UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended July 31, 2008

For the transition period from                      to                     

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

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 September 9, 2008, there were 21,886,288 shares of the Registrant’s common stock, $0.001 par value per share, outstanding.

 

Table of Contents

     The SCO Group, Inc. (the “Company”) markets 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 $7,623,000 for the nine months ended July 31, 2008, and during that same period used cash of $3,602,000 in its operating activities. As of July 31, 2008, the Company had a total of $2,117,000 in cash and $2,680,000 in restricted cash, of which $1,639,000 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 $1,041,000 of restricted cash is payable to Novell for post bankruptcy petition 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 case (“Novell Litigation”) and the IBM case, and possibly others (collectively, 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 ranged from a de minimis amount to in excess of $30,000,000, the latter amount being the amount claimed by Novell, plus interest.

     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 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 arbritation proceeding pending in Europe. 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 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.

     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.

     On July 16, 2008, the Court entered its Findings of Fact, Conclusions of Law, and Order, ruling that (1) the SCOsource agreements with Linux end-users were not SVRx licenses and therefore Novell is not entitled to revenue from those agreements; (2) the 2003 SCOsource agreement with Microsoft contained an SVRx License that was incidental to the UnixWare license in the agreement, and therefore SCO was authorized to enter into the license and Novell is not entitled to revenue from the agreement; (3) the 2003 SCOsource agreement with Sun also contained an authorized incidental SVRx license and Novell is not entitled to revenue attributable to that license; and (4) the same Sun agreement contained an unauthorized amendment of a prior UNIX agreement, and Novell is entitled to $2,547,817 of the revenue from the Sun agreement as attributable to that amendment. The Court directed Novell to file a brief identifying the amount of prejudgment interest it seeks based on this award. On August 29, 2008, Novell filed an Unopposed Submission Regarding Prejudgment Interest, informing the Court that the parties agree that Novell is entitled to $918,122 in prejudgment interest through that date, plus $489 per day until the entry of final judgment, based on the Court’s $2,547,817 award.

     In its ruling of July 16, 2008, the Court also directed Novell to file a proposed Final Judgment consistent with the Court’s trial and summary judgment orders. In its proposed submission to the Court in compliance with this order, Novell took the position that final judgment cannot be entered because certain SCO claims are stayed pending arbitration and the imposition of a constructive trust remains an open question in the Bankruptcy Court. Subsequently, in order to expedite the entry of final judgment, SCO sought to resolve these issues with Novell and agreed to an extension of Novell’s deadline for filing its submission. Based on SCO’s tracing of Sun’s payments under its 2003 SCOsource agreement, Novell agreed that only $625,487 of SCO’s current assets were traceable as trust funds. SCO also proposed dismissing its stayed claims with prejudice on the basis of the Court’s ruling that Novell owns the pre-APA UNIX copy rights in the Court’s summary judgment order of August 10, 2007. On August 29, 2008, in its Submission Regarding the Entry of Final Judgment, Novell informed the Court of the parties’ agreement as to the trust amount, but Novell stood by its position that final judgment could not be entered in light of the stayed claims. On September 15, 2008, SCO filed papers arguing for the entry of final judgment.

     As a result of this order from the Court, the Company has accrued $3,473,000 for this contingent liability and related interest. However, the Company, continues to contest this liability. The Company believes that this order is in error, and that the Company has strong grounds to overturn it and the August 10, 2007 summary judgment upon appeal.

     The Company intends to appeal the adverse August 10, 2007 summary judgment ruling and the July 16, 2008 order as soon as Final Judgment is entered upon those orders. However, in the event that the Company’s assets are further depleted or frozen, the Company may not be in a financial position to appeal those rulings.

     The Company’s management and board of directors determined that filing for relief under Chapter 11 of the United States Bankruptcy Code on September 14, 2007 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 and the July 16, 2008 order.

     Absent a significant cash payment to Novell being required by the final resolution for the aforementioned court order, 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 the carrying amount of the Company’s long-lived assets may not be recovered.

     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 for the District of Delaware. The Debtors’ Chapter 11 cases are being jointly administered under Case No. 07-11337(KG). The Debtors continue to exercise control over their assets and 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. 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.

     On September 18, 2007, the Bankruptcy Court granted the Debtors’ motions to maintain their existing bank accounts and cash management systems, to pay pre-bankruptcy wage-related items, to establish procedures relating to utility providers and to employ temporary employees.

     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 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. On the same day, the Company filed its disclosure statement in connection with the plan of reorganization, under the terms contemplated by the MOU.

     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 an amended or new plan of reorganization to August 11 and October 13, 2008, respectively. A hearing to consider that motion was scheduled for June 17, 2008. The Bankruptcy Court granted the motion on June 17, 2008. The Debtors filed another motion for an extension of their exclusive periods to submit and solicit acceptances of a plan of reorganization to a date 45 and 105 days, respectively, following an entry of a final judgment in the Novell Litigation. The hearing on that motion will be heard September 16, 2008.

     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, the Company 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.

     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 (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 of reorganization.

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 sheets 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 statements of cash flows.

     Operating results for the nine months ended July 31, 2008 are not necessarily indicative of the operating results that may be expected for the year ending October 31, 2008.

     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 the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those 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 net deferred income tax assets.

     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 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 July 31, 2008 and October 31, 2007, respectively. Cash was $2,117,000 and $3,628,000 as of July 31, 2008 and October 31, 2007, respectively. The Company has $100,000 of cash that is federally insured through the financial institutions in which it is deposited. All remaining amounts of cash and restricted cash as of July 31, 2008 exceed federally insured limits.

     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 4,322,000 and 5,646,000 for the three and nine months ended July 31, 2008 and 2007, respectively, are not included in the calculation of diluted net loss per common share because they are anti-dilutive.

IBM

     On 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 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 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 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 claims arising from its termination of IBM’s UNIX licenses. The Company believes that the Court’s August 10, 2007 ruling does not 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.

     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 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.

     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 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 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.

     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.

     On July 16, 2008, the Court entered its Findings of Fact, Conclusions of Law, and Order, ruling that (1) the SCOsource agreements with Linux end-users were not SVRx licenses and therefore Novell is not entitled to revenue from those agreements; (2) the 2003 SCOsource agreement with Microsoft contained an SVRx license that was incidental to the UnixWare license in the agreement, and therefore SCO was authorized to enter into the license and Novell is not entitled to revenue from the agreement; (3) the 2003 SCOsource agreement with Sun also contained an authorized incidental SVRx license and Novell is not entitled to revenue attributable to that license; and (4) the same Sun agreement contained an unauthorized amendment of a prior UNIX agreement, and Novell is entitled to $2,547,817 of the revenue from the Sun agreement as attributable to that amendment. The Court directed Novell to file a brief identifying the amount of prejudgment interest it seeks based on this award. On August 29, 2008, Novell filed an Unopposed Submission Regarding Prejudgment Interest, informing the Court that the parties agree that Novell is entitled to $918,122 in prejudgment interest through that date, plus $489 per day until the entry of final judgment, based on the Court’s $2,547,817 award.

     In its ruling of July 16, 2008, the Court also directed Novell to file a proposed Final Judgment consistent with the Court’s trial and summary judgment orders. In its proposed submission to the Court in compliance with this order, Novell took the position that final judgment cannot be entered because certain SCO claims are stayed pending arbitration and the imposition of a constructive trust remains an open question in the Bankruptcy Court. Subsequently, in order to expedite the entry of final judgment, SCO sought to resolve these issues with Novell and agreed to an extension of Novell’s deadline for filing its submission. Based on SCO’s tracing of Sun’s payments under its 2003 SCOsource agreement, Novell agreed that only $625,487 of SCO’s current assets were traceable as trust funds. SCO also proposed dismissing its stayed claims with prejudice on the basis of the Court’s ruling that Novell owns the pre-APA UNIX copyrights in the Court’s summary judgement order of August 10, 2007. On August 29, 2008, in its Submission Regarding the Entry of Final Judgment, Novell informed the Court of the parties’ agreement as to the trust amount, but Novell stood by its position that final judgment could not be entered in light of the stayed claims. On September 15, 2008, SCO filed papers arguing for the entry of final judgment.

     As a result of this order from the Court, the Company has accrued $3,473,000 for this contingent liability and related interest. However, the Board of Directors and management of the Company, continue to contest this liability. They believe that this order is in error, and that the Company has strong grounds to overturn it and the August 10, 2007 summary judgment upon appeal.

     The Company intends to appeal the adverse August 10, 2007 summary judgment ruling and the July 16, 2008 order as soon as Final Judgment is entered upon those orders.

     In July 2001, the Company and several of its former officers and directors (the “Individual Defendants”) were named as defendants in class action complaints alleging violations of the federal securities laws in the United States District Court, Southern District of New York. On April 19, 2002, plaintiffs filed a Consolidated Amended Complaint, which is now the operative complaint. The complaint seeks unspecified damages and alleges violations of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiffs allege that the underwriter defendants agreed to allocate stock in the Company’s initial public offering to certain investors in exchange for excessive and undisclosed commissions and agreements by those investors to make additional purchases of stock in the aftermarket at pre-determined prices. Plaintiffs allege that the Registration Statement for the Company’s initial public offering was false and misleading because it did not disclose these arrangements.

     The action is being coordinated with approximately three hundred other nearly identical actions filed against other companies. On October 9, 2002, the court dismissed the Individual Defendants from the case without prejudice. This dismissal disposed of the Section 15 and 20(a) control person claims without prejudice, since these claims were asserted only against the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss with respect to the Company.

     On December 5, 2006, the Second Circuit vacated a decision by the district court granting class certification in six “focus” cases, which are intended to serve as test cases. Plaintiffs selected these six cases, which do not include the Company. On April 6, 2007, the Second Circuit panel denied a petition for rehearing filed by the plaintiffs, but noted that the plaintiffs could ask the district court to certify a more narrow class than the one that was rejected.

     Prior to the Second Circuit’s December 5, 2006 ruling, a majority of the issuers, including the Company, and their insurers had submitted a settlement agreement to the district court for approval. In light of the Second Circuit opinion, the parties agreed that the settlement could not be approved. On June 25, 2007, the district court approved a stipulation filed by the plaintiffs and the issuers terminating the proposed settlement. On August 14, 2007, the plaintiffs filed amended complaints in the six focus cases. The amended complaints include a number of changes, such as changes to the definition of the purported class of investors, and the elimination of the individual defendants as defendants. On September 27, 2007, the plaintiffs moved to certify a class in the six focus cases. On November 14, 2007, the issuers and the underwriters named as defendants in the six focus cases filed motions to dismiss the amended complaints against them. On March 26, 2008, the district court dismissed the Securities Act claims of those members of the putative classes in the focus cases who sold their securities for a price in excess of the initial offering price and those who purchased outside the previously certified class period. With respect to all other claims, the motions to dismiss were denied. The Company is awaiting a decision from the Court on the class certification motion.

     Due to the inherent uncertainties of litigation, the Company cannot predict the ultimate outcome of this matter. 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, liquidity or financial position, and will not exceed the $200,000 self-insured retention already paid or accrued by the Company.

     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 automatic 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.

     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, liquidity 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, liquidity or financial position.

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 of directors 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 of directors 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 for the three months ended July 31, 2008 and 2007 was to record $237,000 and $396,000, respectively, of stock-based compensation expense. For the nine months ended July 31, 2008 and 2007, $590,000 and $1,407,000, respectively, of stock-based compensation expense was recorded. For the three and nine months ended July 31, 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 nine months ended July 31, 2008 and 2007, the assumptions used in the Black-Scholes option-pricing model are as follows:

     The estimated fair value of stock options is amortized over the vesting period of the award.

     During the nine months ended July 31, 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 nine months ended July 31, 2008, no options to purchase common stock were exercised. As of July 31, 2008, there were approximately 4,309,000 stock options outstanding with a weighted average exercise price of $3.37per share.

     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 an amended or new plan of reorganization to August 11 and October 13, 2008, respectively. A hearing to consider that motion was scheduled for June 17, 2008. The Bankruptcy Court granted the motion on June 17, 2008. The Debtors filed another motion for an extension of their exclusive periods to submit and solicit acceptances of a plan of reorganization to a date 45 and 105 days, respectively, following the entry of a final judgment in the Novell Litigation. The hearing on that motion will be heard on September 16, 2008.

     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 and notes thereto 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 nine months ended July 31, 2008 and 2007. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

     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 case (the “Novell Litigation” and the IBM case, and possibly others (collectively, 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 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 ranged from a de minimis amount to in excess of $30,000,000, the latter amount being the amount claimed by Novell, plus interest.

     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 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 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 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.

     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.

     On July 16, 2008, the Court entered its Findings of Fact, Conclusions of Law, and Order, ruling that (1) the SCOsource agreements with Linux end-users were not SVRx licenses and therefore Novell is not entitled to revenue from those agreements; (2) the 2003 SCOsource agreement with Microsoft contained an SVRx license that was incidental to the UnixWare license in the agreement, and therefore we were authorized to enter into the license and Novell is not entitled to revenue from the agreement; (3) the 2003 SCOsource agreement with Sun also contained an authorized incidental SVRx license and Novell is not entitled to revenue attributable to that license; and (4) the same Sun agreement contained an unauthorized amendment of a prior UNIX agreement, and Novell is entitled to $2,547,817 of the revenue from the Sun agreement as attributable to that amendment. The Court directed Novell to file a brief identifying the amount of prejudgment interest it seeks based on this award. On August 29, 2008, Novell filed an Unopposed Submission Regarding Prejudgment Interest, informing the Court that the parties agree that Novell is entitled to $918,122 in prejudgment interest through that date, plus $489 per day until the entry of final judgment, based on the Court’s $2,547,817 award.

     In its ruling of July 16, 2008, the Court also directed Novell to file a proposed Final Judgment consistent with the Court’s trial and summary judgment orders. In its proposed submission to the Court in compliance with this order, Novell took the position that final judgment cannot be entered because certain of our claims are stayed pending arbitration and the imposition of a constructive trust remains an open question in the Bankruptcy Court. Subsequently, in order to expedite the entry of final judgment, we sought to resolve these issues with Novell and agreed to an extension of Novell’s deadline for filing its submission. Based on our tracing of Sun’s payments under its 2003 SCOsource agreement, Novell agreed that only $625,487 of our current assets were traceable as trust funds. We also proposed dismissing our stayed claims with prejudice on the basis of the Court’s ruling that Novell owns the pre-APA UNIX copyrights in the Court’s summary judgment order of August 10, 2007. On August 29, 2008, in its Submission Regarding the Entry of Final Judgment, Novell informed the Court of the parties’ agreement as to the trust amount, but Novell stood by its position that final judgment could not be entered in light of the stayed claims. On September 15, 2008, we filed papers arguing for the entry of final judgment.

     As a result of this order from the Court, we have accrued $3,473,000 for this contingent liability and related interest. However, we continue to contest this liability. We believe that this order is in error, and that we have strong grounds to overturn it and the August 10, 2007 summary judgment upon appeal.

     We intend to appeal the adverse August 10, 2007 summary judgment ruling and the July 16, 2008 order as soon as Final Judgment is entered upon those orders. However, in the event that our assets are further depleted or frozen, we may not be in a financial position to appeal those rulings.

     Our management and board of directors determined that filing for relief under Chapter 11 of the United States Bankruptcy Code on September 14, 2007 was appropriate and necessary. As a result of both the Court’s August 10, 2007 order and our entry into Chapter 11, among other factors, 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 and the July 16, 2008 order.

     Absent a significant cash payment to Novell being required by the final resolution for this matter, we believe that the undiscounted future cash flows generated by us will be sufficient to recover the carrying values of our long-lived assets over their expected remaining useful lives. However, if a significant cash payment is required the carrying amount of our long-lived assets may not be recovered (which totaled $184,000 as of July 31, 2008).

     We intend to maintain business operations throughout the reorganization process. Subject to the Bankruptcy Court’s approval, we intend to 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). As the Debtors, we continue to exercise control over our assets and operate our 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. Our foreign subsidiaries, as non-debtors, are not subject to the requirements of the Bankruptcy Code and are not subject to Bankruptcy Court supervision.

     On September 18, 2007, the Bankruptcy Court granted our motions to maintain our existing bank accounts and cash management systems, to pay pre-bankruptcy wage-related items, to establish procedures relating to utility providers and to employ temporary employees.

     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. 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. On February 29, 2008, we filed the Plan and 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 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 an amended or new plan of reorganization to August 11 and October 13, 2008, respectively. A hearing to consider that motion was scheduled for June 17, 2008. The Bankruptcy Court granted the motion on June 17, 2008. We filed another motion for an extension of our exclusive periods to submit and solicit acceptances of a plan of reorganization to a date 45 and 105 days, respectively, following the entry of a final judgment in the Novell Litigation. The hearing on that motion will be heard on September 16, 2008.

     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.

     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 nine months ended July 31, 2008 and 2007:

     Revenue from the UNIX business decreased by $947,000, or 20%, for the three months ended July 31, 2008 compared to the three months ended July 31, 2007 and revenue from the UNIX business decreased by $4,420,000, or 26%, for the nine months ended July 31, 2008 compared to the nine months ended July 31, 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 $5,264,000 for the three months ended July 31, 2007 to $3,362,000 for the three months ended July 31, 2008 and operating costs for the UNIX business decreased from $16,084,000 for the nine months ended July 31, 2007 to $12,628,000 for the nine months ended July 31, 2008. These decreases were primarily attributable to reduced headcount and related costs.

     The decline in our UNIX business revenue will continue if the factors that have contributed to the decline described above continue or 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 nine months ended July 31, 2008 and 2007:

     Revenue from our SCOsource business was $0 for the three months ended July 31, 2007 and July 31, 2008. Revenue decreased from $23,000 for the nine months ended July 31, 2007 to $0 for the nine months ended July 31, 2008. Revenue in the nine month period ended July 31, 2007 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, increased from $1,156,000 for the three months ended July 31, 2007 to $2,876,000 for the three months ended July 31, 2008 and increased from $2,876,000 for the nine months ended July 31, 2007 to $3,476,000 for the nine months ended July 31, 2008. These increases were due to the $2,548,000 judgment in the Novell litigation for an unauthorized amendment to a prior UNIX agreement with Sun as previously mentioned under Recent Developments partially offset by decreases in legal expenses 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 amounts 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 SCOsource revenue in the future.

     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.

     Our critical accounting policies and estimates include the following:

     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 Net Deferred Income Tax Assets. The amount, and ultimate realization, of our net 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 against our entire net deferred income tax assets as of July 31, 2008 and 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. We have accrued $3,473,000 for the Novell claim as a result of the court order of July 16, 2008. This contingent liability is included in the caption Liabilities Subject to Compromise. However, we continue to contest this liability. We believe that this order is in error, and that we have strong grounds to overturn it and the August 10, 2007 summary judgment upon appeal.

     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 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 $124,000 as of July 31, 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 differences may be material, which may have an adverse impact on our future accounts receivable and cash position.

     The following table presents our results of operations for the three and nine months ended July 31, 2008 and 2007:

Revenue

     Revenue for the three months ended July 31, 2008 decreased by $947,000, or 20%, from the three months ended July 31, 2007 and revenue for the nine months ended July 31, 2008 decreased by $4,443,000, or 27%, from the nine months ended July 31, 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 $947,000, or 20%, for the three months ended July 31, 2008 compared to the three months ended July 31, 2007 and the decrease in revenue in the UNIX business of $4,420,000, or 26%, for the nine months ended July 31, 2008 compared to the nine months ended July 31, 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 nine months ended July 31, 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 $520,000, or 14%, for the three months ended July 31, 2008 compared to the three months ended July 31, 2007 and the decrease in products revenue of $3,194,000, or 24%, for the nine months ended July 31, 2008 compared

to the nine months ended July 31, 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 October 31, 2008 and future periods.

     Our products revenue was derived primarily from sales of our OpenServer and UnixWare products. Other products revenue consists mainly of products 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 nine months ended July 31, 2008 compared to the three and nine months ended July 31, 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 products 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 July 31, 2008 and July 31, 2007 and was $0 for the nine months ended July 31, 2008 compared to $23,000 for the nine months ended July 31, 2007. Revenues for the nine months ended July 31, 2007 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 may be 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 $427,000, or 43%, for the three months ended July 31, 2008 compared to the three months ended July 31, 2007 and the decrease in services revenue of $1,226,000, or 38%, for the nine months ended July 31, 2008 compared to the nine months ended July 31, 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 $101,000 for the three months ended July 31, 2008 as compared to the three months ended July 31, 2007 and decreased by $339,000 for the nine months ended July 31, 2008 as compared to the nine months ended July 31, 2007. These 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 increased by $1,720,000, or 149%, during the three months ended July 31, 2008 as compared to the three months ended July 31, 2007 and increased by $600,000, or 21%, for the nine months ended July 31, 2008 as compared to the nine months ended July 31, 2007. These increases were due to the $2,548,000 judgment in the Novell litigation for an unauthorized amendment to a prior UNIX agreement with Sun as previously mentioned under Recent Developments, which is partially offset by 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 in the future. 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 October 31, 2008 or for future periods to be higher than the costs incurred for the three months ended July 31, 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 $203,000, or 45%, for the three months ended July 31, 2008 compared to the three months ended July 31, 2007 and decreased by $594,000, or 38%, for the nine months ended July 31, 2008 compared to the nine months ended July 31, 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 $698,000, or 28%, for the three months ended July 31, 2008 compared with the three months ended July 31, 2007 and the decrease of $666,000, or 9%, for the nine months ended July 31, 2008 compared with the nine months ended July 31, 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, partially offset by an increase in severance and termination costs. Included in sales and marketing expenses for the three months ended July 31, 2008 and 2007 was $50,000 and $68,000, respectively, for stock-based compensation. Included in sales and marketing expenses for the nine months ended July 31, 2008 and 2007 was $135,000 and $286,000, respectively, for stock-based compensation.

     For the three months ending October 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 July 31, 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 $716,000, or 50%, for the three months ended July 31, 2008 compared with the three months ended July 31, 2007 and decreased by $1,825,000, or 39%, for the nine months ended July 31, 2008 compared with the nine months ended July 31, 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 July 31, 2008 and 2007 was $13,000 and $51,000, respectively, of stock-based compensation. Included in research and development expenses for the nine months ended July 31, 2008 and 2007 was $38,000 and $147,000, respectively, for stock-based compensation.

     For the three months ending October 31, 2008, we anticipate that the dollar amount of research and development expenses will be generally consistent with that incurred during the three months ended July 31, 2008.

     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 $488,000, or 35%, during the three months ended July 31, 2008 as compared to the three months ended July 31, 2007 and decreased by $965,000, or 24%, during the nine months ended July 31, 2008 as compared to the nine months ended July 31, 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 July 31, 2008 and 2007 was $98,000 and $197,000, respectively, of stock-based compensation. Included in general and administrative expenses for the nine months ended July 31, 2008 and 2007 was $226,000 and $729,000, respectively, for stock-based compensation.

     For the three months ending October 31, 2008, we anticipate that the dollar amount of general and administrative expenses will be generally consistent with that incurred during the three months ended July 31, 2008.

     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 July 31, 2008, the carrying value of our investment of $373,000 was for our 30% ownership in a Chinese company.

     Reorganization expense consists of legal and professional fees associated with our Chapter 11 bankruptcy and development of a reorganization plan.

     Other income (expense) included the following components for the three and nine months ended July 31, 2008 and 2007: