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IBM sued over failed virtual PC server projects

Big Blue denies alleged 'ponzi scheme'

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IBM's Systems and Technology Group finds itself at the center of controversy again, this time as it is being sued by one of its Big Blue's partners, Devon IT, for allegedly running what the thin client maker calls "a wide-spread Ponzi scheme" over a period of five years.

In the complaint, which you can read here and which was filed by Devon IT and two of its subsidiaries on June 16 in the US District Court for the Eastern District of Pennsylvania, Devon IT alleges that it kicked in $12m in co-development funds over five years for two server-backed PC client virtualization products.

The problem is, according to Devon IT, the money that it provided was not used for development of these products. Devon alleges that some of the top executives in IBM's Systems and Technology Group (who are named in the suit) were aware of this and even continued to take money from Devon IT after IBM had spiked one of the projects. The lawsuit alleges further that the IBM executives, who are under pressure to make their quarterly numbers, used the money to boost the revenues of Systems and Technology Group.

This is where the Devon IT's lawyers bring in the Racketeer Influenced and Corrupt Organizations Act (or RICO) and characterize IBM's alleged behavior not only as a Ponzi scheme, but as racketeering.

IBM did not discuss the case, but issued the following statement: "Devon's overheated claims are without merit. The complaint, which attempts to dress up its lack of supporting evidence into charges based on 'information and belief,' is filled with outright falsehoods, half-truths, and exaggeration. There simply are no facts to support the improper and false conclusions that Devon draws. IBM has refused to be intimidated by months of Devon's threats into paying money that Devon is not properly due or owed. IBM will defend the suit vigorously and promptly seek to dismiss the claims."

The STG executives are: Thomas Bradicich, an IBM Fellow and vice president of systems technology for rack and blade servers; Bernard Meyerson, also an IBM Fellow who held the posts of vice president of strategic alliances and chief technology officer at STG during the term covered by the suit, from 2005 through 2009; James Gargan, vice president and brand executive for System x and BladeCenter servers; and Rodney Adkins, the current general manager of STG and formerly senior vice president of development and manufacturing before his promotion to general manager. Adkins still holds both of those posts.

Adkins rose to his position after Robert Moffat, his predecessor as STG general manager and an heir apparent for the top post at Big Blue, was caught in the Galleon hedge fund insider trading scandal in October. Moffat pleaded guilty to two of the charges levied against him at the end of March and is awaiting sentencing.

The two projects that Devon kicked money into were called Blade and iDataPlex/ClientPlex. The first, which was conceived in 2005, was for a blade-based server that would feed thin clients developed by Devon IT. IBM's initial projections were for 500,000 Blade units to be sold in the first three years of the deal, with Devon IT getting a slice of the Blade action as well as the ability to sell the terminals, according to the suit.

IBM's initial sales projections for the Blade-hosted PCs were for $163.1m in sales over three years, which Devon IT contends the IBM executives knew were false sales projections at the time. Devon IT inked its co-development deal with IBM in early 2007 and started sending the money, which it borrowed from an Irish private equity firm called Claret Capital, and began developing a new thin client, called CP 20, for the Blade PC server. In 2008, says Devon IT, IBM cut those projections back to 156,513 units and $48.9m in revenues for the Blade product.

As this Blade project was underway, IBM came back to Devon IT with another deal relating to its iDataPlex dense-packed, rack servers, with the same idea of using them as a hosted PC solution fronted by thin clients, which according to the suit was to be called ClientPlex. To get in on this action, IBM's executives asked for $11m in co-development funds and had Devon IT get to work on a new thin client, called TC5, which would serve as the front-end this new server complex. Devon borrowed more money from Claret to cover these costs, with the private equity firm ending up with a 33 per cent stake in Devon IT's AD subsidiary.

IBM initially projected that 1.625 million iDataPlex-backed hosted PCs would be sold over three years, with Devon getting about $500 per server node. (Later, when IBM redid the projections, they dropped off again, to 251,542 units over three years.) Hoping that the projections would pan out, and not knowing that IBM had already killed off the Blade project, Devon IT says it kicked in $8m of the $11m in co-development funds for the iDataPlex/ClientPlex product.

Here's the odd bit. According to the lawsuit, IBM's Meyerson said that Big Blue "needed Devon's payments to IBM to be independent of any contractual requirement on the part of IBM, but that all payments from IBM to Devon would have to be tied to some contractual requirement." And its lawyers speculate that IBM "required this dichotomous payment arrangement with Devon so that STG could immediately recognize payments from Devon as revenue as opposed to having to spread them over the term of a contract."

There are many other twists in this lawsuit, including IBM's Bradicich being put on an advisory board for Devon IT in early 2007, and paid $175,000 annually, after IBM's own in-house lawyers rejected the idea of putting Bradicich on the Devon IT board of directors, as he had allegedly asked to be. Devon IT contends that Bradicich breached his fiduciary responsibilities by not advising it that the original Blade hosted PC deal was dead inside IBM as Big Blue continued to solicit development funds for the iDataPlex/ClientPlex product.

Eventually, after Devon IT learned in June 2008 that the original Blade hosted PC project was dead, the executives from both IBM's STG and Devon IT agreed that the partnership agreements between the two companies had to be renegotiated. Meyerson handled the negotiations on behalf of IBM, according to the lawsuit.

After the usual back and forth, Big Blue agreed to pay Devon AD, $100 per iDataPlex board it sold (presumably as a hosted PC, not as an infrastructure server, but the lawsuit is not clear) through the second quarter of 2010 and $10 per board through 2013 with a cap of total royalty payments of $23.8m. The $100 per server fee was intended, according to the suit, to get Devon IT back its $8m in co-development funds, what Meyerson is reported in the suit as calling an "underhand pitch."

Had those numbers panned out, none of us would probably know about any of this (provided what Devon IT is claiming is true, since there are at least two sides to any story and IBM has not yet filed a counterclaim). But the iDataPlex/ClientPlex numbers did not pan out. From the third quarter of 2008 through the first quarter of 2010, a total of 33,570 server units were sold by IBM under the contract, for total royalty payments of $3.36m.

The lawsuit includes nine causes of action, including participation in a RICO enterprise and conspiracy to engage in a pattern of racketeering (against the four IBM executives named in the suit and another count against IBM); breach of fiduciary duty (against Bradicich only); breach of contract (against IBM itself); common law fraud (against all defendants); negligence (on the part of IBM for not managing its executives properly), and a prima facie tort thrown in for good measure, saying that Devon has been harmed.

The company says that in addition to the $12m it gave to IBM for co-development, it reorganized its business model and lost more than $50m in the process. Devon IT says in its suit that it also had to layoff 60 employees and that it defaulted on its loans to Claret, which has won a judgment against Devon IT for $3.45m in its own lawsuit.

Devon also seeks lawyer's fees and triple damages that it says are due because of IBM's alleged fraud was willful. ®

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