On Fiduciary Duty, Breach, And Beyond: How Overstock.Com Lost Sight Of The Long Game – Overstock.com, Inc. (NASDAQ:OSTK)

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(Originally posted on Medium, September 24th, 2019)

Not long ago the Overstock.com LLC management team was hard at work coordinating a revolutionary digital dividend that would propel customer accounts to the first of many digital platforms powered by tZero. The plan was two-fold, at once spurring on adoption of the new platform with some 40,000 new users and simultaneously proving out a system that would make known the scale of the fail-to-deliver (FTD) problem that has plagued the OSTK at intervals for years. Both these aims ring reasonable to this author.

It was against a backdrop of improving performance at the retail unit that then CEO Patrick Byrne stepped aside to make room for the straight shooters to take the reins. The company would provide reliable investor facing communications after his departure, speak in plain English and not tongues, and chart a course for a stable e-commerce business while funding DLT projects that could potentially shape the future. Jonathon Johnson thanked Mr. Byrne for his service in the most recent call, but looked forward to a future where he could focus on the dollars today and the long game of tomorrow, without the media circus. Or so he claimed. Instead, a misstep by the former CEO may shed new light on problems new and old, and send them into bankruptcy.

Somewhere along the way, it would seem, the golden glow around Mr. Byrne’s “Tech Stack for Civilization” blinded everyone. This amulet, the end in itself, justified any means. Portals for conflict of interest and self-dealing permeated the boardroom. There are some clues along the way that illustrate its roots may be far deeper into the culture at OSTK then most investors could have imagined. That it wasn’t uprooted, and remains so to this day, brings even more concern for what may lie below the surface. It culminated in what appears to be a blatant disregard for insider trading restrictions, when the CEO, complicit with 5 insiders who remain near the helm of OSTK, sold 4.7m shares over the course of 3 days. It is of public knowledge that these sales preceded by mere days the cancellation of the digital dividend and the release of revised guidance to the downside.

Exhibit A: Saum “Million Dollar” Noursalehi

Saum Noursalehi has been an employee of Overstock.com since 2005. His role started as a Software Developer, progressed through Manager, to Director, Director of Software Development, SVP of Marketing, SVP of Product Development, and eventually in 2016 to President of Retail. All this time, managing teams and products, he was developing an intimate knowledge of what Overstock.com needed to do and how it could improve. But rather than execute on it internally in his role as a Director or above for 7 years, he founded SiteHelix externally.

It remains unclear to me how in his role as Director of Software Development, or SVP of Product Development, there was no opportunity or room for such an accretive value-add platform to be built in-house. Nevertheless, theoretically this was done in his spare time. Because if it wasn’t, OSTK shareholders effectively paid him to do what happened next. In November of 2016, 3 months after taking title as President of Retail at Overstock.com LLC, Saum entered into a Related Party Transaction. The details of the transaction are staggering. It begins, in almost unbelievable fashion:

WHEREAS, the President of Overstock with responsibility for retail operations is Saum Noursalehi (“Mr. Noursalehi”); and

WHEREAS, Mr. Noursalehi is a co-founder, director and owner of approximately 62% of the equity interest in SiteHelix; and

WHEREAS, the Audit Committee of the Board of Directors of Overstock has approved Overstock’s entry into this Agreement pursuant to Overstock’s Related Party Transactions Policy and has established certain guidelines, parameters and conditions relating to this Agreement and the arrangement between Overstock and SiteHelix (the “SiteHelix Guidelines”); and

WHEREAS, the Board of Directors of Overstock has also approved Overstock’s entry into this Agreement pursuant to Overstock’s Code of Business Conduct and Ethics, subject to the guidelines, parameters and conditions set forth in the SiteHelix Guidelines;

NOW, THEREFORE, the parties agree as follows:

1. PURPOSE.

1.1 Purpose. The purpose of this Agreement is for SiteHelix to provide a license allowing Overstock to use SiteHelix’s proprietary software to provide a self-optimizing user interface and improve customer conversion rates for traffic on Overstock’s websites (“Purpose”).

…”

That “purpose” sounds exactly like what the SVP of Product, or the SVP of Marketing, or the Chief Revenue Officer are supposed to be doing in their day job.

I raise an eyebrow.

What this author finds equally inappropriate is that the Audit committee is explicitly referenced therein as having approved the Related Party Transaction per internal guidelines, which may or may not pass muster with 404 RegS-K, whatever that is. But it is with deepest conviction that I cry foul on the entire Board of Directors for representing this deal as compliant with Overstock’s Code of Business Conduct and Ethics, to which it was most certainly not, paragraphs 2, 4, and 5 among others. If you are still reading this, let the show continue on compensation structure. Schedule 1, item 5. It reads in relevant part:

5. COMPENSATION. In consideration for providing the SiteHelix Software, Overstock agrees to pay SiteHelix an amount equal to 20% of the Lift (as defined below) attributable to Overstock’s use of the SiteHelix Software. Overstock’s compensation obligation under this provision shall terminate upon termination of this Agreement and payment of any previously owed, but unpaid Lift.

a.Lift” is defined as the quantifiable increase in Nectar generated by Overstock’s use of the SiteHelix Software. “Nectar” is defined as the sum of the total dollar value of merchandise sold plus shipping revenue, minus any friction costs including, first cost, inbound and outbound shipping, handling, credit card fees, fraud processing, customer service, and returns fees, and minus site sale discounts and coupon discounts.

Surely “Nectar” cannot mean revenue can it? 20% of revenue seems like a lot to me, but not to the Board. It remains a question mark as to how much money was siphoned off through this arrangement between 2016 and 2018 to Nousalehi; shareholders deserve to know. I suspect in the lawsuits coming down the pipe, one day they will know, but there will be little left for them recover. In the meantime, I cry breach of duty on the entire board. Shareholders deserve answers, how many customers did SiteHelix even have?

The self-enrichment doesn’t end here. In 2018, the agreement became so expensive that Overstock had to buy SiteHelix from Mr. Noursalehi for $3,400,000 in cash and stock, and bury it in the back of the earnings report. If it wasn’t because the agreement had become so expensive, then it was an entirely unjustified purchase. Either way, the board approved, and I cry breach again.

(Author’s Note: Since the original posting of this article on Medium, Patrick Byrne, via Twitter, attempted to clarify the details of this SiteHelix payout to Saum Noursalehi. Patrick Byrne on Twitter By his estimates Saum would have received ~$0.08 for every $100 of revenue generated by Overstock. At $1.5B in revenue this would equate to $1.2M dollars per year. What is even worse about this sort of an arrangement is the level of conflict of interest it presents if all of this is accurate. When the President of Retail is receiving direct compensation off of GROSS PROFITS, without regard to NET PROFITS, a company has assumed a massive dysfunction. The incentives for the President, in this case Saum, would be to increase revenues at all costs, even if they cause the company to lose money. He makes more money when gross profits increase, not when net profits increase. It would be in his own best interest to ramp up marketing and advertising spend, so as to activate more traffic to Overstock.com, and to further activate SiteHelix technology to claim his toll on “lift”. Whats worse, optically, and in hindsight, is that all of this compensation to Mr. Noursalehi would be invisible insofar as the reporting of compensation to Overstock executives in SEC filings. It could be hidden as an expense to a vendor, in this case SiteHelix, so as not to raise any red flags. That this was all board approved is perhaps the craziest thing this author has ever uncovered in his career. One thing is for sure, the flags are up now.)

And the beat rolls on. When Saum assumed the position of CEO of tZero his salary lifted to $1,000,000.00; I will leave that up to God to judge. But rest assured, the board approved. What is more curious is Mr Noursalehi’s option package. For a portfolio company that resembles a venture project more than it does a public company business unit, I would expect the board to use some benchmarks. Most CEO/founders are subject to four-year vesting cycles, after they’ve put in years of sweat equity and their own capital. Saum, a servant at a public company, was granted 2% equity of tZero on a two-year vesting term. For clarity, the valuation cap that was set for the option grant was $275m, and the company was working on a deal with GSR to raise money for tZero on a $1.5B valuation. Had this gone through, Mr. Noursalehi would have reaped an immediate $20m windfall. All of this was approved by the Board of Directors.

Exhibit B: Bitsy and Steve Hopkins are the next curiosity on the list, but we can save them for next time.

…Coming soon

Exhibit C: “Keep Digging Watkins” Once upon a time a multibillion dollar freight, shipping, and logistics provider called Schneider National (NYSE:SNDR) decided it wanted to get into the first-to-final-mile of delivery business (Schneider buys Watkins & Shepard, Lodeso – Furniture Today). Three beds, and three cups of porridge later, it didn’t work out for them, so they moved on Inline XBRL Viewer. If you’re extra studious, you can use ctrl+F “FTFM” in the 10-Q and learn about all the money they lost. The Wall Street Journal coverage of this unfortunate performance for Schneider on August 1st is here: Trucker Schneider National to Close Home Delivery Service. The trade journals cover it with a bit more context: Sudden shutdown of Schneider final-mile unit leaves furniture shippers scrambling for options – FreightWaves. This excerpt from Freight Waves is particularly poignant:

For furniture retailers, the questions are less big picture and more immediate, such as who is going to move goods that aren’t already on the move. Founded in 1974 and with a fleet of 943 trucks, 2,043 trailers and 781 drivers, Watkins & Shepard was the backbone of almost every furniture retailer’s delivery operation, according to an executive of a furniture e-tailer that has used Watkins for years. It continued to do so after the Schneider acquisition, and is now looking for alternate supply sources for 70 to 80 percent of its traffic.

The author surmises that Watkins & Shepard, underneath Schneider National, is the 4th itemized driver for revised retail guidance, referenced in Overstock’s September 23td 8-k as “Watkins’ recent bankruptcy”. If this is true, then there can be no doubt that the entire Overstock executive suite was well aware of this problem at the very latest on August 1st. Any trades made with this information in hand, are being made with the advantage of MNPI. It would be inarguable. This would include Patrick Byrne’s sales, whether he left them as marching orders on August 17th or not. (Author’s Note: Since the original posting of this article on Medium, Byrne has confirmed via Twitter that Watkins/Schnieder is the carrier referenced in the 8-k, though he denies he knew about. He has asserted they are not a major factor for Overstock.com operating results anyway, too small to have been on his radar. This, despite the fact that they made it into the 8-k as top 5 problems affecting guidance.)

Part 2: A Web, But Not Charlotte’s

Exhibit D: What is D&O insurance anyway, who does it serve, and how much does it cost? D&O, otherwise known as directors and officers insurance, is a separate policy from general liability or umbrella insurance that most companies purchase. Directors and Officers (D&O) Insurance Cost. A point worth noting is that the policy is designed to cover the cost of a legal defense on behalf of directors and officers, when the expense goes above and beyond what the company’s general liability insurance covers. It is a benefit for the board of directors mostly, to ensure that they are comfortable when making tough decisions that are in the interest of the shareholders but that may be unpopular. Another appropriate name for it might be CYA Insurance. Directors & Officers D&O Insurance Cost and Coverage | The Hartford

There are elements of D&O designed to protect the company too. For instance, if a company agrees in an employment contract to cover legal defense of its D&Os, then it will be responsible to shoulder the burden of defending any future lawsuits. Ultimately this burden becomes the shareholders problem. D&O, in this regard, provides a company a way of promising something in an employment contract that they don’t like, and sourcing the ability to fulfill that promise outside of the firm (via the insurance writer). Maybe this is what they bought? Typically speaking, D&O insurance is not expensive. And that’s where all the red flags are…whatever Overstock just purchased is not typical.

Overstock.com’s recent 8-k is lacking clarity; they did not specify the aim or the scale of the coverage, so the shareholder (once again) is left with more questions than answers after the company purports to clarify the goings on internally. Per 8-k: “The company’s D&O insurance premiums will significantly increase.”

They could have just as easily specified: “YOY D&O insurance premiums increased from $100,000.00 to $N-millions despite the departure of Patrick Byrne. The board also elected to increase coverage limits by multiple-X.”

But the humble servants at Overstock chose to deliver just enough information so as to exculpate themselves from dereliction of duty in a lawsuit, but not enough for shareholders to make an informed decision. As for the exculpation defense, only the future will tell. What they did tell you is a fact though. “Premiums will significantly increase”… because they’ve already bought the coverage they speak of. Ipso facto! It stings to read that 8-k when, as a shareholder, you realize the performance revision is in part because they bought D&O with your money, for the benefit of protecting themselves when the lawsuits pour in. If one is expecting trouble down the road, buying a lot of insurance is probably a sensible move. Hurricanes hit every year, they have insurance for that.

I think it’s obvious, and maybe even easy, to draw some conclusions that don’t favor the future of Overstock here. But before we jump to assuming these conclusions are ‘facts”, be it clear that some of this is conjecture on the part of the author. Because it has to be. Because management doesn’t communicate to shareholders. Accordingly, I’ve laid out real facts as such, and the rest is just my brain. It’s the result of an educated guess based on untold hours of digging and reading on the part of this analysis. And yet, the observer has but little other choice. All of this could have been cleared up by the firm in the 8-k. I have little thanks to offer management for this.

Questions (easy ones I might add) that remain:

1) Did the leadership at Overstock fall victim to unexpected increase in rates, taking insurance costs from the tens of thousands well into seven figures?

Or

2) Did they elect coverage that is a material shift from year’s prior coverage? If so, why did they choose to break precedent now, and what coverage did they elect? How much coverage? What are the old policy limits, and what are the new ones?

I’ll leave off with two final thoughts.

The first is that I fear this misallocation of shareholder money in D&O insurance is a doubly lost cause anyway. You can buy hurricane insurance yes, but not during hurricane season…CERTAINLY NOT when a big spinning red vortex is all over TV, in the news, and even on CNBC. To that end, purchasing insurance for a problem you already know about is not allowed. To represent that you do not know of any problems (hurricanes in the example) is a dangerous game if you have in fact been watching the news. An insurance provider will deny you on account of the hurricane anyway, and reject your application. It’s not worth the hassle to reject your claim later because FEMA will be fighting for Joe Waterfront and his 3 foot below sea level vacation home.

Corporate policies play differently. They will write your policy, and they will take your seven figure check, and it will be gone. They will also turn around and reject your claim later, refusing to pay when the storm finally hits. They will write you a letter that states you are not covered because it’s a pre-existing problem that you knew about. And then they also come after you for insurance fraud, and that’s where it could get extremely painful for everyone involved in this story.

The second thought is this: if Patrick Byrne is telling the truth about his clean break with communications, that he has honestly represented the state of the union upon his depart, that the MNPI smoking gun that all are staring at out in the open is in fact a Halloween prop, well then buckle thine seatbelts. To take him at his word would mean they were doing great on that third week of August. They’d have been nearly two-thirds the way to a great Q3 result with the commensurate fraction of “significant positive EBITA” to show for it on the bottom line. According to this August 22nd claim, per Overstock CEO Patrick M. Byrne Resigns, Patrick’s “key point’ #2.b reads thusly: ”After my ill-fated experiment last year in copying our competition’s strategy, our retail business has recovered to astate of positive adjusted EBITDA (cf. graph on left).A Media Snippet accompanying this announcement is available by clicking on the image or link below:PBR Image 1b.”

If this is genuine and supported by auditable accounting at Overstock.com, it would mean that the ship turned on a dime the week after he left. And not only did things proceed from that point onward in a slower than expected fashion, but they actually started going in reverse, and unwound the first stellar segment of the quarter by losing money. How then could the run-rate for the tail-end of Q3 be represented as a break-even runway approach to a profitable takeoff into Q4? This logical inconsistency starts to cast doubt on the new guidance that Jonathon Johnson just delivered this week.

I don’t write the 8-k, I don’t represent the story, nor the story the players represent to the world. All I do is read the facts. It would appear they’re weaving quite the tangled web, but when they are done I don’t think it’s going to say “Terrific”, “Radiant”, or “Humble”.

It might say “Some Pig” though.

Disclosure: I am/we are long OSTK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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