(Exact name of registrant as specified in its charter)
Delaware
87-0662823
(State or other jurisdiction of
(I.R.S. Employer Identification Number)
incorporation or organization)
355 South 520 West
Suite 100 Lindon, Utah84042
(Address of principal executive offices and zip code)
(801) 765-4999
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES þ NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a
non-accelerated filer, or a smaller reporting company. See definition of “large accelerated
filer,”“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
(Check One):
Large accelerated filer o
Accelerated filer
o
Non-accelerated filer o
Smaller reporting company
þ
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). (Check one): YES o NO þ
As of June 9, 2008, there were 21,886,288 shares of the Registrant’s common stock, $0.001 par value
per share, outstanding.
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(1) ORGANIZATION AND DESCRIPTION OF BUSINESS
The business of The SCO Group, Inc. (the “Company”) focuses on marketing reliable,
cost-effective UNIX software products and related services for the small-to-medium sized business
market, including replicated site franchises of Fortune 1000 companies. In 2003, the Company
established its SCOsource business to market, protect and defend its intellectual property
surrounding the UNIX operating system which it acquired in 2001 from The Santa Cruz Operation
(“Santa Cruz”), which changed its name to Tarantella, Inc., and was subsequently acquired by Sun
Microsystems.
The Company incurred a net loss of $3,558,000 for the six months ended April 30, 2008, and
during that same period used cash of $2,459,000 in its operating activities. As of April 30, 2008,
the Company had a total of $3,162,000 in cash and $3,131,000 in restricted cash, of which
$1,739,000 is designated to pay for experts, consultants and other expenses in connection with the
litigation between the Company and IBM, Novell and Red Hat (the “SCO Litigation”), and the
remaining $1,392,000 of restricted cash is payable to Novell for its retained binary royalty
stream.
On August 10, 2007, the federal judge overseeing the Company’s lawsuit with Novell, Inc.
(“Novell”) ruled in favor of Novell on several of the summary judgment motions that were before the
United States District Court in Utah (the “Court”). The effect of these rulings was to
significantly reduce or to eliminate certain of the Company’s claims in both the Novell and IBM
cases, and possibly others (the “SCO Litigation”). The Court ruled that Novell was the owner of
the UNIX and UnixWare copyrights that existed at the time of the 1995 Asset Purchase Agreement
between Novell and Santa Cruz (the “APA”), and that Novell retained broad rights to waive the
Company’s contract claims against IBM. The Court ruled that the Company owns the copyrights to
post-APA UnixWare derivatives and that the Company has certain other ownership rights in the UNIX
technology. The Company was directed to accept Novell’s waiver of its UNIX contract claims against
IBM. In addition, the Court determined that certain SCOsource licensing agreements that the
Company executed in fiscal year 2003 and thereafter included older SVRx licenses and that the
Company was possibly required to remit some portion of the proceeds to Novell. Over the Company’s
objection, a bench trial was set to begin on September 17, 2007 and the federal judge was to
determine what portion, if any, of the proceeds of the SCOsource agreements is attributable to such
SVRx licenses and should be remitted to Novell, as well as whether SCO had authority to enter into
such SVRx licenses. Based on Novell’s allegations, the potential payment to Novell for those SVRx
licenses ranges from a de minimis amount to in excess of $30,000,000, the latter amount being the
amount claimed by Novell, plus interest. (A few days before the rescheduled trial Novell reduced
the principal amount it was claiming to under $20,000,000.) Novell also sought to impose a
constructive trust on the Company’s current funds traceable to the SCOsource agreements at issue,
which relief could result in a freeze of the Company’s assets, and the Court indicated that it
would address that issue as well.
The trial of these issues, however, was automatically stayed as a result of the Company’s
filing a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (the
“Bankruptcy Code”) in the United States Bankruptcy Court for the District of Delaware (the
“Bankruptcy Court”) on September 14, 2007. On October 4, 2007, Novell filed a Motion for Relief
from Automatic Stay. On November 27, 2007, the Bankruptcy Court lifted the stay to permit Novell
to pursue the trial scheduled in the Court on the allocation of proceeds from the
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
SCOsource
agreements and the question of SCO’s alleged lack of authority to enter into them, but the
Bankruptcy Court retained jurisdiction to determine whether to impose a constructive trust on any
amounts found to be payable to Novell. Upon the partial lifting of the automatic stay, the Court
scheduled a four-day trial to start on April 29, 2008 on the issues for which the Bankruptcy Court
lifted the stay.
From April 29 through May 2, 2008, the Court held a bench trial on Novell’s monetary claim for
certain portions of fees SCO received from the SCOsource agreements and on whether SCO had the
authority to enter into those agreements. Prior to the commencement of the trial, Novell conceded
that it would not be making a claim to a portion of the fees paid to SCO by Microsoft in 2003 and
Novell therefore reduced the principal amount of its claim to $19,979,561. After the trial and
arguments, the Court took all matters under advisement and stated it would attempt to issue a
ruling without undue delay. It is unknown when these rulings will be issued.
It is the Company’s intent to appeal the adverse August 10, 2007 summary judgment ruling as
soon as that opportunity is available to the Company. However, the Company must complete further
legal proceedings before it can take such an appeal. In the event that any substantial amount of
the Company’s assets are frozen or if its assets or resources are further depleted, the Company may
not be able to appeal the August 10, 2007 ruling.
The Company’s management and Board of Directors determined that filing for relief under
Chapter 11 of the United States Bankruptcy Code was appropriate and necessary. As a result of both
the Court’s August 10, 2007 order and the Company’s entry into Chapter 11, among other factors,
there is substantial doubt about the Company’s ability to continue as a going concern including
continuing the SCO Litigation or appealing the adverse ruling of August 10, 2007.
The accompanying financial statements do not include any adjustments that might result from
the outcome of these uncertainties. Absent a significant cash payment to Novell being required by
the final resolution for this matter, management believes that the undiscounted future cash flows
generated by the Company will be sufficient to recover the carrying values of the Company’s
long-lived assets over their expected remaining useful lives. However, if a significant cash
payment is required, or significant assets are put under a constructive trust, the carrying amount
of the Company’s long-lived assets may not be recovered.
Bankruptcy Filing
On September 14, 2007, the Company and its wholly owned subsidiary, SCO Operations, Inc.
(collectively the “Debtors”), filed voluntary petitions for relief under Chapter 11 of the United
States Bankruptcy Code in the Bankruptcy Court. The Debtors’ Chapter 11 cases are being jointly
administered under Case No. 07-11337 (KG). The Debtors continue to operate their businesses as
“debtors-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the
applicable provisions of the Bankruptcy Code and orders of the Bankruptcy Court. The Company’s
foreign subsidiaries were not included in the filings and will continue their business operations.
The Company’s foreign subsidiaries, as non-debtors, are not subject to the requirements of the
Bankruptcy Code and are not subject to Bankruptcy Court supervision.
In connection with the cases, the Debtors filed motions with the Bankruptcy Court requesting, among
other things, the ability to maintain their existing bank accounts and cash management systems,
permission to pay pre-bankruptcy wage-related items, the establishment of procedures relating to
utility providers and authority to employ temporary employees, in an
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
effort to minimize any disruption the filings might otherwise cause. On September 18, 2007, the
Bankruptcy Court granted the relief requested. As debtors-in-possession, the Debtors continue to
exercise control over their assets and business, subject to the supervision of the Bankruptcy Court
and the requirements under the Bankruptcy Code and Bankruptcy Rules.
As a result of the Chapter 11 filings, realization of assets and liquidation of liabilities
are subject to uncertainty. While operating as debtors-in-possession under the protection of
Chapter 11 of the Bankruptcy Code, the Debtors may sell or otherwise dispose of assets and
liquidate or settle liabilities for amounts other than those reflected in the consolidated
financial statements, in the ordinary course of business, or, if outside the ordinary course of
business, subject to Bankruptcy Court approval.
On February 29, 2008, the Debtors filed their joint Chapter 11 Plan of Reorganization (the
“Plan”) and Disclosure Statement in Connection with the Plan (the “Disclosure Statement”). A
hearing to approve the adequacy of the Disclosure Statement was scheduled before the Bankruptcy
Court on April 2, 2008. The April 2, 2008 hearing proceeded as a status conference regarding the
Debtors’ progress towards a new Memorandum of Understanding (“MOU”) with Stephen Norris Capital
Partners, LLC. Therefore, the Debtors indicated that they were not presently seeking approval of
the adequacy of the Disclosure Statement, which would need to be amended to reflect the changes to
the MOU.
On May 12, 2008, the Debtors filed a motion seeking an extension of their exclusive periods to
submit and solicit acceptances of a plan of reorganization to August 11 and October 13, 2008,
respectively. A hearing to consider that motion is scheduled for June 17, 2008. If our motion is
denied, creditors may file their own proposed plans of reorganization, which might not provide for
as favorable treatment to the Company’s equity securities as the Company plan.
Under the priority scheme established by the Bankruptcy Code, unless creditors agree
otherwise, post-petition liabilities and prepetition liabilities must be satisfied in full before
stockholders are entitled to receive any distribution or retain any property under a plan of
reorganization. The ultimate recovery to creditors and/or stockholders, if any, will not be
determined until confirmation of a plan or plans of reorganization. No assurance can be given as
to what values, if any, will be ascribed in the Chapter 11 cases to each of these constituencies or
what types or amounts of distributions, if any, they would receive, or as to the timing of such
distributions if any. A plan of reorganization could result in holders of the Company’s stock
receiving no distribution on account of their interests and cancellation of their existing stock.
If certain requirements of the Bankruptcy Code are met, a plan of reorganization can be confirmed
notwithstanding its rejection by the class comprising the interests of the Company’s equity
security holders.
Under the supervision of the Bankruptcy Court, management may decide to pursue various
strategic alternatives as deemed appropriate by the Company’s Board of Directors to serve the best
interests of the Company and its stakeholders, including asset sales or strategic partnerships.
Going Concern
The Debtors are operating pursuant to Chapter 11 of the Bankruptcy Code and continuation of
the Company as a going concern is contingent upon, among other things, the Debtors’ ability to (i)
construct and obtain confirmation of a plan of reorganization under the
Bankruptcy Code; (ii) reduce payroll and benefits costs and liabilities under the bankruptcy
process; (iii) achieve profitability; (iv) achieve sufficient cash flows from operating activities;
and
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
(v) obtain financing sources to meet the Company’s future obligations. These matters as well
as the aforementioned ruling in favor of Novell create substantial doubt about the Company’s
ability to continue as a going concern. The accompanying condensed consolidated financial
statements do not reflect any adjustments relating to the recoverability of assets and the
classification of liabilities that might result from the outcome of these uncertainties. In
addition, a plan of reorganization could materially change the amounts and classifications reported
in the condensed consolidated financial statements which do not give effect to any adjustments to
the carrying values of assets or amounts of liabilities that might be necessary as a consequence of
confirmation of a plan or reorganization.
(2) SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of the Company have
been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange
Commission (“SEC”) on a basis consistent with the Company’s annual consolidated financial
statements and, in the opinion of management, reflect all adjustments, consisting only of normal
recurring adjustments, necessary to present fairly the financial information set forth therein.
Certain information and note disclosures normally included in financial statements prepared in
accordance with U.S. generally accepted accounting principles have been condensed or omitted
pursuant to SEC rules and regulations, although the Company believes that the following
disclosures, when read in conjunction with the annual consolidated financial statements and the
notes thereto included in the Company’s most recent annual report on Form 10-K, are adequate to
make the information presented not misleading.
American Institute of Certified Public Accountants Statement of Position (“SOP”) 90-7,
Financial Reporting by Entities in Reorganization under Bankruptcy Code, which is applicable to
companies under Chapter 11 of the Bankruptcy Code, generally does not change the manner in which
financial statements are prepared. It does, however, require among other disclosures that the
financial statements for periods subsequent to the filing of the Chapter 11 petition distinguish
transactions and events that are directly associated with the reorganization from the ongoing
operations of the business. Revenues, expenses, realized gains and losses, and provisions for
losses that can be directly associated with the reorganization and restructuring of the business
must be reported separately as reorganization items in the statements of operations. The balance
sheet must distinguish prepetition liabilities subject to compromise from both those prepetition
liabilities that are not subject to compromise and from post-petition liabilities. Liabilities
that may be affected by a plan of reorganization must be reported at the amounts expected to be
allowed, even if they may be settled for lesser amounts. In addition, reorganization items must be
disclosed separately in the statement of cash flows.
Operating results for the six months ended April 30, 2008 are not necessarily indicative of
the operating results that may be expected for the year ending October 31, 2008.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with U.S. generally accepted accounting
principles requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues and expenses during
the
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
reporting periods. Actual results could differ from these estimates. The Company’s critical
accounting policies and estimates include: revenue recognition, allowances for doubtful accounts
receivable, useful lives and impairment of long-lived assets, litigation reserves, and valuation
allowances against deferred income tax assets.
Revenue Recognition
The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2, as
modified by SOP 98-9. The Company’s revenue has historically been from three sources: (i) product
license revenue, primarily from product sales to resellers, end users and original equipment
manufacturers (“OEMs”); (ii) technical support service revenue, primarily from providing technical
support and consulting services to end users; and (iii) revenue from SCOsource licensing.
The Company recognizes product revenue upon shipment if a signed contract exists, the fee is
fixed or determinable, collection of the resulting receivable is probable and product returns are
reasonably estimable.
The majority of the Company’s revenue transactions relate to product-only sales. On occasion,
the Company has revenue transactions that have multiple elements (such as software products,
maintenance, technical support services, and other services). For software agreements that have
multiple elements, the Company allocates revenue to each component of the contract based on the
relative fair value of the elements. The fair value of each element is based on vendor specific
objective evidence (“VSOE”). VSOE is established when such elements are sold separately. The
Company recognizes revenue when the criteria for product revenue recognition set forth above have
been met. If VSOE of all undelivered elements exists, but VSOE does not exist for one or more
delivered elements, then revenue is recognized using the residual method. Under the residual
method, the fair value of the undelivered elements is deferred and the remaining portion of the
license fee is recognized as revenue in the period when persuasive evidence of an arrangement is
obtained assuming all other revenue recognition criteria are met.
The Company recognizes product revenue from OEMs when the software is sold by the OEM to an
end-user customer. Revenue from technical support services and consulting services is recognized
as the related services are performed. Revenue for maintenance is recognized ratably over the
maintenance period.
The Company considers an arrangement with payment terms longer than the Company’s normal
business practice not to be fixed or determinable and revenue is recognized when the fee becomes
due. The Company typically provides stock rotation rights for sales made through its distribution
channel and sales to distributors are recognized upon shipment by the distributor to end users.
For direct sales not through the Company’s distribution channel, sales are typically non-refundable
and non-cancelable and revenue is recognized upon shipment. The Company estimates its product
returns based on historical experience and maintains an allowance for estimated returns, which is
recorded as a reduction to accounts receivable and revenue.
The Company’s SCOsource revenue to date has been primarily generated from agreements to
utilize the Company’s UNIX source code as well as from intellectual property agreements. The
Company recognizes revenue from SCOsource agreements when a signed contract exists, the fee is
fixed or determinable, collection of the receivable is probable and delivery has occurred. If the
payment terms extend beyond the Company’s normal payment terms, revenue is recognized as the
payments become due.
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
Cash and Cash Equivalents
The Company considers all investments purchased with original maturities of three or fewer
months to be cash equivalents. Cash equivalents were $0 and $1,926,000 as of April 30, 2008 and
October 31, 2007, respectively. Cash was $3,162,000 and $3,628,000 as of April 30, 2008 and
October 31, 2007, respectively. The Company has $100,000 of cash that is federally insured. All
remaining amounts of cash and restricted cash as of April 30, 2008 exceed federally insured limits.
Net Loss Per Common Share
Basic net income or loss per common share (“Basic EPS”) is computed by dividing net income or
loss by the weighted average number of common shares outstanding. Diluted net income or loss per
common share (“Diluted EPS”) is computed by dividing net income or loss by the sum of the weighted
average number of common shares outstanding and the dilutive potential common share equivalents
then outstanding. Potential common share equivalents consist of the weighted average number of
shares issuable upon the exercise of outstanding stock options and warrants to acquire common
stock. If dilutive, the Company computes Diluted EPS using the treasury stock method.
Due to the fact that for all periods presented the Company has incurred net losses, common
share equivalents of 4,380,000 and 5,915,000 for the three and six months ended April 30, 2008 and
2007, respectively, are not included in the calculation of diluted net loss per common share
because they are anti-dilutive.
(3) COMMITMENTS AND CONTINGENCIES
Litigation
IBM
On or about March 6, 2003, the Company filed a civil complaint against IBM. The case is
pending in the United States District Court for the District of Utah, styled The SCO Group, Inc. v.
International Business Machines Corporation, Civil No. 2:03CV0294. In this action, the Company
claims that IBM breached its UNIX source code licenses (both the IBM and Sequent Computer Systems,
Inc. (“Sequent”) licenses) by disclosing restricted information concerning the UNIX source code and
derivative works and related information in connection with IBM’s efforts to promote the Linux
operating system. The Company’s complaint includes, among other things, claims for breach of
contract, unfair competition, tortious interference and copyright infringement. The Company is
seeking damages in an amount to be proved at trial and injunctive relief.
On or about March 6, 2003, the Company notified IBM that IBM was not in compliance with the
Company’s UNIX source code license agreement and on or about June 13, 2003, the Company delivered
to IBM a notice of termination of that agreement, which underlies IBM’s AIX software. On or about
August 11, 2003, the Company sent a similar notice terminating the Sequent source code license.
IBM disputes the Company’s right to terminate those licenses. In
the event the Company’s termination of those licenses is valid and not ultimately defeated by
Novell’s claims, the Company believes IBM is exposed to substantial damages and injunctive
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
relief claims based on its continued use and distribution of the AIX operating system. On
June 9, 2003, Novell sent the Company a notice purporting to waive the Company’s claims against IBM
regarding its license breaches.
On February 27, 2004, the Company filed a second amended complaint which alleges nine causes
of action that are similar to those set forth above, added a new claim for copyright infringement,
and removed the claim for misappropriation of trade secrets. IBM filed an answer and 14
counterclaims. Among other things, IBM asserted that the Company does not have the right to
terminate IBM’s UNIX licenses and claimed that the Company breached the GNU General Public License
and infringed certain patents held by IBM. IBM’s counterclaims include claims for breach of
contract, violation of the Lanham Act, unfair competition, intentional interference with
prospective economic relations, unfair and deceptive trade practices, promissory estoppel, patent
infringement and a declaratory judgment claim for non-infringement of copyrights. On October 6,2005, IBM voluntarily dismissed with prejudice its claims for patent infringement.
On December 22, 2005, the Company filed a voluminous report detailing IBM’s misuse of the
Company’s proprietary material (the “December 2005 Submission”). The Company’s December 2005
Submission included 293 total disclosures, which the Company claims violate its contractual rights
and copyrights. The December 2005 Submission and the disclosures identified therein are the result
of analysis by experienced outside technical consultants.
On February 13, 2006, IBM filed a motion with the Court seeking to limit the Company’s claims
as set forth in the December 2005 Submission. IBM argued that, of the 293 items the Company had
identified, 201 did not meet the level of specificity required by the Court. IBM requested that
the Company be limited to 93 items set forth in the December 2005 Submission, which IBM claimed
meet the required level of specificity. On June 28, 2006, the Magistrate Judge issued a ruling
striking over 180 of the technology disclosures identified in the December 2005 Submission. This
ruling is a limitation on the number of technology disclosures the Company made in its December
2005 Submission, but means that over 100 of the challenged items remain in the case. On July 13,2006, the Company filed objections to the Magistrate Judge’s order with the Court; those objections
challenged the process and the result embodied in the Magistrate Judge’s order. On November 29,2006, the Court affirmed the Magistrate Judge’s order of June 28, 2006. The Company filed a motion
to reconsider the Court’s ruling and a motion to amend the December 2005 Submission. The District
Judge has not ruled on these motions.
On June 8, 2006, IBM filed a motion to confine the Company’s claims to, and strike allegations
in excess of, the December 2005 Submission. In this motion, IBM claims that the Company’s
technology expert reports go beyond the disclosures contained in the Company’s December 2005
Submission and that those expert reports should be restricted to that extent. On December 21,2006, the Magistrate Judge granted IBM’s motion. The Company filed objections to that ruling with
the Court. The District Judge has not ruled on these objections.
Both parties have filed expert reports and substantially finished expert discovery. IBM filed
six motions for summary judgment that, if granted in whole or in substantial part, could resolve
the Company’s claims in IBM’s favor or substantially reduce the Company’s claims. The Company
filed three motions for summary judgment.
As a result of the Court’s order of August 10, 2007, in the SCO v. Novell case, several of the
Company’s claims against IBM may be dismissed. These claims include its claims that IBM
breached its UNIX license agreements and the Company’s claims arising from its termination of IBM’s
UNIX licenses. The Company believes that the Court’s August 10, 2007 ruling does not
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
resolve certain claims in the case, or aspects of those claims, including the Company’s claim
for unfair competition arising out of the Project Monterey initiative in the late 1990’s. IBM has
taken the position that the Court’s order of August 10, 2007 in the Novell case resolves all of the
Company’s claims against IBM in IBM’s favor. The Company disputes this position. IBM’s
counterclaims against the Company remain in the case subject to pending motions for summary
judgment.
Proceedings in the SCO v. IBM matter were automatically stayed as a result of the Company’s
filing a voluntary petition for relief under Chapter 11 of the Bankruptcy Code on September 14,2007.
Novell, Inc.
On January 20, 2004, the Company filed suit in Court against Novell, Inc. for slander of title
seeking relief for its alleged bad faith effort to interfere with the Company’s ownership of
copyrights related to the Company’s UNIX source code and derivative works and the Company’s
UnixWare product. The case is pending in the Court under the caption, The SCO Group, Inc. v.
Novell, Inc., Civil No. 2:04CV00139. In the lawsuit, the Company requested preliminary and
permanent injunctive relief as well as damages. Through these claims, the Company seeks to require
Novell to assign to the Company all copyrights that the Company believes Novell has wrongfully
registered, to prevent Novell from claiming any ownership interest in those copyrights, and to
require Novell to retract or withdraw all representations it has made regarding its purported
ownership of those copyrights and UNIX itself.
Novell filed two motions to dismiss claiming, among other things, that Novell’s false
statements were not issued with malice and are privileged under the law. The Court denied both
motions. On July 29, 2005, Novell filed its answer and counterclaims against the Company,
asserting counterclaims for the Company’s alleged breaches of the 1995 Asset Purchase Agreement
between Novell and the Company’s predecessor-in-interest, The Santa Cruz Operation (the “APA”), for
slander of title, restitution/unjust enrichment, an accounting related to Novell’s retained
interest in SRVx royalties, and for declaratory relief regarding Novell’s alleged rights under the
APA. On or about December 30, 2005, the Company filed a motion for leave to amend its complaint to
assert additional claims against Novell including copyright infringement, unfair competition and a
breach of Novell’s limited license to use the Company’s UNIX code. Novell consented to the
Company’s filing of these additional claims.
On or about April 10, 2006, Novell filed a motion to stay the case in Utah pending a request
for arbitration that Novell and its subsidiary SuSE Linux, GmbH (“SuSE”) filed on the same date in
the International Court of Arbitration. Through these proceedings, Novell claims that the Company
granted SuSE the right to use UNIX intellectual property through the Company’s participation in the
UnitedLinux initiative in 2002 and that, through its acquisition of SuSE, Novell acquired SuSE’s
rights as a member of UnitedLinux. On August 21, 2006, the District Court ordered that portions of
claims related to SuSE should be stayed pending the arbitration but that the other portions of
claims in the case should proceed.
The three-person arbitration panel has been selected for the SuSE arbitration but that process
has been stayed by the Bankruptcy Court in Delaware, as explained below.
In September 2006, Novell filed an Amended Counterclaim asserting nine claims for relief
including, among other things, claims for slander of title, breach of contract, declaratory relief
and claims for an accounting and for a constructive trust over certain revenue the Company
collected from Sun and Microsoft in 2003. In September 2006, Novell also filed a motion for
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
summary judgment or a preliminary injunction, asking the Court to rule that Novell was
entitled to that revenue under the APA. The Company opposed the motion and filed a cross-motion
for summary judgment or partial summary judgment. Those motions were argued before the Court on
January 23, 2007.
On December 1, 2006, Novell also filed a motion for summary judgment on its Fourth
Counterclaim, asking the Court to rule that Novell had retained broad waiver rights and other
rights over SVRx Licenses it transferred under the 1995 Asset Purchase Agreement. With its
opposition to this motion, the Company filed its own cross-motion for summary judgment, asking the
Court to rule that the rights Novell retained under the APA are much narrower than Novell claims.
On April 9, 2007, the Company filed a Motion for Partial Summary Judgment on Its First,
Second, and Fifth Causes of Action and for Summary Judgment on Novell’s First Counterclaim, arguing
that Novell transferred the UNIX and UnixWare copyrights under the plain language of the amended
Asset Purchase Agreement, as confirmed by testimony of at least nine witnesses, including Novell’s
own CEO at the time of the Agreement. On April 20, 2007, Novell filed motions for summary judgment
asking the Court to rule that Novell retained the UNIX and UnixWare copyrights under the APA, that
the Company did not meet its burden of establishing special damages on its slander of title claim,
and that the portion of the Company’s contract and unfair-competition claims based on non-compete
provisions in the APA and a related agreement should not proceed to a jury trial. On May 31 and
June 4, 2007, the Court heard oral argument on these motions and the pending motion and
cross-motion for summary judgment on Novell’s Fourth Counterclaim, taking the motions under
advisement.
On August 10, 2007, the Court ruled in favor of Novell on several of the summary judgment
motions that were pending. The effect of these rulings was to significantly reduce or to eliminate
certain of the Company’s claims in both the Novell and IBM cases, and possibly others. The Court
ruled that Novell was the owner of the UNIX and UnixWare copyrights that existed at the time of the
APA and that Novell retained broad rights to waive the Company’s contract claims against IBM. The
Court also ruled that the Company owns the copyrights to post-APA UnixWare derivatives and that the
Company has certain other ownership rights in the UNIX technology. The Company was directed to
accept Novell’s waiver of its UNIX contract claims against IBM. In addition, the Court determined
that certain SCOsource licensing agreements that the Company executed in fiscal year 2003 and
thereafter included older SVRx licenses and that the Company was possibly required to remit some
portion of the proceeds to Novell. Over the Company’s objection, a bench trial was set to begin on
September 17, 2007, and the federal judge was to determine what portion, if any, of the proceeds of
the SCOsource agreements is attributable to such SVRx licenses and should be remitted to Novell, as
well as whether SCO had authority to enter into such SVRx licenses. Based on Novell’s allegations,
the potential payment to Novell for those SVRx licenses ranged from a de minimis amount to in
excess of $30,000,000, the latter amount being the amount claimed by Novell, plus interest. (A few
days before the rescheduled trial Novell reduced the principal amount it was claiming to under
$20,000,000.) Novell also sought to impose a constructive trust on the Company’s current funds
traceable to the SCOsource agreements at issue, which relief could result in a freeze of the
Company’s assets, and the Court indicated that it would address that issue as well.
The trial of these issues, however, was automatically stayed as a result of the Company’s
filing a voluntary petition for relief under Chapter 11 of the Bankruptcy Code on September 14,2007. On October 4, 2007, Novell filed a Motion for Relief from Automatic Stay. On
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
November 27, 2007, the Bankruptcy Court lifted the stay to permit Novell to pursue the trial scheduled in
the Court on the allocation of proceeds from the SCOsource agreements and the question of SCO’s
alleged lack of authority to enter into them, but the Bankruptcy Court retained jurisdiction to
determine whether to impose a constructive trust on any amounts found to be payable to Novell. The
Bankruptcy Court also ruled that the automatic stay applies to the SuSE arbitration proceeding
pending in Europe. As described above and below, upon the partial lifting of the automatic stay,
the Court scheduled a four-day trial on those matters for which the Bankruptcy Court lifted the
stay, which started on April 29, 2008 and concluded on May 2, 2008.
On December 21, 2007, Novell filed a motion for summary judgment on the issue of whether the
Company had the authority to enter into the SCOsource licenses. The parties have fully briefed the
motion, and the Court has set oral argument on this and any other pending motions for summary
judgment for April 30, 2008. On March 7, 2008, the Company filed a Motion for Judgment on the
Pleadings on Novell’s Claims for Money or Claim for Declaratory Relief, in which the Company
argues, based on Novell’s version of the facts, that either its claims for money from SCOsource
agreements or its claim seeking a declaration that SCO lacked the authority to enter into those
agreements must fail. The Court heard oral arguments on this motion, as well as Novell’s pending
motion for summary judgment, on the second day of trial, April 30, 2008. The Court has not ruled
on these motions.
From April 29 through May 2, 2008, the Court held a bench trial on Novell’s monetary claim for
certain portions of fees SCO received from the SCOsource agreements and on whether SCO had the
authority to enter into those agreements, as explained above. Prior to the commencement of the
trial, Novell conceded that it would not be making a claim to a portion of the fees paid to SCO by
Microsoft in 2003 and Novell therefore reduced the principal amount of its claim to $19,979,561.
After the trial and arguments, the Court took all matters under advisement and stated it would
attempt to issue a ruling without undue delay. It is unknown when these rulings will be issued.
IPO Class Action Matter
The Company is an issuer defendant in a series of class action lawsuits involving over 300
issuers that have been consolidated under In re Initial Public Offering Securities Litigation, 21
MC 92 (SAS). The consolidated complaint alleges, among other things, certain improprieties
regarding the underwriters’ conduct during the Company’s initial public offering and the failure to
disclose such conduct in the registration statement in violation of the Securities Act of 1933, as
amended. Class standing was certified for all of these cases by the United States District Court
for the Southern District of New York (the “District Court of New York”).
The plaintiffs, the issuers and the insurance companies negotiated and executed an agreement
to settle the dispute between the plaintiffs and the issuers. While the settlement agreement was
awaiting approval by the district court, the court of appeals overturned the class certification on
December 5, 2006. It is unlikely a settlement of a class action can remain effective as the class
is de-certified. If the decision by the court of appeals is not reversed, the Company does not
believe the settlement will stand, and it is possible the lawsuit may fragment into individual
actions. At this time, the Company does not know and cannot predict the legal or procedural
results of such an action. If the de-certification is reversed, and if thereafter the settlement
agreement is approved by the District Court of New York, and if no cross-claims, counterclaims or
third-party claims are later asserted, this action will be dismissed with respect to the Company
and its directors. If the settlement agreement is not approved by the District Court
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
of New York, the matter will continue unless another settlement agreement is reached.
Plaintiffs have filed a second amended complaint.
The Company has notified its underwriters and insurance companies of the existence of the
claims. Management presently believes, after consultation with legal counsel, that the ultimate
outcome of this matter will not have a material adverse effect on the Company’s results of
operations or financial position and will not exceed the $200,000 self-insured retention already
paid or accrued by the Company.
Red Hat, Inc.
On August 4, 2003, Red Hat, Inc. filed a complaint against the Company. The action is pending
in the United States District Court for the District of Delaware (the “District Court of Delaware”)
under the case caption, Red Hat, Inc. v. The SCO Group, Inc., Civil No. 03-772. Red Hat asserts
that the Linux operating system does not infringe on the Company’s UNIX intellectual property
rights and seeks a declaratory judgment for non-infringement of copyrights and no misappropriation
of trade secrets. In addition, Red Hat claims the Company has engaged in false advertising in
violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference
with prospective business opportunities, trade libel and disparagement. On April 6, 2004, the
District Court of Delaware denied the Company’s motion to dismiss this case; however, the District
Court of Delaware stayed the case and requested status reports every 90 days regarding the case
against IBM. Red Hat filed a motion for reconsideration, which the District Court of Delaware
denied on March 31, 2005. This matter was also automatically stayed upon the Company’s filing its
Chapter 11 petitions. In the event that the stay is lifted, including the bankruptcy stay, and Red
Hat is allowed to pursue its claims, the Company will likely assert counterclaims against Red Hat.
The Company intends to vigorously defend this action.
Other Matters
In April 2003, the Company’s former Indian distributor filed a claim in India, requesting
summary judgment for payment of approximately $1,428,000, and an order that the Company trade in
India only through the distributor and/or give a security deposit until the claim is paid. The
distributor claims that the Company is responsible to repurchase certain software products and to
reimburse the distributor for certain other operating costs. Management does not believe that the
Company is responsible to reimburse the distributor for any operating costs and also believes that
the return rights related to any remaining inventory have lapsed. The distributor also requested
that the Indian Courts grant interim relief in the form of attachment of local assets. These
requests for interim relief have failed in the Court, discovery has commenced, and hearings on the
main claims have been held and are ongoing. The Company intends to vigorously defend this action.
Pursuit and defense of the above-mentioned matters will be costly, and management expects
legal fees and related expenses will be substantial. A material, negative impact on the Company’s
results of operations or financial position from the Red Hat, IPO Class Action, or Indian
Distributor matters, or the IBM or Novell counterclaims is not estimable.
The Company is a party to certain other legal proceedings arising in the ordinary course of
business, and management believes, after consultation with legal counsel, that the ultimate outcome
of these legal proceedings will not have a material adverse effect on the Company’s results of
operations, financial position or liquidity.
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
(4) STOCKHOLDERS’ EQUITY
Equity Plans
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 incorporates an evergreen formula pursuant to which on each November 1, the aggregate
number of shares reserved for issuance under the 2004 Plan will increase by a number of shares
equal to 3% of the outstanding shares on the day preceding (October 31). 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% after the completion of 1 year of service and then 1/36 per month for the remaining 3
years and would be fully vested at the end of 4 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.
The effect of accounting for stock-based awards under SFAS No. 123(R) for the three months ended
April 30, 2008 and 2007 was to record $238,000 and $535,000, respectively, of stock-based
compensation expense. For the six months ended April 30, 2008 and 2007, $352,000
THE SCO GROUP, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)
and $1,011,000, respectively, of stock-based compensation expense was recorded. For the three and
six months ended April 30, 2008 and 2007, the Company has allocated stock-based compensation
expense to the following statement of operations captions:
With respect to stock options granted during the three and six months ended April 30, 2008 and
2007, the assumptions used in the Black-Scholes option-pricing model are as follows:
The estimated fair value of stock options are amortized over the vesting period of the award.
During the six months ended April 30, 2008, the Company granted options to purchase
approximately 60,000 shares of common stock with an average exercise price of $0.08 per share.
None of these stock options were granted with an exercise price below the quoted market price on
the date of grant. During the six months ended April 30, 2008, no options to purchase common stock
were exercised. As of April 30, 2008, there were approximately 4,355,000 stock options outstanding
with a weighted average exercise price of $3.38 per share.
(5) SEGMENT INFORMATION
The Company’s resources are allocated and operating results managed to the operating income
(loss) level for each of the Company’s segments: UNIX and SCOsource. Both segments are based on
the Company’s UNIX intellectual property. The UNIX business sells and distributes UNIX products
and services through an extensive distribution channel and to corporate end-users and the SCOsource
business enforces and protects the Company’s UNIX intellectual property. Segment disclosures for
the Company are as follows:
On February 13, 2008, the Company entered into a Memorandum of Understanding (the “MOU”) with
Stephen Norris Capital Partners, LLC, a Delaware limited liability company (“SNCP”), whereby, SNCP
agreed to provide financing to fund the Company’s plan of reorganization filed on February 29, 2008
in the Company’s Chapter 11 bankruptcy case presently pending in the United States Bankruptcy Court
for the District of Delaware, In re: The SCO Group, Inc, Case No. 07-11337(KG). The Company on
the same day filed its disclosure statement in connection with the plan of reorganization, under
the terms contemplated by the MOU.
The MOU is not a definitive agreement. It is a non-binding summary of the intentions of the
parties and is subject to change. As such, the MOU, the plan of reorganization and the transactions
they contemplate are subject to various changes and conditions precedent, including: (1) SNCP’s
due diligence and (2) the Bankruptcy Court’s approval. A hearing to approve the adequacy of the
Disclosure Statement was scheduled before the Bankruptcy Court on April 2, 2008. The April 2, 2008
hearing proceeded as a status conference regarding the Company’s progress towards a new MOU with
SNCP. Therefore, the Company indicated that it was not presently seeking approval of the adequacy
of the Disclosure Statement, which would need to be amended to reflect the changes to the MOU. On
May 12, 2008, the Company filed a motion seeking an extension of its exclusive periods to submit
and solicit acceptances of a plan of reorganization to August 11 and October 13, 2008,
respectively. A hearing to consider that motion is scheduled for June 17, 2008.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s Discussion and Analysis of Financial Condition and Results of Operations and
other parts of this quarterly report on Form 10-Q contain forward-looking statements that involve
risks and uncertainties. Forward-looking statements can also be identified by words such as
“intends,”“anticipates,”“expects,”“believes,”“plans,” and similar terms. Forward-looking
statements are not guarantees of future performance and our actual results may differ significantly
from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not
limited to, those set forth below under “Forward-Looking Statements and Factors that May Affect
Future Results and Financial Condition” and Part II, Item 1A – Risk Factors and elsewhere in this
Form 10-Q. The
following discussion should be read in conjunction with our unaudited condensed consolidated
financial statements and notes thereto included in this Form 10-Q and our audited consolidated
financial statements included in our annual report on Form 10-K for the year ended October 31, 2007
filed with the Securities and Exchange Commission and management’s discussion and analysis
contained therein. All information presented herein is based on the three and six months ended
April 30, 2008 and 2007. We assume no obligation to revise or update any forward-looking
statements for any reason, except as required by law.
Recent Developments
Novell, Inc. Ruling. On August 10, 2007, the federal judge overseeing our lawsuit with
Novell, Inc. (“Novell”) ruled in favor of Novell on several of the summary judgment motions that
were before the United States District Court in Utah (the “Court”). The effect of these rulings
was to significantly reduce or eliminate certain of our claims in both the Novell and IBM cases,
and possibly others (the “SCO Litigation”). The Court ruled that Novell was the owner of the UNIX
and UnixWare copyrights that existed at the time of the 1995 Asset Purchase Agreement between
Novell and the Santa Cruz operations (the “APA”), and that Novell retained broad rights to waive
our contract claims against IBM. The Court also ruled that we own the copyrights to post APA
UnixWare derivatives and that we have certain other ownership rights in the UNIX technology. We
were directed to accept Novell’s waiver of our UNIX contract claims against IBM. In addition, the
Court determined that certain SCOsource licensing agreements that we executed in fiscal year 2003
and thereafter included older SVRx licenses and that we were possibly required to remit some
portion of the proceeds to Novell. Over our objection, a bench trial was set to begin on September17, 2007 and the federal judge was to determine what portion, if any, of the proceeds of the
SCOsource agreements is attributable to such SVRx licenses and should be remitted to Novell as well
as whether we had authority to enter into such SVRx licenses. The potential payment to Novell for
those SVRx licenses ranges from a de minimis amount to in excess of $30,000,000, the latter amount
being the amount claimed by Novell, plus interest. (A few days before the rescheduled trial Novell
reduced the principal amount it was claiming to under $20,000,000.) Novell also sought to impose a
constructive trust on our current funds traceable to those sources, which could result in a freeze
of our assets.
The trial of these issues, however, was automatically stayed as a result of our filing a
voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (the
“Bankruptcy Code”) in the United States Bankruptcy Court for the District of Delaware (the
“Bankruptcy Court”) on September 14, 2007. On October 4, 2007, Novell filed a Motion for Relief
from Automatic Stay. On November 27, 2007, the Bankruptcy Court lifted the stay to permit Novell
to pursue the trial scheduled in the Court on the allocation of proceeds from the SCOsource
agreements and the question of our alleged lack of authority to enter into them, but the Bankruptcy
Court retained jurisdiction to determine whether to impose a constructive trust on any amounts
found to be payable to Novell. The Bankruptcy Court in Delaware also ruled that the bankruptcy
stay applies to the SuSE arbitration proceeding pending in Europe. Upon the partial lifting of the
automatic stay, the Court scheduled a four-day trial to start on April 29, 2008 on the issues for
which the Bankruptcy Court lifted the stay.
From April 29 through May 2, 2008, the Court held a bench trial on Novell’s monetary claim for
certain portions of fees we received from the SCOsource agreements and on whether we had the
authority to enter into those agreements, as explained above. Prior to the commencement of the
trial, Novell conceded that it would not be making a claim to a portion of the fees paid to us by
Microsoft in 2003 and Novell therefore reduced the principal amount of its claim to $19,979,561.
After the trial and arguments, the Court took all matters under advisement and stated it would
attempt to issue a ruling without undue delay. It is unknown when these rulings will be issued.
It is our intent to appeal the adverse August 10, 2007 summary judgment rulings as soon as
that opportunity is available to us. However, we complete further legal proceedings before we can
take such an appeal. In the event that any substantial amount of our assets are frozen or if our
assets or resources are further depleted, we may not be able to appeal the August 10, 2007 rulings.
Our management and Board of Directors determined that filing for relief under Chapter 11 of
the United States Bankruptcy Code was appropriate and necessary. As a result of both the Court’s
August 10, 2007 order and our entry into Chapter 11, among other matters, there is substantial
doubt about our ability to continue as a going concern.
Our financial statements do not include any adjustments that might result from the outcome of
these uncertainties. Absent a significant cash payment to Novell being required by the final
resolution for this matter, management believes that the undiscounted future cash flows generated
by us will be sufficient to recover the carrying amounts of our long-lived assets over their
expected remaining useful lives. However, if a significant cash payment is required, or
significant assets are put under a constructive trust, the carrying amounts of our long-lived
assets may not be recovered (which totaled $230,000 as of April 30, 2008). The Bankruptcy Court in
Delaware has ruled that it will retain jurisdiction over the constructive trust issue but lifted
the stay to allow Novell’s claims for amounts due under the SCOsource agreements and our authority
to enter into those licenses to go to trial in the Court. A four-day bench trial was held on the
issues on April 29, 2008 through May 2, 2008 in the Court. Novell has determined to file a motion
for summary judgment on the issue of whether we had the authority to enter into the SCOsource
licenses. The Court scheduled oral argument on this and any other pending summary judgment motions
for April 30, 2008. We have also filed a motion for judgment on the pleadings arguing that Novell
cannot, under the law and its own version of the facts, claim that the SCOsource licenses and
agreements were not authorized and also claim that it is entitled to the royalties or fees obtained
from those licenses. That motion is also being briefed by the parties.
We intend to maintain business operations throughout the reorganization process. Subject to
the Bankruptcy Court’s approval, we will use our cash, restricted cash and subsequent cash inflows
to meet our working capital needs throughout the reorganization process.
Bankruptcy Filing. On September 14, 2007, The SCO Group, Inc. (the “Company”) and its wholly
owned subsidiary, SCO Operations, Inc. (collectively, the “Debtors”), filed voluntary petitions for
relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court
for the District of Delaware The Debtors’ Chapter 11 cases are being jointly administered under
Case Nos. 07-11337 and 07-11338(KG). The Debtors continue to operate their businesses as
“debtors-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the
applicable provisions of the Bankruptcy Code and orders of the Bankruptcy Court. Our foreign
subsidiaries were not included in the filings and will continue their business operations. Our
foreign subsidiaries, as non-debtors, are not subject to the requirements of the Bankruptcy Code
and are not subject to Bankruptcy Court supervision.
In connection with our cases, we filed motions with the Bankruptcy Court requesting, among
other things, the ability to maintain our existing bank accounts and cash management systems,
permission to pay pre-bankruptcy wage-related items, the establishment of procedures relating to
utility providers and authority to employ temporary employees, in an effort to minimize any
disruption the filings might otherwise cause. On September 18, 2007, the Bankruptcy Court granted
the relief requested. As debtors-in-possession, we continue to exercise control over our assets
and business, subject to the supervision of the Bankruptcy Court and the requirements of the
Bankruptcy Code and bankruptcy rules.
On February 13, 2008, we entered into a Memorandum of Understanding (the “MOU”) with Stephen
Norris Capital Partners, LLC, a Delaware limited liability company (“SNCP”), whereby SNCP agreed to
provide financing to fund our plan of reorganization filed on February 29, 2008 in the Company’s
Chapter 11 bankruptcy case presently pending in the United States Bankruptcy Court for the District
of Delaware, In re: The SCO Group, Inc, Case No. 07-11337(KG). On the same day, we filed our
disclosure statement in connection with the plan of reorganization, under the terms contemplated by
the MOU.
The MOU is not a definitive agreement. It is a non-binding summary of the intentions of the
parties and is subject to change. As such, the MOU, our plan of reorganization and the transactions
they contemplate are subject to various changes and conditions precedent, including: (1) SNCP’s
due diligence and (2) the Bankruptcy Court’s approval. A hearing to approve the adequacy of the
Disclosure Statement was scheduled before the Bankruptcy Court on April 2, 2008. The April 2, 2008
hearing proceeded as a status conference regarding our progress towards a new MOU with SNCP.
Therefore, we indicated that we were not presently seeking approval of the adequacy of the
Disclosure Statement, which would need to be amended to reflect the changes to the MOU.
On May 12, 2008, we filed a motion seeking an extension of our exclusive periods to submit and
solicit acceptances of a plan of reorganization to August 11 and October 13, 2008, respectively.
A hearing to consider that motion is scheduled for June 17, 2008. If our motion is denied, creditors
may file their own proposed plans of reorganization. The plans of reorganization proposed by
creditors may be less favorable to our stockholders.
As a result of the Chapter 11 filings, realization of assets and liquidation of liabilities
are subject to uncertainty. While operating as debtors-in-possession under the protection of
Chapter 11 of the Bankruptcy Code, we may sell or otherwise dispose of assets and liquidate or
settle liabilities for amounts other than those reflected in the condensed consolidated financial
statements, in the ordinary course of business, or, if outside the ordinary course of business,
subject to Bankruptcy Court approval.
In addition, under the priority scheme established by the Bankruptcy Code, unless creditors
agree otherwise, post-petition liabilities and prepetition liabilities must be satisfied in full
before stockholders are entitled to receive any distribution or retain any property under a plan of
reorganization. The ultimate recovery by creditors and/or stockholders, if any, will not be
determined until confirmation of a plan or plans of reorganization. No assurance can be given as
to what values, if any, will be ascribed in the Chapter 11 cases to each of these constituencies or
what types or amounts of distributions, if any, they would receive, or as to the timing of any such
distributions. A plan of reorganization could result in holders of our stock receiving no
distribution on account of their interests and cancellation of their existing stock. If certain
requirements of the Bankruptcy Code are met, a plan of reorganization can be confirmed
notwithstanding its rejection by the class comprising the interests of our equity security holders.
Accordingly, we urge that the appropriate caution be exercised with respect to existing and future
investments in any of these securities as the value and prospects are highly speculative.
Under the supervision of the Bankruptcy Court, we may decide to pursue various strategic
alternatives as deemed appropriate by our Board of Directors to serve the best interests of the
Company and our stockholders, including asset sales or strategic partnerships.
Reduction in Force. On January 31, 2008, in an effort to reduce ongoing operating expenses
and conform our business to our current objectives and opportunities, we began the implementation
of a reduction in force. We reduced our workforce by 25 positions or a reduction of approximately
21% of our total workforce and this reduction was completed in April 2008. We incurred
approximately $350,000 in severance and termination costs associated with this
reduction in force. We believe that this reduction in force will allow us to continue to
focus on and serve our UNIX customer base and to deliver on key opportunities with our
mobility products and services.
Business Focus
UNIX Business. Our UNIX business serves the needs of small-to-medium sized businesses as well
as replicated site franchisees of Fortune 1000 companies, by providing reliable, cost effective
UNIX software technology for distributed, embedded and network-based systems. Our UNIX business
includes our mobility product and services offerings. Our largest source of UNIX business revenue
is derived from existing customers through our worldwide, indirect, leveraged channel of partners,
which includes distributors and independent solution providers. We have a presence in a number of
countries that provide support and services to customers and resellers. The other principal
channel for selling and marketing our UNIX products is through existing customers that have a large
number of replicated sites or franchisees.
We access these corporations through their information technology or purchasing departments
with our Area Sales Managers (“ASMs”) in the United States and through our reseller channel in
countries outside the United States. In addition, we also sell our operating system products to
original equipment manufacturers (“OEMs”). Our sales of UNIX products and services during the last
several years have been primarily to existing UNIX customers and not newly acquired customers. Our
UNIX business revenue depends significantly on our ability to market and sell our products to
existing customers and to generate upgrades from existing customers.
The following table shows the operating results of the UNIX business for the three and six
months ended April 30, 2008 and 2007:
Revenue from the UNIX business decreased by $2,353,000, or 39%, for the three months ended
April 30, 2008 compared to the three months ended April 30, 2007 and revenue from the
UNIX business decreased by $3,473,000, or 29%, for the six months ended April 30, 2008
compared to the six months ended April 30, 2007. The revenue from this business has been declining
over the last several years primarily as a result of increased competition from alternative
operating systems, particularly Linux. We believe the inclusion of our UNIX code and derivative
works in Linux has been a contributor to the decline in our UNIX business because users of Linux
generally do not pay for the operating system itself, but pay for services and maintenance. The
Linux operating system competes directly with our OpenServer and UnixWare products and has taken
significant market share from these products.
Operating costs for the UNIX business decreased from $5,298,000 for the three months ended
April 30, 2007 to $4,328,000 for the three months ended April 30, 2008 and operating costs
for the UNIX business decreased from $10,820,000 for the six months ended April 30, 2007
to$9,266,000 for the six months ended April 30, 2008. These decreases were primarily
attributable to reduced headcount and related costs as well as not incurring amortization expense
from intangible assets due to the fact that they became fully amortized during the three months
ended October 31, 2006.
The decline in our UNIX business revenue will continue to be accelerated if industry partners
continue to withdraw their support for our products. The decline in our UNIX business and our
SCOsource business may cause industry partners, developers and hardware and software vendors to
choose not to support or certify to our UNIX operating system products. This would lead to an
accelerated decline in revenue and an increase in negative cash flows from our UNIX business.
SCOsource Business. During the year ended October 31, 2003, we became aware that our UNIX
code and derivative works had been inappropriately included by others in the Linux operating
system. We believe the inclusion of our UNIX code and derivative works in Linux has been a
contributor to the decline in our UNIX business because users of Linux generally do not pay for the
operating system itself, but pay for services and maintenance. The Linux operating system competes
directly with our OpenServer and UnixWare products and has taken significant market share from
these products.
In an effort to establish, protect and defend our UNIX intellectual property rights, we
initiated our SCOsource business. We have incurred significant legal costs in an effort to defend
and protect our UNIX intellectual property rights. We expect that costs and expenses for this
business for the year ending October 31, 2008 will continue to be significant.
The following table shows the operating results of the SCOsource business for the three and
six months ended April 30, 2008 and 2007:
Revenue from our SCOsource business was $0 for the three months ended April 30, 2007 and April30, 2008. Revenue decreased from $23,000 for the six months ended April 30, 2007 to
$0 for the six months ended April 30, 2008. Revenue in the above mentioned periods was
primarily attributable to sales of our SCOsource IP agreements.
Cost of revenue, which primarily includes legal and professional fees incurred in connection with
defending our UNIX intellectual property rights in the SCO Litigation, decreased from $1,066,000
for the three months ended April 30, 2007 to $333,000 for the three months ended April 30, 2008 and
decreased from $1,720,000 for the six months ended April 30, 2007 to $600,000 for the six months
ended April 30, 2008. The decreases in cost of revenue were primarily attributable to significant
decreases in legal services provided by technical, industry, damage and other experts in connection
with the SCO Litigation. In addition to the expenses incurred above,
we may pay one or more contingency fees upon certain amount we or our stockholders may receive as a
result of a settlement, judgment, or a sale of our company.
Because of the unique and unpredictable nature of the SCO Litigation, the occurrence and
timing of certain expenses such as damage, industry and technical review and other consultants is
difficult to predict, it is therefore difficult to predict the total cost of this revenue for the
upcoming quarters.
Because of the uncertainties related to our SCOsource business, the success of the SCOsource
business depends on the strength of our intellectual property rights and claims regarding UNIX,
including our claims against Novell and the strength of our claim that unauthorized UNIX source
code and derivative works are contained in Linux.
Critical Accounting Policies
Our critical accounting policies and estimates include the following:
•
Revenue recognition;
•
Valuation allowances against deferred income tax assets;
•
Litigation reserves;
•
Useful lives and impairment of property and equipment; and
•
Allowances for doubtful accounts receivable.
Revenue Recognition. We recognize revenue in accordance with Statement of Position (“SOP”)
97-2, as modified by SOP 98-9. Our revenue has historically been from three sources: (i) product
license revenue, primarily from product sales to resellers, end users and OEMs; (ii) technical
support service revenue, primarily from providing technical support and consulting services to end
users; and (iii) revenue from SCOsource.
We recognize product revenues upon shipment if a signed contract exists, the fee is fixed or
determinable, collection of the resulting receivable is probable and product returns are reasonably
estimable.
The majority of our revenue transactions relate to product-only sales. On occasion, we have
revenue transactions that have multiple elements (such as software products, maintenance, technical
support services, and other services). For software agreements that have multiple elements, we
allocate revenue to each component of the contract based on the relative fair value of the
elements. The fair value of each element is based on vendor specific objective evidence (”VSOE”).
VSOE is established when such elements are sold separately. We recognize revenue when the criteria
for product revenue recognition set forth above have been met. If VSOE of all undelivered elements
exists, but VSOE does not exist for one or more delivered elements, then revenue is recognized
using the residual method. Under the residual method, the fair value of the undelivered elements
is deferred and the remaining portion of the license fee is recognized as revenue in the period
when persuasive evidence of an arrangement is obtained assuming all other revenue recognition
criteria are met.
We recognize product revenues from OEMs when the software is sold by the OEM to an end-user
customer. Revenues from technical support services and consulting services are recognized as the
related services are performed. Revenues for maintenance are recognized ratably over the
maintenance period.
We consider an arrangement with payment terms longer than our normal business practice not to be
fixed or determinable and revenue is recognized when the fee becomes due.
We typically provide
stock rotation rights for sales made through our distribution channel and sales to distributors are
recognized upon shipment by the distributor to end users. For direct
sales not through our distribution channel, sales are typically non-refundable and non-cancelable
and revenue is recognized upon shipment. We estimate our product returns based on historical
experience and maintain an allowance for estimated returns, which is recorded as a reduction to
accounts receivable and revenue.
Our SCOsource revenues to date have been primarily generated from agreements to utilize our
UNIX source code as well as from intellectual property compliance agreements. We recognize revenue
from SCOsource agreements when a signed contract exists, the fee is fixed or determinable,
collection of the receivable is probable and delivery has occurred. If the payment terms extend
beyond our normal payment terms, revenue is recognized as the payments become due.
Valuation Allowances Against Deferred Income Tax Assets. The amount, and ultimate
realization, of our deferred income tax assets depends, in part, upon the tax laws in effect, our
future earnings, if any, and other future events, the effects of which cannot be determined. We
provided a valuation allowance of $78,570,000 against our entire net deferred income tax assets as
of October 31, 2007. The valuation allowance was recorded because of our history of net operating
losses and the uncertainties regarding our future operating profitability and taxable income.
Litigation Reserves. We are party to a number of legal matters described in more detail
elsewhere in this Form 10-Q, including under Part II, Item I – Legal Proceedings. Pursuit and
defense of these matters will be costly, and management expects the costs for legal fees and
related expenses will be substantial. A material, negative impact on our results of operations or
financial position from the Red Hat, Inc., IPO Class Action, or Indian Distributor matters, or the
IBM and Novell counterclaims may be probable but not estimable. Because these matters are not
estimable, we have not recorded any reserves or contingencies related to these legal matters. In
the event that our assumptions used to evaluate these matters change in future periods, we may be
required to record a liability for an adverse outcome, which could have a material adverse effect
on our results of operations, financial position and liquidity.
Useful Lives and Impairment of Property and Equipment. We review our long-lived assets for
impairment at each balance sheet date and when events or changes in circumstances indicate that the
carrying value of an asset may not be recoverable. 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.
Economic useful lives of long-lived assets are assessed and adjusted as circumstances dictate.
Write-downs of long-lived assets may be necessary if, in the future, the fair value of these
assets is less than the carrying value. If the operating trends for our UNIX or SCOsource
businesses licensing 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.
Allowance for Doubtful Accounts Receivable. We offer credit terms on the sale of our products
to a majority of our customers and require no collateral from these customers. We perform ongoing
credit evaluations of our customers’ financial condition and maintain an allowance for doubtful
accounts based upon our historical collection experience and a specific review of customer balances
to determine expected collectability. Our policies for determining allowances for doubtful
accounts receivable have been applied consistently. Our allowance for doubtful accounts receivable
was $199,000 as of April 30, 2008. We have not experienced
material differences from the actual amounts provided for bad debts and our recorded estimates.
However, our actual bad debts in future periods may differ from our current estimates and the
Revenue for the three months ended April 30, 2008 decreased by $2,353,000, or 39%, from the
three months ended April 30, 2007 and revenue for the six months ended April 30, 2008 decreased by
$3,496,000, or 29%, from the six months ended April 30, 2007. These decreases were primarily
attributable to a continued decline in our UNIX business as a result of the factors described
below.
Revenue generated from our UNIX business and SCOsource business is as follows:
The decrease in revenue in the UNIX business of $2,353,000, or 39%, for the three months ended
April 30, 2008 compared to the three months ended April 30, 2007 and the decrease in revenue in the
UNIX business of $3,473,000, or 29%, for the six months ended April 30, 2008 compared to the six
months ended April 30, 2007 was primarily attributable to continued competition from other
operating systems, particularly Linux, and from continuing negative publicity from the SCO
Litigation and our filing Chapter 11 bankruptcy. We believe that the inclusion of our UNIX code
and derivative works in Linux has been a contributor to the decline in our UNIX revenues because
users of Linux generally do not pay for the operating system itself, but pay for services and
maintenance. We anticipate that for the year ending October 31, 2008 our UNIX revenues will
decline from UNIX revenues generated in the year ended October 31, 2007 as a result of this
continued competition and negative publicity from the SCO Litigation and our filing of Chapter 11
bankruptcy.
Sales of our UNIX products and services during the three and six months ended April 30, 2008
and 2007 were primarily to 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. Our UNIX revenue may be lower than currently anticipated if (i) we are not successful
with our existing customers, (ii) we lose the support of any of our existing hardware and software
vendors, or (iii) our key industry partners withdraw their marketing and certification support or
direct their support to our competitors.
Our products revenue consists of software licenses for UNIX products such as OpenServer and
UnixWare, as well as sales of UNIX-related products. Products revenue also includes revenue
derived from OEMs, distribution partners and large accounts. We rely heavily on our two-tier
distribution channel and any disruption in our distribution channel could have an adverse impact on
future revenue.
The decrease in products revenue of $1,847,000, or 38%, for the three months ended April 30,2008 compared to the three months ended April 30, 2007 and the decrease in products revenue of
$2,674,000, or 27%, for the six months ended April 30, 2008 compared to the six months ended April30, 2007 was primarily attributable to decreased sales of OpenServer and UnixWare products. These
decreases primarily resulted from continued competition in the operating system market,
particularly Linux, and from continuing negative publicity from the SCO Litigation and our filing
of Chapter 11 bankruptcy, which have adversely impacted and delayed our customers’ buying
decisions. We believe that this competition from Linux will continue for the year ending October31, 2008 and future periods.
Our products revenue was derived primarily from sales of our OpenServer and UnixWare products.
Other products revenue consists mainly of product maintenance and other UNIX-related products.
Revenue for these products was as follows:
The decrease in revenue for OpenServer and UnixWare for the three and six months ended April30, 2008 compared to the three and six months ended April 30, 2007 is primarily the result of
continued competition, particularly from Linux operating system providers, and from continuing
negative publicity from the SCO Litigation and our filing of Chapter 11 bankruptcy. The decrease
in other products revenues is primarily attributed to decreased sales of UNIX-related products and
decreased sales of product maintenance, which is sold separately from the product.
We initiated our SCOsource business for the purpose of protecting and defending our
intellectual property rights in our UNIX source code and derivative works. SCOsource revenue was
$0 for the three months ended April 30, 2008 and April 30, 2007 and was $0 for the six months ended
April 30, 2008 compared to $23,000 for the six months ended April 30, 2007. Revenues were
primarily attributable to sales of our SCOsource agreements.
We are unable to predict the amount and timing of future SCOsource revenue, and if generated,
the revenue will be sporadic and dependent on the outcome of the SCO Litigation.
Services revenue consists primarily of technical support fees, engineering services fees,
professional services fees and consulting fees. These fees are typically charged and invoiced
separately from UNIX products sales. The decrease in services revenue of $506,000, or 45%, for the
three months ended April 30, 2008 compared to the three months ended April 30, 2007 and the
decrease in services revenue of $799,000, or 36%, for the six months ended April 30, 2008 compared
to the six months ended April 30, 2007 was primarily attributable to the renewal of fewer support
and engineering services contracts.
The majority of our support and professional services revenue continues to be derived from
services for UNIX-based operating system products. Our future level of services revenue depends in
part on our ability to generate UNIX products revenue from new customers as well as to renew annual
support and services agreements with existing UNIX customers.
Cost of products revenue consists of manufacturing costs, royalties to third-party vendors,
technology costs and overhead costs. Cost of products revenue decreased by $149,000, or 44%, for
the three months ended April 30, 2008 as compared to the three months ended April 30, 2007 and
decreased by $238,000, or 33%, for the six months ended April 30, 2008 as compared to the six
months ended April 30, 2007. The decrease in the dollar amount of cost of products revenue was
primarily attributable to lower products revenue as margins did not vary considerably.
Cost of SCOsource revenue includes legal and professional fees incurred in connection with our
SCO Litigation, the salaries and related personnel costs of SCOsource employees, and an allocation
of corporate costs.
Cost of SCOsource revenue decreased by $733,000, or 69%, during the three months ended April30, 2008 as compared to the three months ended April 30, 2007 and decreased by $1,120,000, or 65%,
for the six months ended April 30, 2008 as compared to the six months ended April 30, 2007. The
decrease in cost of SCOsource revenue was primarily attributable to decreases in legal services
provided by technical, industry, damage and other experts in connection with the SCO Litigation.
Because of the unique and unpredictable nature of the SCO Litigation, the occurrence and
timing of certain expenses is difficult to predict, and will be difficult to predict for the
upcoming quarters. We will continue to make payments for technical, damage and industry experts,
consultants and for other fees. Future legal fees may include
contingency payments made to the law firms
as a result of a settlement, judgment, or sale of our Company, which could cause the cost of
SCOsource revenue for the three months ending July 31, 2008 or for future periods to be higher than
the costs incurred for the three months ended April 30, 2008.
Cost of services revenue includes the salaries and related personnel costs of employees
delivering services revenue as well as third-party service agreements. Cost of services revenue
decreased by $263,000, or 48%, for the three months ended April 30, 2008 compared to the three
months ended April 30, 2007 and decreased by $391,000, or 35%, for the six months ended April 30,2008 compared to the six months ended April 30, 2007. These decreases were primarily attributable
to a reduction of employee and employee-related costs.
Sales and marketing expenses consist of the salaries, commissions and other personnel costs of
employees involved in the revenue generation process, as well as advertising and corporate
allocations. The decrease in sales and marketing expenses of $269,000, or 11%, for the three
months ended April 30, 2008 compared with the three months ended April 30, 2007 and the increase of
$32,000, or 1%, for the six months ended April 30, 2008 compared with the six months ended April30, 2007 was primarily attributable to lower commissions, lower travel expenses, reduced
discretionary marketing spending and lower co-operative advertising as a result of lower revenue,
offset by an increase in severance and termination costs. Included in sales and marketing expenses
for the three months ended April 30, 2008 and 2007 was $56,000 and $107,000, respectively, for
stock-based compensation. Included in sales and marketing expenses for the six months ended April30, 2008 and 2007 was $85,000 and $218,000, respectively, for stock-based compensation.
For the three months ending July 31, 2008, we anticipate that the dollar amount of sales and
marketing expenses will be generally consistent with that incurred during the three months ended
April 30, 2008.
Research and development expenses consist of the salaries and benefits of software engineers,
consulting expenses and corporate allocations. Research and development expenses decreased by
$623,000, or 40%, for the three months ended April 30, 2008 compared with the three months ended
April 30, 2007 and decreased by $1,109,000, or 33%, for the six months ended April 30, 2008
compared with the six months ended April 30, 2007. The decrease in research and development
expenses was primarily attributable to reduced employee and employee-related costs. Included in
research and development expenses for the three months ended April 30, 2008 and 2007 was $13,000
and $54,000, respectively, of stock-based compensation. Included in research and development
expenses for the six months ended April 30, 2008 and 2007 was $25,000 and $97,000, respectively,
for stock-based compensation.
General and administrative expenses consist of the salaries and benefits of finance, human
resources, and executive management and expenses for professional services and corporate
allocations. General and administrative expenses decreased by $78,000, or 6%, during the three
months ended April 30, 2008 as compared to the three months ended April 30, 2007 and decreased by
$477,000, or 18%, during the six months ended April 30, 2008 as compared to the six months ended
April 30, 2007. The decrease in general and administrative expenses was primarily attributable to
decreased professional services costs and reduced stock-based compensation expenses. Included in
general and administrative expenses for the three months ended April 30, 2008 and 2007 was $94,000
and $283,000, respectively, of stock-based compensation. Included in general and administrative
expenses for the six months ended April 30, 2008 and 2007 was $127,000 and $532,000, respectively,
for stock-based compensation.
Equity in Income (Loss) of Affiliate
We account for our ownership interests in companies in which we own at least 20% and less than
50% using the equity method of accounting. Under the equity method, we record our portion of the
entities’ net income or net loss in our consolidated statements of operations. As of April 30,2008, the carrying value of our investment of $486,000 was for our 30% ownership in a Chinese
company.
Interest income decreased by $91,000 for the three months ended April 30, 2008 as compared to
the three months ended April 30, 2007 and decreased by $138,000
for the six months ended
April 30, 2008 as compared to the six months ended April 30, 2007 and was primarily attributable to
lower cash and available-for-sale marketable securities balances.
Other income (expense), net, increased $66,000 for the three months ended April 30, 2008 as
compared to the three months ended April 30, 2007 and increased $500,000 for the six months ended
April 30, 2008 as compared to the six months ended April 30, 2007. The six month increase was
primarily attributable to a realized gain as a result of a sale of intellectual property and an
increase in realized gains as a result of changes in foreign currency rates and balances.
Provision for Income Taxes
The provision for income taxes was $46,000 for the three months ended April 30, 2008 and
$81,000 for the three months ended April 30, 2007 and was $157,000 for the six months ended April30, 2008 and $193,000 for the six months ended April 30, 2007. Our provision for income
taxes is primarily related to earnings in foreign subsidiaries as well as from withholding
taxes on revenue generated in certain foreign locations.
Our cash and cash equivalents balance decreased from $5,554,000 as of October 31, 2007 to
$3,162,000 as of April 30, 2008. As of April 30, 2008, we also had $3,131,000 of restricted cash,
of which $1,739,000 is set aside to cover expert and other costs related to the SCO Litigation and
$1,392,000 is set aside for royalties payable to Novell.
We intend to use the cash as of April 30, 2008 to run our UNIX business and pursue the SCO
Litigation, and believe that we have sufficient liquidity resources to fund our operations through
at least October 31, 2008.
Our net cash used in operating activities during the six months ended April 30, 2008 was
$2,459,000 and was attributable to a net loss of $3,558,000, non-cash items of $499,000 and changes
in operating assets and liabilities of $600,000.
Our net cash used in operating activities during the six months ended April 30, 2007 was
$50,000 and was attributable to a net loss of $2,167,000, non-cash items of $1,107,000 and changes
in operating assets and liabilities of $1,010,000.
Our investing activities have historically consisted of equipment purchases and the purchase
and sale of available-for-sale marketable securities. During the six months ended April 30, 2008,
cash used in investing activities was $7,000, which was for the purchases of equipment.
During the six months ended April 30, 2007, cash provided by investing activities was
$2,200,000, which was primarily a result of proceeds from the sale of available-for-sale marketable
securities of $2,249,000, offset by purchases of equipment of $49,000.
Our financing activities provided $22,000 during the six months ended April 30, 2008 which
were generated from proceeds received from the sale of common stock through our employee stock
purchase plan.
Our financing activities provided $234,000 of cash during the six months ended April 30, 2007.
The primary sources of cash were from the exercise of options to acquire common stock of $4,000
and proceeds of $230,000 received from the sale of common stock through our employee stock purchase
plan.
Our net accounts receivable balance decreased from $3,365,000 as of October 31, 2007 to
$2,738,000 as of April 30, 2008, primarily as a result of lower sales (and related invoicing)
generated during the three months ended April 30, 2008 as compared to the three months ended
October 31, 2007. The majority of our accounts receivable are current and our allowance for
doubtful accounts was $199,000 as of April 30, 2008, which represented approximately 7 percent of
our gross accounts receivable balance . Our write-offs of uncollectible accounts during the three
and six months ended April 30, 2008 and 2007 were not significant.
We are continuing to pay for expert, consulting and other expenses relating to the SCO
Litigation. These expenses have been material in the past and even though we expect these expenses
to be lower for the year ending October 31, 2008 as compared to the year ended October 31, 2007, we
expect them to continue to be material to our financial statements.
In addition to the cash expenditures mentioned above, we may pay one or more contingency fees
upon certain amount we or our stockholders may receive as a result of a
settlement, judgment, or a sale of our company. On October 31, 2004, we entered into an
engagement agreement (the “Engagement Agreement”) with Boies, Schiller & Flexner LLP, Kevin McBride
and Berger Singerman P.A. (the “Law Firms”). This Engagement Agreement supersedes and replaces the
original engagement agreement that was entered into in February 2003. The Engagement Agreement
governs the relationship between the Law Firms and us in connection with the Law Firms’
representation of us in the SCO Litigation. Berger Singerman P.A. was a member of this group of
Law Firms. With our consent, the engagement of this firm was mutually terminated. The last
payment received by Berger Singerman P.A. was on November 24, 2004. Further, Berger Singerman P.A.
waived its rights under the Engagement Agreement upon the parties’ agreement for Berger Singerman
P.A. to represent the Debtors in their bankruptcy cases.
We may pay one or more contingency fees upon certain amount that we or our stockholders may
receive as a result of a settlement, judgment or a sale of the company. The contingency fee
amounts payable to the Law Firms (which no longer includes Berger Singerman P.A.) will be, subject
to certain credits and adjustments, as follows:
•
33 percent of any aggregate recovery amounts received up to $350,000,000, reduced by
all professional fees previously paid relating to these proceedings;
•
plus 25 percent of any aggregate recovery amounts above $350,000,000 but less than or
equal to $700,000,000;
•
plus 20 percent of any aggregate recovery amounts in excess of $700,000,000.
The Engagement Agreement provides that, except for the compensation obligations specifically
described above, we will not be obligated to pay any legal fees, whether hourly, contingent or
otherwise, to the Law Firms, or any other law firms that may be engaged by the Law Firms, in
connection with the SCO Litigation through the end of the current litigation between us and IBM,
including any appeals.
Contractual Obligations
We have entered into operating leases for our corporate offices located in the United States
and our international sales offices. We have commitments under these leases that extend through
the year ending December 31, 2012.
The following table summarizes our contractual operating lease obligations as of April 30,2008:
Less than
More than
Total
1 year
1 - 3 years
3 - 5 years
5 years
(In thousands)
Operating lease obligations
$
1,347
$
450
$
864
$
33
$
—
As of April 30, 2008, we did not have any long-term debt obligations, purchase obligations or
material capital lease obligations.
Our ability to reduce costs to offset revenue declines in our UNIX business is limited because
of contractual commitments to maintain and support our existing UNIX customers. The decline in our
UNIX business may be accelerated if industry partners withdraw their support as a result of the SCO
Litigation. In addition, the SCO Litigation may cause industry partners, developers and hardware
and software vendors to choose not to support or certify to our UNIX operating system products.
This would lead to an accelerated decline in our UNIX products and
services revenue. If our UNIX products and services revenue is less than expected, our
liquidity will be adversely impacted.
In the event that cash required to fund operations and strategic initiatives exceeds our
current cash resources, 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 the SCO Litigation. We may not be able to raise capital for any number of
reasons, including those listed under the section “Risk Factors” under Part II, Item 1A of this
Form 10-Q. If additional equity financing is available, it may not be available to us on favorable
terms or at all 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 our common stock would also be impaired. The restructuring
imposed by the Bankruptcy Court may also adversely affect our ability to raise debt or equity
capital. Our recent delisting from NASDAQ will also impair our ability to raise capital.
Forward-Looking Statements and Factors That May Affect Future Results and Financial Condition
With the exception of historical facts, the statements contained in Management’s Discussion
and Analysis of Financial Condition and Results of Operations are “forward-looking statements”
within the meaning of the Private Securities Litigation Reform Act of 1995, which reflect our
current expectations and beliefs regarding our future results of operations, performance and
achievements. These statements are subject to risks and uncertainties and are based upon
assumptions and beliefs that may or may not materialize. These forward-looking statements include,
but are not limited to, statements concerning:
•
Our intention to appeal the adverse August 10, 2007 summary judgment ruling;
•
Our belief that the undiscounted future cash flows generated by us will be
sufficient to recover the carrying amounts of our long-lived assets over their
expected remaining useful lives;
•
Our intention to maintain business operations throughout the reorganization
process;
•
Our intention to use our cash, restricted cash and subsequent cash inflows to meet
our working capital needs throughout the reorganization process;
•
Our intention to continue operating and to file a plan of reorganization with the
Bankruptcy Court;
•
Our belief that our reduction in workforce will allow us to continue to focus on
and serve our UNIX customer base and to deliver on key opportunities with our mobile
products and services;
•
Our intention to vigorously defend legal claims and counterclaims brought against
us by others;
•
Our intention to continue to pursue the SCO Litigation;
•
Our belief that our allowance for doubtful accounts receivable is adequate and that
write-offs of uncollectible accounts will not materially exceed that allowance;
•
The strength of our intellectual property rights and contractual claims regarding
UNIX generally and specifically the strength of our claim that unauthorized UNIX
source code and derivatives of UNIX source code are prevalent in Linux;
•
Our belief that competition from Linux will continue during the year ending October31, 2008 and future periods;
•
Our expectation that we will continue to be unable to predict the amount and timing
of SCOsource revenue, and when generated, the revenue will be sporadic and dependent
on the outcome of the SCO Litigation;
•
Our expectation that future services revenue will depend in part on our ability to
generate UNIX products revenue from new customers as well as the renewal of annual
support and services agreements from existing UNIX customers;
Our expectation that for the year ending October 31, 2008 our total
UNIX revenue will decline from UNIX revenue generated in the year ended October31, 2007 as a result of continued competition and negative publicity;
•
Our intention to use cash to run our UNIX business and pursue the SCO Litigation;
•
Our belief that we have sufficient liquidity resources to fund our operations
through at least October 31, 2008;
•
Our intention to continue to pay for expert, consulting and other expenses through
the conclusion of our litigation with IBM, and our expectation that although these
expenses are expected to decrease for the year ending October 31, 2008 as compared to
the year ended October 31, 2007, that they will continue to be material to our
financial statements;
•
Our expectation for the three months ending July 31, 2008 that because of the
unique and unpredictable nature of the SCO Litigation, the occurrence and timing of
certain expenses is difficult to predict, and will be difficult to predict for the
upcoming quarters; and
•
Our belief that certain legal actions to which we are a party will not have a
material adverse effect on us.
We wish to caution readers that our operating results are subject to various risks and
uncertainties that could cause our actual results and outcomes to differ materially from those
discussed or anticipated, including confirmation of a plan of reorganization, the outcomes and
developments in our Chapter 11 bankruptcy case, court rulings in the bankruptcy proceedings, the
impact of the bankruptcy proceedings or other pending litigation, developments in our litigation,
our cash balances and available cash, continued competitive pressure on the Company’s operating
system products, which could impact the Company’s results of operations, adverse developments in
and increased or unforeseen legal costs related to the Company’s litigation, the inability to
devote sufficient resources to the development and marketing of the Company’s products, including
the Me Inc. mobile services and development platform, and the possibility that customers and
companies with whom the Company has formed partnerships will decide to terminate or reduce their
relationships with the Company, and the factors set forth below in Part II, Item 1A-Risk Factors.
We also wish to advise readers not to place any undue reliance on the forward-looking statements
contained in this report, which reflect our beliefs and expectations only as of the date of this
report. We assume no obligation to update or revise these forward-looking statements to reflect
new events or circumstances or any changes in our beliefs or expectations, other than as required
by law.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Risk. We have foreign offices and operations in Europe and Asia. As a
result, a portion of our revenues are derived from sales to customers outside the United States.
Our international revenues are primarily denominated in U.S. dollars, Euros and United Kingdom
Pounds. Most of the operating expenses related to our foreign-based operations are denominated in
foreign currencies and therefore operating results are affected by changes in the U.S. dollar
exchange rate in relation to foreign currencies such as the Euro, among others. If the U.S. dollar
weakens compared to the Euro and other currencies, our operating expenses for foreign operations
will be higher when translated back into U.S. dollars. Our revenues can also be affected by
general economic conditions in the United States, Europe and other international markets. Our
results of operations may be affected in the short term by fluctuations in foreign currency
exchange rates.
Interest Rate Risk. The primary objective of our cash management strategy is to invest
available funds in a manner that assures safety and liquidity and maximizes yield within such
constraints. We believe that a hypothetical movement in interest rates, either up or down of up to
2%, would not have a material adverse impact on our cash. We do not borrow money for short-term
investment purposes.
Investment Risk. We have historically invested in equity instruments of privately held and
public companies in the technology industry for business and strategic purposes. Investments are
accounted for under the cost method if our ownership is less than 20 percent and we are not able to
exercise influence over operations. We account for our ownership interests in companies in which
we own at least 20% and less than 50% using the equity method of accounting. Under the equity
method, we record our portion of the entities’ net income or net loss in our consolidated
statements of operations. Our investment policy is to regularly review the assumptions and
operating performance of these companies and to record impairment losses when events and
circumstances indicate that these investments may be impaired. As of April 30, 2008, we did not
hold any cost method investments. As of April 30, 2008, the carrying value of our equity method
investment of $486,000 was for our 30% ownership in a Chinese company.
The stock market in general and the market for shares of technology companies in particular,
have experienced price fluctuations. In addition, factors such as new product introductions by our
competitors or developments in the SCO Litigation, or development in our reorganization process
under Chapter 11 bankruptcy may have a significant impact on the market price of our common stock.
Furthermore, quarter-to-quarter fluctuations in our results of operations may have a significant
impact on the market price of our common stock. These conditions could cause the price of our
common stock to fluctuate substantially over short periods of time.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure 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) under the Securities Exchange Act of 1934 (the “Exchange
Act”)). Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that, as of the end of the period covered by this report, our disclosure controls and
procedures were effective.
Changes in internal control over financial reporting. During the most recent fiscal quarter
covered by this report, there has been no change in our internal control over financial reporting
(as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is
reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Certain legal proceedings in which we are involved are discussed in Part I, Item 3, of our
Annual Report on Form 10-K for the year ended October 31, 2007. In addition, for more information
regarding our legal proceedings, please see Note 3 included in Part 1, Item 1.
Unaudited Financial Statements – Notes to Condensed Consolidated Financial Statements, which
information is incorporated herein by reference.
ITEM 1A. RISK FACTORS
Investing in our securities involves a high degree of risk. In addition to the other
information contained in this Form 10-Q, you should consider the following risk factors before
investing in our securities.
We do not have a history of profitable operations and our cash resources are limited.
Our year ended October 31, 2003 was the first full year we were profitable in our operating
history. Our profitability for the year ended October 31, 2003 resulted primarily from our
SCOsource business. For the years ended October 31, 2007, 2006 and 2005, we incurred net losses
applicable to common stockholders of $6,826,000, $16,598,000 and $10,726,000, respectively, and for
the six months ended April 30, 2008 we incurred a net loss of $3,558,000. As of April 30, 2008,
our accumulated deficit was $261,924,000.
If our revenues from the sale of our UNIX products and services continue to decline, or if we
continue to devote significant cash resources to the SCO Litigation, we will need to further reduce
operating expenses to generate positive cash flows. On January 31, 2008, in an effort to reduce
ongoing operating expenses and to conform our business to our current objectives and opportunities,
we began the implementation of a reduction in force. We reduced our workforce by 25 positions or a
reduction of approximately 21% of our total workforce and this reduction was completed in April
2008. 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.
As of April 30, 2008, we had a total of $3,162,000 in cash and an additional $3,131,000 of
restricted cash of which $1,739,000 is to be used to pursue the SCO Litigation. Since October 31,2004, we have spent a total of $13,261,000 for expert, consulting and other costs and fees as
agreed to in the Engagement Agreement with our legal counsel in the SCO Litigation. Our limited
cash resources may not be sufficient to fund continuing losses from operations and the expenses of
the SCO Litigation.
A long period of operating under Chapter 11 may harm our business.
A long period of operating under Chapter 11 could adversely affect our business and
operations. So long as the Chapter 11 cases continue, our senior management will be required to
spend a significant amount of time and effort dealing with the bankruptcy reorganization instead of
focusing exclusively on business operations. A prolonged period of operating under Chapter 11 may
also make it more difficult to attract and retain management and other key personnel necessary to
the success and growth of our business. In addition, the longer the Chapter 11 cases continue, the
more likely it is that our customers and suppliers will lose confidence in our ability to
successfully reorganize our businesses and seek to establish alternative commercial relationships.
Furthermore, so long as the Chapter 11 cases continue, we will be required to incur
substantial costs for professional fees and other expenses associated with the administration of
the cases. A prolonged continuation of the Chapter 11 cases may also require us to seek financing.
If we require financing during the Chapter 11 cases and we are unable to obtain the
financing on favorable terms or at all, our chances of successfully reorganizing our
businesses may be seriously jeopardized.
We may not be able to obtain confirmation of our Chapter 11 plan; we may not be able to emerge from
Bankruptcy and we may be liquidated.
To successfully emerge from Chapter 11 bankruptcy protection as a viable entity, one must meet
certain statutory requirements with respect to adequacy of disclosure with respect to the Chapter
11 plan of reorganization (the “Plan”), soliciting and obtaining the requisite acceptances of the
Plan, and fulfilling other statutory conditions for confirmation. We may not receive the requisite
acceptances to confirm the Plan. Even if the requisite acceptances of the Plan are received, the
Bankruptcy Court may not confirm the Plan.
On February 29, 2008, we filed the Plan and Disclosure Statement with the United States
Bankruptcy Court. The Plan is subject to, among other conditions, Bankruptcy Court approval. A
hearing for approval of the Disclosure Statement was scheduled before the Bankruptcy Court on April2, 2008. The April 2, 2008 hearing proceeded as a status conference regarding our progress towards
a new Memorandum of Understanding (“MOU”) with Stephen Norris Capital Partners, LLC. Therefore, we
indicated that we were not presently seeking approval of the adequacy of the Disclosure Statement,
which would need to be amended to reflect the changes to the MOU.
On May 12, 2008, we filed a motion seeking an extension of our exclusive period to submit and
solicit acceptance to a plan of reorganization. A hearing to consider that motion is scheduled for
June 17, 2008. If our motion is denied, creditors may file their own proposed plans of
reorganization. Plans filed by creditors may be less favorable to our stockholders.
If we lose our motion to extend the exclusive period to file our Plan or if our Plan is not
confirmed by the Bankruptcy Court, it is unclear whether we would be able to reorganize our
businesses and what, if anything, holders of claims against us would ultimately receive with
respect to their claims. If an alternative reorganization could not be agreed upon, it is possible
that our bankruptcy proceeding could be converted to a liquidation under Chapter 7 and we would
have to liquidate our assets, in which case it is likely that holders of claims would receive
substantially less favorable treatment than they would receive if we were to emerge as a viable,
reorganized entity and stockholders would likely receive nothing from the liquidation.
A plan of reorganization may result in holders of our common stock receiving no distribution on
account of their interests and cancellation of their common stock.
Under the priority scheme established by the Bankruptcy Code, unless creditors agree
otherwise, post-petition liabilities and prepetition liabilities must be satisfied in full before
stockholders are entitled to receive any distribution or retain any property under a plan of
reorganization. The ultimate recovery to creditors and/or stockholders, if any, will not be
determined until confirmation of a plan or plans of reorganization. No assurance can be given as
to what values, if any, will be ascribed in the Chapter 11 cases to each of these constituencies or
what types or amounts of distributions, if any, they would receive. No assurance can be provided
regarding the date any plan or plans of reorganization will be proposed, confirmed or consummated
or regarding when any distributions could be made to parties in interest. A plan of reorganization
could result in holders of our common stock receiving no distribution on account of their interests
and cancellation of their existing stock. If certain requirements of the Bankruptcy Code are met,
a plan of reorganization can be confirmed notwithstanding its rejection by the class comprising the
interests of our equity security holders. Therefore, an investment in our common stock is highly
speculative.
In addition, if a trustee is appointed to operate the Debtors in Chapter 11 (or the case is
converted to a case under Chapter 7), the trustee would assume control of our assets, including the
SCO Litigation.
We have suffered a significant setback in our lawsuit with Novell that has significantly
limited our claims and raises substantial doubt about our ability to continue as a going concern
and we may not prevail in our lawsuits with IBM, Novell and others.
On August 10, 2007, the Court ruled in favor of Novell on several of the summary judgment
motions that were pending. The effect of these rulings was to significantly reduce or to eliminate
certain of our claims in both the Novell and IBM cases, and possibly others. The Court ruled that
Novell was the owner of the UNIX and UnixWare copyrights that existed at the time of the APA and
that Novell retained broad rights to waive our contract claims against IBM. The Court ruled that
we own the copyrights to post-APA UnixWare derivatives and that we have certain other ownership
rights in the UNIX technology. We were directed to accept Novell’s waiver of its UNIX contract
claims against IBM. In addition, the Court determined that certain SCOsource licensing agreements
that we executed in fiscal year 2003 and thereafter included older SVRx licenses and that we were
possibly required to remit some portion of the proceeds to Novell. Over our objection, a bench
trial was set to begin on September 17, 2007, and the federal judge was to determine what portion,
if any, of the proceeds of the SCOsource agreements is attributable to such SVRx licenses and
should be remitted to Novell, as well as whether we had authority to enter into such SVRx licenses.
The potential payment to Novell for those SVRx licenses ranges from a de minimis amount to in
excess of $30,000,000, the latter amount being the amount claimed by Novell, plus interest. (A few
days before the rescheduled trial Novell reduced the principal amount it was claiming to under
$20,000,000.) Novell also sought to impose a constructive trust on our current funds traceable to
those sources, which could result in a freeze of our assets.
The trial of these issues, however, was automatically stayed as a result of our filing a
voluntary petition for relief under Chapter 11 of the Bankruptcy Code on September 14, 2007. On
October 4, 2007, Novell filed a Motion for Relief from Automatic Stay. On November 27, 2007, the
Bankruptcy Court lifted the stay to permit Novell to pursue the trial scheduled in the Court in
Utah on the allocation of proceeds from the SCOsource agreements and the question of SCO’s alleged
lack of authority to enter into them, but the Bankruptcy Court retained jurisdiction to determine
whether to impose a constructive trust on any amounts found to be payable to Novell.
On April 29 through May 2, 2008, the Court held a bench trial on Novell’s monetary claim for
certain portions of fees we received from the SCOsource agreements and whether we had the authority
to enter into those agreements. Prior to the commencement of the trial, Novell conceded that it
would not be making a claim to a portion of the fees paid to us by Microsoft in 2003 and Novell,
therefore, reduced the principal amount of its claim to $19,979,561. The Court also held oral
argument on the motions filed by us and Novell. After the trial and arguments the
Court took all matters under advisement and stated it would attempt to issue a ruling without
undue delay. It is unknown when rulings might be issued.
It is our intent to appeal the August 10, 2007 summary judgment rulings as soon as that
opportunity is available to us. However, we must complete further legal proceedings before we can
take such an appeal. In the event that any substantial amount of our assets are frozen or if our
assets or resources are further depleted, we may not be able to appeal the August 10, 2007 ruling.
Our management and Board of Directors determined that filing for relief under Chapter 11 of
the United States Bankruptcy Code was appropriate and necessary. As a result of both the Court’s
August 10, 2007 ruling and our entering into Chapter 11, among other matters, there is substantial
doubt about our ability to continue as a going concern including continuing the SCO Litigation or
appealing the adverse ruling of August 10, 2007.
Our financial statements do not include any adjustments that might result from the outcome of
these uncertainties. Absent a significant cash payment to Novell being required by the final
resolution for this matter, management believes that the undiscounted future cash flows generated
by us will be sufficient to recover the carrying amounts of our long-lived assets over their
expected remaining useful lives. However, if a significant cash payment to Novell is required, or
significant assets are put under a constructive trust, the carrying amounts of our long-lived
assets may not be recovered.
The lawsuits with IBM and Novell will continue to be costly. In the event that we are not
successful with the IBM or Novell motions, or the continuing litigation requires more cash than
expected, our business and operations would be materially harmed.
We must continue to pay for expert, consulting and other expenses through the conclusion of
our litigation with IBM and Novell. As we continue with discovery and other trial preparations, we
may be required to place additional amounts into the escrow account, which could further reduce our
liquidity position.
If the Court imposes a constructive trust on proceeds of the fiscal year 2003 SCOsource agreements,
we may not be able to continue in business.
The federal district judge overseeing our lawsuit with Novell had scheduled a bench trial that
was set to begin on September 17, 2007. At that time, the federal judge was to determine what
portion, if any, of the proceeds of the SCOsource agreements are attributable to older SVRx
licenses and should be remitted to Novell, and whether we had the authority to enter into certain
SCOsource agreements beginning in 2003, including large transactions with Sun and Microsoft. The
potential proceeds payable to Novell ranges from a de minimis amount to in excess of $30,000,000,
(now approximately $20,000,000) the latter amount being the amount claimed by Novell, plus
interest. Novell also sought to impose a constructive trust on our current funds traceable to
these sources. The trial of these issues, however, was stayed as a result of our bankruptcy
filing. On October 4, 2007, Novell filed a Motion for Relief from Automatic Stay. On November 27,2007, the Bankruptcy Court lifted the stay to permit Novell to pursue the trial scheduled in the
Court on the allocation of proceeds from the SCOsource agreements and the question of our alleged
lack of authority to enter into them, but the Bankruptcy Court retained jurisdiction to determine
whether to impose a constructive trust on any amounts found to be payable to Novell. From April
29 through May 2, 2008, the Court held a bench trial on Novell’s monetary claim for certain
portions of fees we received from the SCOsource agreements and whether we had the authority to
enter into those agreements, as explained above. Prior to the commencement of the trial, Novell
conceded that it would not be making a claim to a portion of the fees paid to us by Microsoft in
2003 and Novell, therefore, reduced the principal amount of
its claim to $19,979,561. The Court also held oral argument on the motions filed by us and
Novell. After the trial and arguments the Court took all matters under advisement and stated it
would attempt to issue a ruling without undue delay. It is unknown when rulings might be issued.
It is not known when the constructive trust issue will be addressed.
If the Bankruptcy Court imposes a constructive trust in an amount that exceeds our cash and
restricted cash, or if the amounts subject to the constructive trust are otherwise significant, we
may not be able to continue to operate our business absent confirmation of the Plan.
Our claims relating to our UNIX intellectual property may subject us to additional legal
proceedings.
In August 2003, Red Hat brought a lawsuit against us asserting that the Linux operating system
does not infringe our UNIX intellectual property rights and seeking a declaratory judgment for
non-infringement of copyrights and non-misappropriation of trade secrets. In addition, Red Hat
claims we have engaged in false advertising in violation of the Lanham Act, deceptive trade
practices, unfair competition, tortious interference with prospective business opportunities, and
trade libel and disparagement. This case is currently stayed pending the resolution of our suit
against IBM and because of the bankruptcy proceedings. If Red Hat is successful in its claim
against us, our business and results of operations could be materially harmed.
Our Engagement Agreement with the Law Firms representing us in the SCO Litigation requires us to
pay for expert, consulting and other costs, which could harm our liquidity position.
On October 31, 2004, we entered into an engagement agreement (the “Engagement Agreement”) with
Boies, Schiller & Flexner LLP, Kevin McBride and Berger Singerman P.A. (the “Law Firms”). This
Engagement Agreement supersedes and replaces the original engagement agreement that was entered
into in February 2003. The Engagement Agreement governs the relationship between the Law Firms and
us in connection with the Law Firms’ representation of us in the SCO Litigation. Berger Singerman
P.A. was a member of this group of Law Firms. With our consent, the engagement of this firm was
mutually terminated. The last payment received by Berger Singerman P.A. was on November 24, 2004.
Further, Berger Singerman P.A. waived its rights under the Engagement Agreement upon the parties’
agreement for Berger Singerman P.A. to represent the Debtors in their bankruptcy cases.
We must pay one or more contingency fees upon certain amount that we or our stockholders may
receive as a result of a settlement, judgment or a sale of the company. The contingency fee
amounts payable to the Law Firms (which no longer includes Berger Singerman P.A.) will be, subject
to certain credits and adjustments, as follows:
•
33 percent of any aggregate recovery amounts received up to $350,000,000, reduced by
all professional fees previously paid with respect to these proceedings;
•
plus 25 percent of any aggregate recovery amounts above $350,000,000 but less than or
equal to $700,000,000;
•
plus 20 percent of any aggregate recovery amounts in excess of $700,000,000.
The Engagement Agreement specifically provides that, except for the compensation obligations
specifically described above, we will not be obligated to pay any legal fees, whether hourly,
contingent or otherwise, to the Law Firms, or any other law firms that may be engaged by the Law
Firms, in connection with our SCO Litigation through the end of the current litigation between it
and IBM, including any appeals.
On June 5, 2006, we entered into an amendment to the Engagement Agreement and agreed with the
Law Firms to deposit an additional $5,000,000 into the escrow account to cover
additional expert, consulting and other expenses. During October 2006, we deposited an
additional $5,000,000 into the escrow account. In the event that we exhaust these funds, we must
continue to pay for expert, consulting and other expenses through the conclusion of our litigation
with IBM. As we continue with discovery and other trial preparations, we may be required to place
additional amounts into the escrow account, which could further reduce our liquidity position. As
of April 30, 2008, we had a total of $3,162,000 in cash and an additional $3,131,000 of restricted
cash to be used to pursue the SCO Litigation. From October 31, 2004 through April 30, 2008, we
have spent a total of $13,261,000 for expert, consulting and other costs and fees as agreed to in
the Engagement Agreement with the Law Firms in the SCO Litigation. In light of the Chapter 11
filings, the payment of fees under the Engagement Agreement to the Law Firms (other than Berger
Singerman P.A.) is subject to Bankruptcy Court approval.
Developments in the SCO Litigation and fluctuations in our operating results or the failure of our
operating results to meet the expectations of public market analysts and investors may negatively
impact our stock price and our ability to continue in business.
Developments in the SCO Litigation and fluctuations in our operating results or our failure to
meet the expectations of analysts or investors, even in the short-term, could cause our stock price
to decline significantly. Because of the potential for fluctuations in our expenses related to the
SCO Litigation in any particular period, you should not rely on comparisons of our results of
operations as an indication of future performance.
Factors that may affect our results include:
•
our ability to operate effectively under Chapter 11 protection and changes in
business attitudes toward UNIX as a viable operating system compared to other
competing operating systems, especially Linux, as well as the possibility that the
automatic stay triggered by our Chapter 11 filing will be lifted or modified, and a
constructive trust will be imposed upon our cash in a significant amount or the
failure to confirm our reorganization plan;
•
the outcome of pending litigation with Novell and pending motions for summary
judgment in our lawsuit with IBM and Novell, adverse rulings relating to IBM’s and
Novell’s counterclaims, and results of, developments in, or costs of the SCO
Litigation as well as adverse publicity regarding our business and the SCO Litigation;
•
changes in general economic conditions, such as recessions, that could affect
capital expenditures in the software industry;
•
the interest level of resellers in recommending our UNIX business solutions
to end users and the introduction, development, timing, competitive pricing and market
acceptance of our products and services and those of our competitors;
•
the contingency and other costs we may pay to the Law Firms representing us
in our efforts to establish and defend our intellectual property rights;
•
changes in attitudes of customers and partners due to the decline in our UNIX
business and our position against the inclusion of our UNIX code and derivative works
in Linux; and
•
the activities of short sellers.
We also experience fluctuations in operating results in interim periods in Europe and the Asia
Pacific regions due to seasonal slowdowns and economic conditions in these areas. Seasonal
slowdowns in these regions typically occur during the summer months.
As a result of the factors listed above and elsewhere, it is possible that our results of
operations may be below the expectations of public market analysts and investors in any particular
period. This could cause our stock price to decline. If revenue falls below our expectations, and
we are unable to quickly reduce our spending in response, our operating results will be lower than
expected. Our stock price may fall in response to these events. Our common stock may be worthless
unless our confirmed plan of reorganization results in full payment of all creditor claims, of
which there can be no assurance.
For a further description of recent developments in our litigation with Novell, see
“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Recent
Developments, Novell, Inc. Ruling.” For a further description of the risks we face as a result of
filing for Chapter 11, see “A long period of operating under Chapter 11 may harm our business”, “We
may not be able to obtain confirmation of our Chapter 11 plan”, “A plan of reorganization may
result in holders of our common stock receiving no distribution on account of their interests and
cancellation of their common stock”, and “Operating under the U.S. Bankruptcy Code may restrict our
ability to pursue our business strategies.”
If we are unable to retain key personnel in an intensely competitive environment, our operations
could be adversely affected.
We need to retain our key management, technical and support personnel. Competition for
qualified professionals in the software industry is intense, and departures of existing personnel
could be disruptive to our business and might result in the departure of other employees. During
October 2006, and in January 2008, we were required to reduce our operating expenses and eliminated
certain positions within our worldwide workforce in an effort to reduce operating costs. The loss
or departure of any officers or key employees could harm our ability to implement our business plan
and could adversely affect our operations. Our future success depends to a significant extent on
the continued service and coordination of our management team. For a discussion of the risks we
face in attracting and retaining employees due to our Chapter 11 filing, see “A long period of
operating under Chapter 11 may harm our business.”
We operate in a highly competitive market and face significant competition from a variety of
current and potential sources; many of our current and potential competitors have greater financial
and technical resources than we do; thus, we may fail to compete effectively.
In the operating system market, our competitors include IBM, Red Hat, Novell, Sun, Microsoft,
and other UNIX and Linux distributors. These and other competitors are aggressively pursuing the
current UNIX operating system market. Many of these competitors have access to substantially
greater resources than we do. The major competitive alternative to our UNIX products is Linux.
The expansion of our competitors’ offerings may restrict the overall market available for our UNIX
products, including some markets where we have been successful in the past.
Our future success may depend in part on our ability to continue to meet the increasing needs
of our customers by supporting existing and emerging technologies. If we do not have the resources
to enhance our products to meet these evolving needs, we may not remain competitive and be able to
sustain our business. Additionally, because technological advancement in the UNIX operating system
market and alternative operating system markets is progressing at an advanced pace, we will have to
develop and introduce enhancements to our existing products and any new products on a timely basis
to keep pace with these developments, evolving industry standards, changing customer requirements
and keeping current on certifications. Our failure to meet any of these and other competitive
pressures may render our existing products and services obsolete, which would have an adverse
impact on our revenues and operations.
The success of our UNIX business will depend on the level of commitment and certification we
receive from industry partners and developers. In recent years, we have seen hardware and software
vendors as well as software developers turn their certification and application development efforts
toward Linux and elect not to continue to support or certify to our UNIX operating system products.
If this trend continues, our competitive position will be adversely impacted and our future
revenues from our UNIX business will decline. The decline in our UNIX business may be accelerated
if industry partners withdraw their support from us for any reason, including our SCO Litigation.
If the market for UNIX continues to contract, our business will be harmed.
Our revenues from the sale of UNIX products have declined over the last several years. This
decrease in revenues has been attributable primarily to increased competition from other operating
systems, particularly Linux, and from the negative publicity we have received from the SCO
Litigation. Our sales of UNIX products and services are primarily to existing customers. If the
demand for UNIX products continues to decline, and we are unable to develop UNIX products and
services that successfully address a market demand, our UNIX revenues will continue to decline,
industry participants may not certify to our operating system and products, we may not be able to
attract new customers or retain existing customers and our business and results of operations will
be adversely affected. Additionally, with the recent adverse summary judgment rulings in our
lawsuit with Novell and our entry into Chapter 11, customers may likely determine to no longer buy
our products and services. Because of the long adoption cycle for operating system purchases and
the long sales cycle of our operating system products, we may not be able to reverse these revenue
declines quickly.
We may lose the support of industry partners leading to an accelerated decline in our UNIX products
and services revenues.
The decline in our UNIX business, the recent rulings in our lawsuit with Novell and our filing
for protection under Chapter 11 may cause industry partners, developers, customers and hardware and
software vendors to choose not to support or certify to our UNIX operating system products. This
would lead to an increased decline in our UNIX products and services revenues and would adversely
impact our results of operations and liquidity.
We rely on our indirect sales channel for distribution of our products, and any disruption of our
channel at any level could adversely affect the sales of our products.
We have a two-tiered distribution channel. The relationships we have developed with resellers
allow us to offer our products and services to a much larger customer base than we would otherwise
be able to reach through our own direct sales and marketing efforts. Some solution providers also
purchase solutions through our resellers, and we anticipate they will continue to do so. Because
we usually sell indirectly through resellers, we cannot control the relationships through which
resellers, solution providers or equipment integrators purchase our products. In turn, we do not
control the presentation of our products to end users. Therefore, our sales could be affected by
disruptions in the relationships between us and our resellers, between our resellers and solution
providers, or between solution providers and end users. Also, resellers and solution providers may
choose not to emphasize our products to their customers. Any of these occurrences could diminish
the effectiveness of our distribution channel and lead to decreased sales.
Our foreign-based operations and sales are subject to the imposition of governmental controls
and taxes and fluctuations in currency exchange rates that could hurt our results.
We have employees or contractors in certain locations in Europe, the Middle East, Latin
America, and Asia. These foreign operations are subject to certain inherent risks, including:
•
potential loss of developed technology through piracy, misappropriation, or
more lenient laws regarding intellectual property protection;
•
imposition of governmental controls, including trade restrictions and other
tax requirements;
•
fluctuations in currency exchange rates and economic instability;
•
longer payment cycles for sales in foreign countries;
•
seasonal reduction in business activity; and
•
substantial wind down and severance expenses that local law may require be
paid in connection with any termination of our overseas operations.
In addition, certain of our operating expenses are denominated in local currencies, creating
risk of foreign currency translation losses that could reduce our financial results and cash flows.
When we generate profits in foreign countries, our effective income tax rate is increased.
During the three months ended April 30, 2004, our India office was assessed withholding taxes
by the Government of India Income Tax Department. The Tax Department assessed a 15% withholding
tax on certain revenue transactions in India that the Tax Department deemed royalty revenues under
the Income Tax Act. We have filed an appeal with the Tax Department and believe that revenue from
our packaged software does not qualify for royalty treatment and therefore would not be subject to
withholding tax. However, we may be unsuccessful in our appeal against the Tax Department and be
obligated to pay the assessed taxable amounts. Because of our international operations, we may be
subject to additional withholding or other taxes from other international jurisdictions.
We have lost our listing on the Nasdaq Capital Market as a result of our bankruptcy filing and the
loss of our listing has made our stock significantly less liquid and has significantly reduced its
value.
As a result of our having filed for protection under Chapter 11 of the U.S. Bankruptcy Code,
Nasdaq has used its authority under Marketplace Rules 4300, 4450(f) and IM-4300 to delist our
securities from The Nasdaq Capital Market.
Upon delisting from the Nasdaq Capital Market, our stock is traded on the Pink Sheets. In
order to trade on the Pink Sheets, there must be market makers for our stock. Without a number of
market makers in our stock, our stock would be less liquid than it would otherwise be, and the
value of our stock could decrease. In addition, compliance with the rules and regulations of the
Exchange Act relating to “penny stock” may make it more difficult for holders of our common stock
to resell their shares to third parties or to otherwise dispose of them.
Our stock price is volatile.
The trading price for our common stock has been volatile during the last several years and our
share price has changed dramatically over short periods. We believe that changes in our stock
price are affected by the factors mentioned above as well as from changing public perceptions
concerning the strength of the SCO Litigation, developments in our Bankruptcy proceeding and other
factors beyond our control. Public perception can change quickly and without any change or
development in our underlying business or litigation position. An investment in our stock is
subject to such volatility and, consequently, is subject to significant risk.
There are risks associated with the potential exercise of our outstanding options.
As of May 31, 2008, we have issued outstanding options to purchase up to approximately 4,355,000
shares of common stock with an average exercise price of $3.53 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 stock
options may exercise them at a time when we would otherwise be able to obtain additional equity
capital on terms more favorable to us.
Our stock price could decline further because of the activities of short sellers.
Our stock has attracted significant interest from short sellers. The activities of short
sellers could further reduce the price of our stock or inhibit increases in our stock price.
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.
Our stockholder rights plan could make it more difficult for a hostile bid for our company or a
change of control transaction to succeed at current market prices for our stock.
We have adopted a stockholder rights plan. The power given to the Board of Directors by the
stockholder rights plan may make it more difficult for a change of control of our Company to occur
or for our Company to be acquired if the acquisition is opposed by our Board of Directors.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following matters were submitted to and approved by our stockholders at our annual meeting
held April 23, 2008:
1.
To elect seven members to the Board of Directors to serve until their
successors have been appointed. All directors were elected with Ralph J. Yarro III
receiving 15,830,312 votes in favor and 871,520 votes withheld; R. Duff Thompson
receiving 15,903,214 votes in favor and 798,618 votes withheld; Darcy G. Mott
receiving 15,903,973 votes in favor and 797,859 votes withheld; Darl C. McBride
receiving 15,882,192 votes in favor and 819,680 votes withheld; Daniel W. Campbell
receiving 15,903,271 votes in favor and 798,561 votes withheld; Omar T. Leeman
receiving 15,895,986 votes in favor and 805,846 votes withheld; and J. Kent Millington
receiving 15,904,014 votes in favor and 797,818 votes withheld.
2.
To ratify the appointment of Tanner LC as our independent registered public
accounting firm. This motion was passed with 16,344,727 votes in favor, 353,808 votes
against, and 3,297 abstentions.
Certificate of Correction correcting the Certificate of Designation for
Series A-1 Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to
SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).
31.1
Certification of Darl C. McBride, President and Chief Executive Officer,
pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2
Certification of Kenneth R. Nielsen, Chief Financial Officer, pursuant to
Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1
Certification of Darl C. McBride, President and Chief Executive Officer,
pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of Kenneth R. Nielsen, Chief Financial Officer, pursuant to
Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Certificate of Correction correcting the Certificate of Designation for
Series A-1 Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to
SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).
31.1
Certification of Darl C. McBride, President and Chief Executive Officer,
pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2
Certification of Kenneth R. Nielsen, Chief Financial Officer, pursuant to
Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1
Certification of Darl C. McBride, President and Chief Executive Officer,
pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of Kenneth R. Nielsen, Chief Financial Officer, pursuant to
Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
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Dates Referenced Herein and Documents Incorporated by Reference