stock would also be impaired. . . .

We have issued shares and options under our Equity Compensation Plans that were not exempt from registration or qualification under federal and state securities laws, and, as a result, we may incur liability to repurchase such shares and options and may face additional potential claims under federal and state securities laws. . . .  

  We may face additional rescission liability to plan participants holding unexercised stock options in California, Georgia and possibly other states.  Additionally, federal securities laws do not provide that a rescission offer will terminate a plan participant’s right to rescind a sale of stock that was not registered as required, and our possible rescission offer may not terminate a plan participant’s right to rescind a sale of stock that was not registered as required under federal law.  If we do not make the planned rescission offer to all plan participants, or any or all of the offerees reject the rescission offer, we may continue to be subject to rescission risk under federal and state securities laws. . . .

Accounting Series Release (“ASR”) No. 268 and Emerging Issues Task Force (“EITF”) Topic D-98 require that stock subject to rescission or redemption requirements outside the control of the Company to be classified outside of permanent equity.  The exercise of the rescission right is at the holders’ discretion, but exercise of that right may depend in part on the fair value of the Company’s common stock which is outside of the Company’s and the holders’ control.  Consequently, common stock subject to rescission is classified as temporary equity.  If the Company’s possible rescission offer is made and accepted by plan participants holding shares acquired under the Equity Compensation Plans or otherwise entitled to recover damages from the Company in respect of such shares they have sold, or such plan participants otherwise make rescission claims against the Company, the Company could be required to make aggregate payments to these plan participants of up to $528,000 in the aggregate, excluding interest and other possible fees, based upon approximately 499,000 shares outstanding under the Plans as of October 31, 2004.  

In the event the Company completes a rescission offer or plan participants otherwise exercise rescission rights, any amounts the Company may pay to plan participants, excluding interest and other possible charges, will be deducted from common stock subject to rescission, and, in the event a plan participant declines a rescission offer or otherwise is determined to no longer have a rescission right, any remaining amounts recorded to common stock subject to rescission will be recorded as permanent equity.  

If you have reached this far with me, perhaps you join me in my puzzlement. Why, exactly, is SCO perpetually striving to slow the IBM case down, as it seems to me they have done for a long time? Who benefits from that strategy? I can't see how the company benefits in any way. In fact, it appears the company is hanging on by its fingernails now. So what's the point of it all? Are individuals benefiting?

Re the stock options plans:

There are risks associated with the potential exercise of our outstanding options.  

As of March 15, 2005, we have issued and outstanding options to purchase up to approximately 3,481,000 shares of common stock with an average exercise price of $4.18 per share.  The existence of such rights to acquire common stock at fixed prices may prove a hindrance to our efforts to raise future equity and debt funding, and the exercise of such rights will dilute the percentage ownership interest of our stockholders and may dilute the value of their ownership.  The possible future sale of shares issuable on the exercise of outstanding options could adversely affect the prevailing market price for our common stock.  Further, the holders of the outstanding rights may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us. . . .

The right of our board of directors to authorize additional shares of preferred stock could adversely impact the rights of holders of our common stock.

  Our board of directors currently has the right, with respect to the 5,000,000 shares of our preferred stock, to authorize the issuance of one or more additional series of our preferred stock with such voting, dividend and other rights as our directors determine.  The board of directors can designate new series of preferred stock without the approval of the holders of our common stock. The rights of holders of our common stock may be adversely affected by the rights of any holders of additional shares of preferred stock that may be issued in the future, including without limitation, further dilution of the equity ownership percentage of our holders of common stock and their voting power if we issue preferred stock with voting rights. Additionally, the issuance of preferred stock could make it more difficult for a third party to acquire a majority of our outstanding voting stock. . . .

Stock Options

   During the year ended October 31, 1998, the Company adopted the 1998 Stock Option Plan (the “1998 Plan”) that provided for the granting of nonqualified stock options to purchase shares of common stock.  On December 1, 1999, the Company’s board of directors approved the 1999 Omnibus Stock Incentive Plan (the “1999 Plan”), which was intended to serve as the successor equity incentive program to the 1998 Plan.  The 1999 Plan allows for the grant of awards in the form of incentive and non-qualified stock options, stock appreciation rights, restricted shares, phantom stock and stock bonuses.  Awards may be granted to individuals in the Company’s employ or service.  

On May 16, 2003, the Company’s stockholders approved the 2002 Omnibus Stock Incentive Plan (the “2002 Plan”) upon the recommendation of the board of directors.  The 2002 Plan permits the award of stock options, stock appreciation rights, restricted stock, phantom stock rights, and stock bonuses.  Stock options may have an exercise price equal to, less than, or greater than the fair market value of the common stock on the date of grant, except that the exercise price of incentive stock options must be equal to or greater than the fair market value of the common stock as of the date of grant.

  On April 20, 2004, the Company’s stockholders approved the 2004 Omnibus Stock Incentive Plan (the “2004 Plan”) upon the recommendation of the board of directors.  The 2004 Plan allows for the award of up to 1,500,000 shares of the Company’s common stock and permits the award of stock options, stock appreciation rights, restricted stock, phantom stock rights, and stock bonuses.  The 2004 Plan is administered by the Compensation Committee of the Company’s board of directors.  The Compensation Committee has the ability to determine the terms of the option, the exercise price, the number of shares subject to each option, and the exercisability of the options.  Stock options may have an exercise price equal to, less than, or greater than the fair market value of the common stock on the date of grant, except that the exercise price of incentive stock options must be equal to or greater than the fair market value of the common stock as of the date of grant.  Shares issued pursuant to the 2004 Plan may be authorized and unissued shares, treasury shares or shares acquired by the Company for purposes of the 2004 Plan.

  Under the terms of the 1998, 1999, 2002 and 2004 Plans, options generally expire 10 years from the date of grant or within 90 days of termination.  Options granted under these plans generally vest at 25 percent after the completion of one year of service and then 1/36 per month for the remaining three years and would be fully vested at the end of four years.

  The board may suspend, revise, terminate or amend any of the option plans at any time; provided, however, that stockholder approval must be obtained if and to the extent that the board deems it appropriate to satisfy Section 162(m) of the Code, Section 422 of the Code or the rules of any stock exchange on which the common stock is listed.  No action under the option plans may, without the consent of the participant, reduce the participant’s rights under any outstanding award.

  As of October 31, 2004, 232,000 shares were available for issuance under the 1999 Plan, 452,000 shares were available for issuance under the 2000 Plan, and 1,145,000 shares were available for issuance under the 2004 Plan.  . . .

Restricted Stock Awards

  During the year ended October 31, 2004, the Company did not grant any shares of restricted stock.  During the year ended October 31, 2003, the Company issued 180,000 shares of restricted stock to certain key employees.  The restrictions on the restricted stock awards granted to key employees lapse over a period of 24 months.  The fair value of the restricted stock awards granted was approximately $374,000.  The fair value of the restricted stock awards was recorded as a component of deferred compensation and is amortized to stock-based compensation as the restrictions lapse.  Additionally in 2003, the Company’s board of directors approved a resolution to receive remaining amounts owed to them for services provided during the year ended October 31, 2002 fiscal year in the form of restricted stock awards.  The Company issued 27,500 shares of common stock with a fair value of $36,000 that was expensed as a component of options and shares for services in the above table.  Finally, the Company granted 150,000 shares of restricted common stock to members of the Company’s board of directors with a fair value of $195,000 and was recorded as a component of deferred compensation.  The restricted common stock issued to the board of directors was in lieu of cash compensation for their services to the Company during fiscal year 2003 and the restrictions lapsed on October 31, 2003.  

During the year ended October 31, 2002, the Company issued 450,000 shares of restricted stock to certain key employees.  The restrictions related to the restricted stock awards lapse over a period of 24 months.  The fair value of the restricted stock awards granted of $495,000 was recorded as a component of deferred compensation and is amortized to stock-based compensation as the restrictions lapse. . . .

Repurchase of Common Stock  

On March 10, 2004, the Company’s board of directors authorized management, in its discretion, to purchase up to 1,500,000 shares of the Company’s common stock over the 24-month period following March 10, 2004, the time at which the repurchase program was effective.  Any repurchased shares will be held in treasury and will be available for general corporate purposes.  The repurchase program will allow the Company to repurchase its shares from time to time in accordance with the requirements of the Securities and Exchange Commission on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors.  During the year ended October 31, 2004, the Company purchased approximately 290,000 shares of its common stock at a total cost of approximately $2,414,000. . . .

(12) RELATED PARTY TRANSACTIONS  

Canopy  

As of October 31, 2004, the chairman of the Company’s board of directors was the president and chief executive officer and a director of Canopy.  Additionally, another director of the Company was the chief financial officer of Canopy.  As of October 31, 2004, Canopy owned approximately 31 percent of the Company’s issued and outstanding common stock.  As described in more detail in Note 16, Canopy transferred all of its shares of common stock effective March 11, 2005.  

In connection with the Company’s acquisition of Vultus (see Note 3), the Company assumed the obligations of Vultus under two secured notes payable to Canopy totaling $1,073,000.  In connection with the assumption of the notes payable to Canopy, Canopy agreed to accept the issuance of approximately 138,000 shares of the Company’s common stock in full satisfaction of the obligations.  The Company also issued Canopy approximately 37,000 shares of its common stock as part of the purchase price for the acquisition.  Canopy was a stockholder and significant debt holder of Vultus.  

On April 30, 2003, the Company and Center 7, Inc. (“C7”) entered into a Marketing and Distribution Master Agreement (the “Marketing Agreement”) and an Assignment Agreement.  On October 2, 2003, C7 assigned the Assignment Agreement to Vintela, Inc. (“Vintela”) and Vintela and the Company entered into a new marketing agreement (the “Vintela Agreement”).  Both C7 and Vintela are majority owned by Canopy.  Under the Vintela Agreement, the Company was appointed as a worldwide distributor for Vintela products to co-brand, market and distribute these products.  

Under the Assignment Agreement, the Company assigned the copyright applications, patents and contracts related to Volution Manager, Volution Authentication, Volution Online and Volution Manager Update Service (collectively, the “Assigned Software”).  As consideration for this assignment, C7 issued and Vintela assumed, a $500,000 non-recourse promissory note payable to the Company, secured by the Assigned Software.  This note was originally due on April 30, 2005 with interest payable at a rate of one percent above the prime rate as reported in the Wall Street Journal.  

In November 2004, the Company and Vintela began discussions to cancel the Vintela Agreement and to pay the promissory note early.  On December 1, 2004, the Company agreed with Vintela, the successor to C7, to forego any interest charges on the promissory note in return for an immediate payment of the $500,000 and the cancellation of the Vintela Agreement.  On December 9, 2004, the Company received the $500,000 payment from Vintela and will record the transaction during the three months ending January 31, 2005.  

During the time the Company was developing the Assigned Software, it had expensed all amounts for its research and development efforts.  As a result, at the time the promissory note was executed, the Company had no recorded basis in the Assigned Software.  Because the transfer of the Assigned Software was to a related party in exchange for a promissory note and there was substantial doubt as to the ability of C7 to pay the note, no gain was recognized by the Company until payment was received on December 9, 2004.  

Re Improved Controls and Procedures:

Item 9A.  Controls and Procedures

  Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, and subsequent evaluations, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report and as a result of the material weakness in our internal controls described below, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms.  

We have a material weakness with respect to accounting for capital stock and stock option transactions.  We have issued certain shares of our common stock under our equity compensation plans without complying with the registration requirements of federal and applicable state securities laws.  As a result, the holders of such shares may have a rescission right, and, consequently, certain amounts the Company received upon purchase of such shares must be reclassified from permanent equity to temporary equity.  As of October 31, 2004 we recorded temporary equity of $528,000 related to certain shares of common stock issued under the Company’s equity compensation plans that are subject to rescission.  We determined that we lacked procedures to reconcile shares issued with shares available under registration statements in a timely manner.

  In addition, we incorrectly accounted for dividends on Series A Convertible Preferred Stock by not recording dividends payable as of January 31, 2004 and April 30, 2004.  We also incorrectly accounted for compensation expense by not properly accounting for a non-routine stock option grant to a non-employee.  Neither of the above mentioned matters impacted the financial statements as of and for the year ended October 31, 2004.  We determined that we lacked resources with proper experience to review the Company’s accounting for capital stock and stock option transactions.  

Our internal controls over financial reporting did not identify the preceding error prior to the completion of the financial statements.  We have discussed these matters with the Audit Committee of the Board of Directors and with KPMG LLP, our independent auditors.  In response, we have implemented in our internal control procedures additional detail transactional controls, an equity compliance checklist and additional review and approval procedures.  

During the most recent quarter ended October 31, 2004, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.  However, as discussed above, changes have been implemented subsequent to the period covered by this Form 10-K to add additional controls to correct the material weakness in internal control over financial reporting.

Re Executive Compensation

We learn that Chris Sontag has a new title, as of January, Senior Vice President, Business Development. He was, as you'll recall, Senior VP of SCOsource. Darl McBride is making less this year than he did last year, as is SCO, now that I think of it. He earned $257,498 in salary and got $35,000 as a bonus paid for work done in 2003. In that year, he earned a salary of $230,769, less than for 2004, but he got bonuses and commisions totaling $755,278, restricted stock awards worth $78,511 and "Securities Underlying Options -- 200,000." So his better year was 2003, the heady time period with Microsoft and Sun coughed up money galore. In 2002, his salary was only $80,525 for a partial year with SCO, beginning in June, but it also lists "Securities Underlying Options - 2002 - 600,000":

Mr. McBride was hired as our President and Chief Executive Officer in June 2002.  With respect to 200,000 options issued to Mr. McBride during fiscal year 2002, vesting commences five years after the date of grant, subject to acceleration of vesting if certain performance objectives are achieved.  One such objective was our becoming profitable before the fourth quarter of fiscal year 2003, which in fact occurred.  Accordingly, Mr. McBride is now vested as to 50,000 shares related to such grant.  The bonus of $35,000 earned by Mr. McBride in fiscal year 2004 was paid during fiscal year 2005.  Of the $755,278 bonus earned by Mr. McBride in fiscal year 2003, $480,134 was paid during fiscal year 2003 and the remaining $275,144 was paid during fiscal year 2004. . . .

Option Grants in Last Fiscal Year. . . .

On December 8, 2004, each of the above named executive officers received an option grant to acquire common shares at an exercise price of $4.85 per share.  Mr. McBride received a grant of 100,000 shares; Mr. Young received a grant of 150,000 shares; Mr. Sontag received a grant of 25,000 shares; Mr. Hunsaker received a grant of 25,000 shares; and Mr. Tibbitts received a grant of 150,000 shares. . . .

CEO Compensation. 

In reviewing and setting the total compensation of the Company’s Chief Executive Officer for the 2004 fiscal year, the Compensation Committee sought to make that compensation competitive, while at the same time assuring that a significant percentage of compensation was tied to the Company’s performance.  The Compensation Committee reviewed the national and regional compensation surveys described above for chief executive officers of comparable software companies to determine an appropriate compensation level.  During fiscal year 2004, the base salary for Darl McBride, the Company’s Chief Executive Officer, was $257,498.  Mr. McBride received an annual performance bonus of $35,000 for fiscal year 2004 that was paid in the first quarter of fiscal year 2005.  Mr. McBride earned this bonus as a result of attaining specific objectives focused on the Company’s intellectual property litigation being managed effectively, resolving and simplifying the Company’s capital structure and restoring the Company’s UNIX division to operating profitability.  

Mr. McBride did not receive an option grant in fiscal year 2004.  However, in the first quarter of fiscal year 2005, he was awarded an option to purchase 100,000 shares of the Company’s common stock at an exercise price of $4.85 per share. This option vests over four years, although vesting accelerates upon a change in control of the Company.  As was the case for the other executives, this award was determined based upon Mr. McBride’s current equity holdings in the Company and related vesting to maintain alignment of his interests with the stockholders generally.

On a chart, you find the following:

Number of Shares Underlying
Unexercised Options at
October 31, 2004

  Exercisable 362,499
  Unexercisable 437,501

Value of Unexercised
In-the-Money Options at
October 31, 2004

  Exercisable 701,040
  Unexercisable 812,960

Re Stockholders:

The principal stockholders now are Ralph Yarro, of course, with 31.4%, BayStar, which now has 9.7%, Royce & Associates, at 7.3%, and Capital Guardian Trust Company, at 8.1%. McBride has 2.4%, which they itemize in a footnote:

Consists of 7,003 shares of restricted common stock, 8,000 shares of common stock acquired in an open-market purchase, 3,615 shares of common stock acquired through our Employee Stock Purchase Plan, 100 shares of common stock, and options to purchase 437,499 shares of common stock.

Re Code of Ethics:

Finally, SCO has put up a code of ethics, which applies to the board members too, which you can find here on SCO's website [PDF]. Keeping Thumper's advice from the movie "Bambi" firmly in mind, I will just say the nicest thing I can think of, "Better late than never."

Those are my highlights, and I hope categorizing it all was helpful to you. As you know, I'm no bean counter, so I'll leave interpretations on that to others better qualified than I.


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