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SEC filing reveals Lindows sued Xandros

By Jason Prince on May 10, 2004 (8:00:00 AM)

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Buried in recently published financial documents is the news that Lindows, Inc., has been engaged in a lawsuit with rival and one-time partner Xandros, Inc. since the middle of December 2002. Lindows claims that Xandros failed to repay a $750,000 loan, and that the company and other defendants engaged in fraud and criminal misrepresentation during the negotiations leading up to Lindows' investment in Xandros.

The information came to light when, on April 20, Lindows, Inc. filed a registration statement with the U.S. Securities and Exchange Commission for an initial public offering (IPO) of common stock.

According to court documents obtained by Newsforge, Lindows and Xandros began negotiations to enter into a strategic relationship in the second half of 2001. Two directors of the venture capital firm Linux Global Partners, Michael A. Bego and William J. Roseman, contacted Lindows executives and suggested that Lindows invest in Xandros, a newly formed entity that had been created by LGP to develop an operating system based on code from Canadian software company Corel. Lindows loaned Xandros a total of $750,000 and received three Promissory Notes in exchange, and the two companies entered into a strategic alliance on November 20, 2001.

According to the documents, the partnership began to unravel about a year later, and effectively ended on December 13, 2002, when Lindows sued Xandros and Linux Global Partners, as well as Bego and Roseman individually, for fraud and breach of contract.

"There is nothing terribly unusual about the lawsuit as far as I can tell," Thomas Carey, a partner at law firm Bromburg & Sunstein, a Boston-based law firm concentrating on intellectual property, business and litigation, told NewsForge. "Disputes are common when an amorous relationship turns sour, and technology companies are not immune from this dynamic." Carey, an expert in business practice, says that this case is unusual only because the plaintiff can afford to go to court. "Startups are less likely to sue because they are less likely to have the money to proceed," he said.

The claims

The first and most important claim made by Lindows relates to the three securities issued to the company by Xandros in late 2001. Originally there were to be two Promissory Notes valued at $250,000 and a third valued at $500,000; however, in the end the third Note was only valued at $250,000. The first Promissory Note was signed on November 20, 2001, the same day that the two companies put their seal on a larger Strategic Alliance Agreement; the further two Notes were signed on December 6 and December 21, 2001. According to the terms of the Promissory Notes, the convertible securities were to be repaid in three lots, each Note falling due one year after the date it was signed.

Lindows claims that as the Promissory Notes fell due in December 2002, Xandros failed to repay any of the $750,000 (with interest), nor did they repay the due amount in Xandros common stock, as was allowed under certain conditions according to the terms of the Notes.

The second claim is more complicated, and relates to the decision-making process surrounding the investment Lindows made in Xandros. Lindows alleges that the defendants deliberately misled them by misrepresenting the financial status of Xandros. The specifics of this allegation are not made very clear in the court documents obtained by NewsForge, but Lindows claims that had they known more about Xandros' financial status and other "relevant information" they may not have chosen to invest the $750,000 in the company. Apparently central to this allegation is the claim that Xandros made in the second half of 2001 to have secured $10 million in funding from Linux Global Partners.

On August 29, 2001, Xandros issued a press release claiming that the startup had "secured a $10 million capital commitment from NY-based Linux Global Partners." The reality appears to have been more complex; LGP had promised to attempt to raise $10 million dollars by selling equity in itself to investors, and the agreement was to secure an understanding that the proceeds from this attempt were to be made available exclusively to Xandros. The funds would be exchanged in return for additional Xandros stock. LGP then hired a third party, Connecticut-based Allen Capital Markets, to do the work on their behalf. The $10 million figure was a ballpark amount, not an exact legal commitment.

While it is not unusual for a company to simplify matters for the press, Lindows seems to be alleging that Xandros withheld the specifics of this arrangement from them as well, merely stating that they had been offered $10 million from Linux Global Partners, that around $1.2 million had already been handed over by LGP, and that the balance was to arrive shortly.

Lindows claims that they were considering an outright purchase of Xandros in the fall of 2001, and that their investment was designed to allow them to both keep Xandros trading in the short-term while the balance of the $10 million was outstanding, and to allow them to convert their investment into Xandros shares should this become desirable; otherwise the money would be paid back with an 8% return the following year. Lindows alleges that Xandros and Linux Global Partners misrepresented the true status and import of the capital commitment throughout their initial dealings with the company.

The response

To date, the defendants have largely ignored Lindows' specific allegations; instead they have filed a motion that seeks to compel Lindows to enter into arbitration, while at the same time staying or dismissing the court action. However, three key defendents -- Michael Bego, William Roseman, and LGP co-founder and Xandros Chairman Dr. Frederick H. Berenstein -- have now been deposed (interviewed under oath without a judge being present). The parts of their testimony that do not relate to the Xandros motion may be a preview of the defense that they intend to present should the case go to trial.

In their sworn testimony, both William Roseman and Michael Bego maintain that it was their understanding that the funds provided by Lindows were pre-payments towards the revenue-sharing scheme established as part of the Strategic Alliance Agreement (SAA). The strategic alliance was designed to allow Lindows to put Xandros technology into Lindows' own operating system; in return, Lindows would pay royalties to Xandros, possibly as high as 50% of total operating system revenue.

Lindows does not call the SAA into question, but does maintain that the convertible securities were entirely separate, and not an integral part of the agreement.

The documentary evidence that is currently available regarding the alleged connection between the convertible securities and the SAA is contradictory. There is no mention of the Strategic Alliance Agreement or of the alleged connection between the SAA and the convertible securities in any of the Promissory Notes. The text of the SAA has been suppressed by the court and is therefore not available for review, but it appears from what was said at the depositions and in subsequent submissions by Lindows that there is also no mention of the Promissory Notes in the SAA. However, a clause in the first Promissory Note mentions a Letter Agreement "regarding this Note and future investments in [Xandros] by [Lindows]," and the second Promissory Note mentions the existence of an amendment to the same Letter Agreement; the third Note makes no mention of a Letter Agreement at all.

To add to the complexity, none of the parties can find a signed and dated copy of the original Letter Agreement, although both parties have produced a copy of the amendment letter, and Michael Bego has produced an unsigned, undated copy of the Letter Agreement itself. The Letter Agreement explicitly states that all of the convertible securities are to be credited as pre-payments towards the revenue-sharing scheme outlined in the SAA. However, the evidence for the claim that the money invested by Lindows in the convertible securities were pre-payments toward the revenue sharing scheme remains extremely tenuous for two reasons: firstly, the fact that neither party can find a signed, dated copy of the Letter Agreement, which not only raises doubts about its authenticity, but may also make the Letter Agreement as it stands inadmissible as evidence, authentic or not; and secondly, the fact that neither the SAA nor the Promissory Notes themselves menti on or even allude to such an arrangement -- the only confirmation remains that single unsigned and undated document.

There obviously was a Letter Agreement of some kind, but the evidence as provided by both parties is insufficient to come to a conclusion, although the SAA may shed further light on the matter. In a written submission on January 20 of this year, Kevin Carmony, president of Lindows, Inc., said that as far as he recalled, "no such document was ever signed by either party because no agreement regarding 'Future Investment' was ever reached between Lindows.com and Xandros, Inc."

In spite of this declaration, the first Promissory Note, which was signed by both parties, explicitly states that such an agreement exists. Further, the second Promissory Note clearly mentions an amendment to the Letter Agreement, and the amendment letter, as submitted by both Lindows and Xandros, and signed by both Michael Bego and Kevin Carmony, refers to the original Letter Agreement as "regarding Future Investment." However, neither Xandros nor Lindows has produced a copy of the amendment letter in which the date of the Letter Agreement is filled in -- in both copies the space where the date should be filled in by hand is blank. This is a remarkable oversight when one considers that the other legal documents submitted by both parties (other than the disputed Letter Agreement) are all scrupulously dated.

The Xandros motion

Rather than responding directly to the charges, the defendants on February 20, 2003, filed a motion to compel Lindows to enter into arbitration. The suit remains largely on hold while the presiding judge considers this motion. Xandros argues that the aforementioned Letter Agreement proves that a link exists between the Promissory Notes and the Strategic Alliance Agreement. This is important in the context of the Xandros motion because the Strategic Alliance Agreement has an arbitration clause, which could prevent Lindows from obtaining a jury trial, and instead put the case into the hands of an impartial arbiter. Xandros argues that the arbitration clause in the SAA extends by implication to any related contracts, such as the Promissory Notes, and that the judge should refer Lindows' complaint to arbitration, and either stay or dismiss the court action. Lindows disputes the admissibility of the Letter Agreement itself due to the fact that neither party can produce a dated and signed copy. If the Letter Agreement can be dismissed from evidence, the chances of Xandros proving a link between the Promissory Notes and the SAA are reduced, although not completely eliminated.

In addition to disputing the Letter Agreement, and as an alternative line of reasoning to fall back on should the Letter Agreement be accepted as evidence, Lindows argues that because of the constitutional guarantee to trial by jury in civil cases, the court must analyze any disputed contracts -- in this case, the three Promissory Notes -- under California law before invoking the Federal Arbitration Act's rule that arbitration is to be favored in most cases. They contend that state law requires that any extrinsic documents related to a disputed contract are only to be taken into account by the court when the language in the actual contract is ambiguous; and they argue that the Promissory Notes clearly indicate that it is the intention of the signatories to resolve any disputes in a court of law, not by arbitration.

According to Bromburg & Sunstein's Carey, the fate of Xandros' motion is unclear, as contract interpretation by the judiciary is erratic at best. "These arguments about extrinsic documents and their effect on an arbitration clause are common," he says. "The results of the arguments are unpredictable, and it often depends on what the judge hearing them had for lunch that day. This is not a question of the Seventh Amendment; it is a question of contract interpretation.

"That being said," Carey continues, "the Notes other than the December 21 Note will probably end up in arbitration to be interpreted in light of the side letter. The December 21 Note, which makes no reference to a side agreement, should be strictly enforceable in court, without being scrutinized in light of extrinsic documents.

"Xandros' position regarding the SAA and the arbitration appears very weak," Carey concludes. "They signed the note, they agreed to repay the money, and they haven't. That kind of case is usually a slam dunk."

It is likely, therefore, that Lindows will get its day in court -- and that this case will be with us for quite some time to come.

Jason Prince is studying Computer Science at Australia's Macquarie University. His areas of interest include Linux in small businesses and education, as well as Customer Relationship Management (CRM).

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on SEC filing reveals Lindows sued Xandros

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I think it's fair...

Posted by: Anonymous Coward on May 10, 2004 09:05 PM
I think it's fair for Lindows Inc. to go after Xandros for the money they are owed. I hope this wraps up quickly though as it can only damage the momentum linux is garnering.

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Go Lindows!

Posted by: Anonymous Coward on May 11, 2004 04:28 AM
I think Lindows is doing good to the Linux community with it's businesses and lawsuits... first they opposed MS and now they even clean up a bit within the Linux community. We don't want the kind of business practices it seems Xandros has been making!
Play fair or don't play at all!

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