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Howard B. Sirota

Wednesday, November 4, 2009

Overstock.com Litigation Analysis 2009-2010

Overstock.com Litigation Analysis 2009-2010

Overstock.com’s pending litigation portfolio may have a material financial effect upon the Company’s financial statements for 2009-2010 with a scheduled February 9, 2010 jury trial of the claims by Overstock.com against Rocker et al. and the claims against Overstock.com by the defendants.

In addition, Overstock.com has pending the Great Naked Short Selling Conspiracy Case against the major broker-dealers in America, a sinkhole of e-discovery of enormous proportions to even attempt to prove the case, much less settle it, much less try the case. Throw in the usual cluster of business litigation of class actions to patent suits. Add a pending SEC investigation of the already thrice-restated financials for good measure.

Overstock.com is incurring ramping-up legal expenses that will peak in the Rocker case over the next two quarters, concluding discovery, motions, and perhaps a trial. In 2009 Overstock.com has not been expensing all of its legal expenses, netting an unrelated settlement against the actual pending cases’ costs, thereby understating expenses and overstating reported net income. In the fourth quarter of 2009 and in 2010 legal expenses should not have such offsets and are likely to be at a run-rate of as much as $5 million in the fourth quarter 2009 and $10 million in the first quarter of 2010 if the Rocker case actually goes to trial.

Regardless of the outcome, on a cash basis, the Rocker case will require substantial legal and expert fees and expenses through 2010 and beyond. In my opinion, Overstock.com has overstated its claimed damages recovery if liability is proven, and there is no pot of gold awaiting Overstock.com in Marin County Superior Court in California. To the contrary, with David Boies representing Rocker, Overstock.com may be rendered insolvent by a verdict in favor of Rocker and Copper River.

The history of sketchy public companies suing short-sellers is ugly. To my knowledge, no issuer has ever recovered any substantial sum in such a case. In my opinion, it is very unlikely that Overstock.com will recover anything from Rocker and very likely that any settlement recovery will be nuisance value. If there is a trial, I would expect Copper River to prevail on its claims against Overstock.com. I’m thinking Nemeroff v. Abelson and the Mazzeo fiasco reprised.

The Great Naked Short Selling Case involves enormous e-discovery of the major prime brokers in America who are the defendants, who include defunct Bear Stearns and Lehman, whose records will be extraordinarily expensive to obtain and analyze, and the show-stopper DTCC. Whether intended or not, the automated book-entry system of DTCC destroyed the ability to trace particular shares through the successive buyers and sellers of “those” shares. For example, public investors’ Section 11 rights in stock offerings is one year on paper and in the real world only 90 days until the first Rule 144 sale, at which point the fungible treatment of shares and book-entry netting of the DTCC systems makes it impossible to trace any after-market trade to any particular source. The courts have continued to follow the pre-DTCC requirement of tracing purchase back to the shares in the offering, even though that is today impossible.
The e-trail ends at DTCC, the “Bermuda Triangle” of particular shares, and with major hedge-fund prime brokers Bear and Lehman gone, you cannot ever have an even-incomplete record of short-selling that traces the trail of who sold which shares to whom over time.

Overstock.com does not have any “magic grits” to trace particular shares through market participants at DTCC. The cost to attempt to do so would require a large staff of lawyers, paralegals, experts and computer vendors that would be in excess of $25 million over a period of years to come. In short, this case has been and continues to be a “crusade” rather than a rational economic decision by a fiduciary.

Overstock.com is represented by a “consortium” of law firms that presumably are on a modified contingency arrangement re fees but unlikely to be advancing costs and expenses. Lead lawyer John O’Quinn recently passed away. Co-Lead Counsel Wes Christian was recently sanctioned in an unrelated short-selling conspiracy case in federal court in New York that sank like a rock. Ironically in light of Patrick Byrne’s kooky bigotry, Local Counsel for Overstock.com is Stein & Lubin, reminiscent that Archie Bunker’s lawyers were “Rabinowitz, Rabinowitz & Rabinowitz.”
In conclusion, Overstock.com faces rising cash outlays and large chunks of management time expended in futile litigation in which it is the plaintiff, significant expense and exposure in the cluster of business litigation in which it is the defendant, and a significant probability that it will incur extraordinary legal and audit fees regarding the pending SEC investigation of its financial statements. In my opinion, the new auditor, Grant Thornton, is likely to conduct additional procedures in light of the circumstances.

Disclosure: I became aware of Patrick Byrne and Overstock.com in 2007 through Sam E. Antar, and have spoken out about Patrick Byrne’s anti-Semitism since that time. While I believe that my analysis is accurate, I do have an axe to grind here. Time will tell.

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