Jury Verdict Against JDA Software Exposes Hidden Industry Risks

by: MGI Research

Wednesday's announcement of the $246 million jury verdict against JDA Software (NASDAQ:JDAS), surrounding its i2 product, highlights the hidden legal risks that are often poorly understood by technology investors and management. In an unrelated legal development, Oracle (NYSE:ORCL) was hit with a whistleblower-driven case involving software pricing for GSA government contracts.

In the specific case involving i2, a Texas jury awarded Dillard's Stores (NYSE:DDS) close to $100 million in actual damages and $150 million in punitive damages, with jurors unanimous on all but 2 of the 24 questions in the charge. The size of this jury award is unprecedented in the software industry, and will likely have broad ramifications beyond the scope of JDA Software, a mid-size provider of enterprise applications.

The amount of the judgment exceeds JDA's available cash and surpasses i2’s revenues for 12 months ending 9/30/2009. JDA Software is most certainly going to appeal the verdict to have it either set aside or modified. The company has a $20 million liability insurance policy with a $5 million deductible, which may offset some or all of the potential future actual damages. The appeal process is likely to take up to 24 months.

The legal situation places question marks over JDA's due diligence and disclosure during the i2 transaction. JDA's latest 10-K from March 2010 does not mention the case specifically, and contains only generic boilerplate language on Legal Proceedings. There could be other legal cases against i2 that may gain more visibility, as plaintiffs could feel emboldened by the precedent of the Dillard's case.

Curiously, the $100 million in actual damages awarded to Dillard’s would seem to be material for a company like Dillard's that typically generates just under $100 million in quarterly operating income and would thus require SEC disclosure. Our initial research check did not uncover any special charges that Dillard’s had taken on any losses related to the i2 implementation, but a more thorough review is needed.

In its press release, JDA indicated that Dillard's is continuing to utilize i2 products, but it is unclear if this pertains to the same products as those named in the suit. In the meantime, whatever the impact of the i2 implementation, since 2001, DDS stock has largely outperformed all of its peers (Macy’s (NYSE:M), Nordstrom’s (NYSE:JWN), Saks (NYSE:SKS)) and sector ETFs, with Sears Holdings (NASDAQ:SHLD) being the sole exception.

Aside from the current i2/Dillard's fiasco, up till now we tended to view JDA as a fundamentally sound software business. It is difficult to assess the degree to which this latest legal challenge may put the brakes on JDA's sales pipeline, but the risks have definitely gone up. The situation will, no doubt, be exploited by JDA's competitors such as Oracle, SAP (NYSE:SAP) and Epicor (NASDAQ:EPIC).

Overall, this legal case may force the software industry to re-evaluate all its contracts specifically in areas such as representations and warranties as well as legal venues and use of arbitration in place of jury trials. Such a trend would inevitably help larger software firms and put smaller tech companies at a disadvantage, as their legal costs will rise disproportionately versus the larger suppliers.

SaaS companies may not be immune to this kind of legal action and PaaS companies could face risks that are even higher. With all due respect to the jury system, we remain skeptical of the ability of juries to decipher nuances of enterprise software contracts. For example, in the Dillard's case there was no specific mention of any customization that Dillard's or i2 has performed on the product - a common practice in most enterprise software installations, especially within the retail industry.

JDAS stock is likely to be under pressure for a while as legal and business uncertainties and costs rise. We believe this verdict will eventually be set aside and/or the amount reduced. If the judgment stands as is, it has the potential to upend the valuation dynamics of the entire tech industry, and in particular those smaller companies that provide innovative mission-critical software solutions. Software companies should be reviewing their contracts to address potential exposure to jury trial in cases involving sales of complex software solutions that combine off-the-shelf software and professional services.

Disclosure: No positions

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