Unassociated Document
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
DC 20549
FORM
10-Q
(Mark
one)
x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE
ACT OF 1934
For
the
quarterly period ended September 30, 2007
or
TRANSITION
REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
OF
1934
For
the
transition period from _________ to ________
Commission
File Number: 000-28985
VoIP,
Inc.
(Exact
name of issuer as specified in its charter)
Texas
|
|
75-2785941
|
(State
or other jurisdiction of incorporation or organization)
|
|
(I.R.S.
Employer Identification No.)
|
151
So. Wymore Rd, Suite 3000, Altamonte Springs, FL 32714
(Address
of principal executive offices)
(407)
398-3232
(Issuer's
telephone number)
Indicate
by check whether the registrant (1) filed all reports required to be filed
by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the
past
90 days. YES x
NOo
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):
Large
accelerated filer o
Accelerated filer o
Non-accelerated filer
x
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
126-2 of the Exchange Act). YES
o
NO
x
State
the
number of shares outstanding of each of the issuer's classes of common equity
as
of the latest practicable date: November 8, 2007:
13,208,482.
VoIP,
Inc.
Form
10-Q for the Quarter Ended September 30, 2007
|
|
|
Page
|
Part
I - Financial Information
|
3
|
|
|
|
|
|
Item
1
|
Financial
Statements
|
3
|
|
|
|
|
|
Item
2
|
Management's
Discussion and Analysis of Financial Condition and Results of
Operations
|
23
|
|
|
|
|
|
Item
3
|
Qualitative
and Quantitative Disclosures About Market Risk
|
36
|
|
|
|
|
|
Item
4
|
Controls
and Procedures
|
36
|
|
|
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|
Part
II - Other Information
|
39
|
|
|
|
|
|
Item
1
|
Legal
Proceedings
|
39
|
|
|
|
|
|
Item
1. A
|
Risk
Factors
|
39
|
|
|
|
|
|
Item
2
|
Unregistered
Sales of Equity Securities and Use of Proceeds
|
39
|
|
|
|
|
|
Item
3
|
Defaults
upon Senior Securities
|
39
|
|
|
|
|
|
Item
4
|
Submission
of Matters to a Vote of Security Holders
|
39
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|
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|
|
|
Item
5
|
Other
Information
|
39
|
|
|
|
|
|
Item
6
|
Exhibits
|
40
|
|
|
|
|
Signatures
|
41
|
PART
I - FINANCIAL INFORMATION
ITEM
1. FINANCIAL STATEMENTS
VoIP,
Inc.
Consolidated
Balance Sheets
|
|
September 30, 2007
|
|
December 31, 2006
|
|
|
|
(Unaudited)
|
|
|
|
ASSETS
|
|
|
|
|
|
|
|
|
|
|
|
Current
assets:
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
68,491
|
|
$
|
90,172
|
|
Accounts
receivable, net
|
|
|
1,107,209
|
|
|
375,946
|
|
Due
from related parties
|
|
|
-
|
|
|
31,227
|
|
Prepaid
expenses and deposits
|
|
|
490,026
|
|
|
373,746
|
|
Total
current assets
|
|
|
1,665,726
|
|
|
871,091
|
|
|
|
|
|
|
|
|
|
Property
and equipment, net
|
|
|
5,419,144
|
|
|
6,604,285
|
|
Goodwill
and other intangible assets
|
|
|
24,033,697
|
|
|
25,992,034
|
|
Net
assets from discontinued operations
|
|
|
-
|
|
|
2,367,007
|
|
Other
assets
|
|
|
40,105
|
|
|
94,546
|
|
|
|
|
|
|
|
|
|
TOTAL
ASSETS
|
|
$
|
31,158,672
|
|
$
|
35,928,963
|
|
|
|
|
|
|
|
|
|
LIABILITIES
AND SHAREHOLDERS' EQUITY
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
3,494,223
|
|
$
|
7,987,316
|
|
Accrued
expenses
|
|
|
3,754,588
|
|
|
4,534,777
|
|
Loans
payable
|
|
|
513,750
|
|
|
2,574,835
|
|
Convertible
notes payable
|
|
|
13,682,981
|
|
|
5,902,217
|
|
Fair
value liability for warrants
|
|
|
-
|
|
|
5,102,731
|
|
Financing
penalties and other stock-based payables
|
|
|
4,084,065
|
|
|
4,748,380
|
|
Accrued
litigation charges
|
|
|
1,905,000
|
|
|
1,054,130
|
|
Notes
and advances from investors
|
|
|
-
|
|
|
616,667
|
|
Note
payable - related party
|
|
|
300,000
|
|
|
-
|
|
Net
liabilities from discontinued operations
|
|
|
109,997
|
|
|
-
|
|
Other
current liabilities
|
|
|
109,969
|
|
|
140,425
|
|
Total
current liabilities
|
|
|
27,954,573
|
|
|
32,661,478
|
|
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
159,568
|
|
|
222,669
|
|
|
|
|
|
|
|
|
|
TOTAL
LIABILITIES
|
|
|
28,114,141
|
|
|
32,884,147
|
|
|
|
|
|
|
|
|
|
Shareholders'
equity:
|
|
|
|
|
|
|
|
Common
stock - $0.001 par value; 400,000,000 shares authorized; 11,372,700
and
4,930,485 shares issued and outstanding
|
|
|
11,373
|
|
|
4,930
|
|
Preferred
stock - $0.001 par value; 25,000,000 shares authorized; none issued
or
outstanding
|
|
|
-
|
|
|
-
|
|
Additional
paid-in capital
|
|
|
114,088,266
|
|
|
79,036,498
|
|
Accumulated
deficit
|
|
|
(111,055,108
|
)
|
|
(75,996,612
|
)
|
Total
shareholders' equity
|
|
|
3,044,531
|
|
|
3,044,816
|
|
|
|
|
|
|
|
|
|
TOTAL
LIABILITIES AND SHAREHOLDERS' EQUITY
|
|
$
|
31,158,672
|
|
$
|
35,928,963
|
|
The
accompanying notes are an integral part of these consolidated financial
statements.
VoIP
Inc.
Consolidated
Statements of Operations (Unaudited)
|
|
Nine Months Ended September 30
|
|
Three Months Ended September 30
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
6,229,058
|
|
$
|
4,775,489
|
|
$
|
2,579,542
|
|
$
|
598,170
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost
of sales
|
|
|
6,036,130
|
|
|
6,769,876
|
|
|
1,909,676
|
|
|
943,375
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
profit (loss)
|
|
|
192,928
|
|
|
(1,994,387
|
)
|
|
669,866
|
|
|
(345,205
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Compensation
and related expenses
|
|
|
5,611,811
|
|
|
11,705,542
|
|
|
2,228,336
|
|
|
5,213,947
|
|
Professional,
legal and consulting expenses
|
|
|
4,651,492
|
|
|
4,117,972
|
|
|
1,473,553
|
|
|
1,721,657
|
|
Depreciation
and amortization
|
|
|
3,182,522
|
|
|
3,588,833
|
|
|
1,051,487
|
|
|
996,253
|
|
General
and administrative expenses
|
|
|
1,068,615
|
|
|
1,690,459
|
|
|
429,774
|
|
|
489,336
|
|
Total
operating expenses
|
|
|
14,514,440
|
|
|
21,102,806
|
|
|
5,183,150
|
|
|
8,421,193
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
from continuing operations before other income and
expenses
|
|
|
(14,321,512
|
)
|
|
(23,097,193
|
)
|
|
(4,513,284
|
)
|
|
(8,766,398
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other
(income) expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
expense
|
|
|
8,839,848
|
|
|
5,093,939
|
|
|
3,454,857
|
|
|
1,884,298
|
|
Financing
penalties and expenses
|
|
|
7,598,162
|
|
|
6,838,913
|
|
|
3,088,113
|
|
|
4,139,522
|
|
Change
in fair value liability for warrants
|
|
|
1,196,768
|
|
|
(6,743,453
|
)
|
|
(1,487,514
|
)
|
|
(3,371,291
|
)
|
Litigation
charges (credits)
|
|
|
(2,469,020
|
)
|
|
710,000
|
|
|
(1,489
|
)
|
|
-
|
|
Total
other expenses
|
|
|
15,165,758
|
|
|
5,899,399
|
|
|
5,053,967
|
|
|
2,652,529
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
before income taxes and results of discontinued operations
|
|
|
(29,487,270
|
)
|
|
(28,996,592
|
)
|
|
(9,567,251
|
)
|
|
(11,418,927
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision
for income taxes
|
|
|
- |
|
|
-
|
|
|
-
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss before discontinued operations
|
|
|
(29,487,270
|
)
|
|
(28,996,592
|
)
|
|
(9,567,251
|
)
|
|
(11,418,927
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
from discontinued operations, net of income taxes
|
|
|
(5,571,226
|
)
|
|
(2,314,848
|
)
|
|
(51,567
|
)
|
|
(893,780
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(35,058,496
|
)
|
$
|
(31,311,440
|
)
|
$
|
(9,618,818
|
)
|
$
|
(12,312,707
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
and diluted loss per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
before discontinued operations
|
|
$
|
(3.87
|
)
|
$
|
(8.50
|
)
|
$
|
(0.92
|
)
|
$
|
(3.24
|
)
|
Loss
from discontinued operations, net of income taxes
|
|
|
(0.73
|
)
|
|
(0.68
|
)
|
|
(0.01
|
)
|
|
(0.25
|
)
|
Net
loss per share
|
|
$
|
(4.60
|
)
|
$
|
(9.18
|
)
|
$
|
(0.93
|
)
|
$
|
(3.49
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average number of shares outstanding
|
|
|
7,619,005
|
|
|
3,409,765
|
|
|
10,395,797
|
|
|
3,525,455
|
|
The
accompanying notes are an integral part of these consolidated financial
statements.
VoIP,
Inc.
Consolidated
Statements of Cash Flows (Unaudited)
|
|
Nine Months Ended September 30
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
CASH
FLOWS FROM OPERATING ACTIVITIES
|
|
|
|
|
|
Continuing
operations:
|
|
|
|
|
|
Net
loss before discontinued operations
|
|
$
|
(29,487,270
|
)
|
$
|
(28,996,592
|
)
|
Adjustments
to reconcile net loss to net cash used in operating
activities:
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
3,182,522
|
|
|
3,637,616
|
|
Common
shares issued for services
|
|
|
4,272,570
|
|
|
2,427,779
|
|
Options
and warrants issued for services and compensation
|
|
|
1,186,724
|
|
|
7,955,725
|
|
Amortization
of debt discounts
|
|
|
8,023,287
|
|
|
3,732,769
|
|
Increase
(decrease) in fair value liability for warrants
|
|
|
1,196,768
|
|
|
(6,743,453
|
)
|
Impairment
loss for contract cancellation
|
|
|
-
|
|
|
1,043,683
|
|
Noncash
nonregistration penalties
|
|
|
5,668,055
|
|
|
5,242,782
|
|
Noncash
litigation gain, net
|
|
|
(2,519,612
|
)
|
|
(397,821
|
)
|
Noncash
financing and interest expense
|
|
|
1,396,129
|
|
|
-
|
|
Provision
for bad debt
|
|
|
645
|
|
|
161,686
|
|
Changes
in operating assets and liabilities:
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
(914,983
|
)
|
|
111,184
|
|
Due
from related parties
|
|
|
31,227
|
|
|
142,786
|
|
Prepaid
expenses and deposits
|
|
|
(116,280
|
)
|
|
17,611
|
|
Accounts
payable and accrued expenses
|
|
|
(1,105,311
|
)
|
|
944,110
|
|
Nonregistration
penalties and other stock-based payables
|
|
|
815,040
|
|
|
-
|
|
Accrued
litigation charges
|
|
|
1,963,511
|
|
|
-
|
|
Other
current liabilities
|
|
|
(93,557
|
)
|
|
(325,785
|
)
|
Net
cash used in continuing operating activities
|
|
|
(6,500,535
|
)
|
|
(11,045,920
|
)
|
Discontinued
operations:
|
|
|
|
|
|
|
|
Loss
from discontinued operations
|
|
|
(5,571,226
|
)
|
|
(2,314,848
|
)
|
Provision
for discontinued operations
|
|
|
6,177,004
|
|
|
-
|
|
Goodwill
impairment charge
|
|
|
-
|
|
|
839,101
|
|
Net
cash provided by (used in) discontinued operating activities
|
|
|
605,778
|
|
|
(1,475,747
|
)
|
Net
cash used in operating activities
|
|
|
(5,894,757
|
)
|
|
(12,521,667
|
)
|
|
|
|
|
|
|
|
|
CASH
FLOWS FROM INVESTING ACTIVITIES
|
|
|
|
|
|
|
|
Continuing
operations:
|
|
|
|
|
|
|
|
Purchase
of property and equipment and other assets
|
|
|
(33,894
|
)
|
|
(135,743
|
)
|
Net
cash used in continuing investing activities
|
|
|
(33,894
|
)
|
|
(135,743
|
)
|
Discontinued
operations:
|
|
|
|
|
|
|
|
Net
assets - DTNet and Phone House
|
|
|
-
|
|
|
1,554,295
|
|
Net
cash provided by discontinued investing activities
|
|
|
-
|
|
|
1,554,295
|
|
Net
cash (used in) provided by investing activities
|
|
|
(33,894
|
)
|
|
1,418,552
|
|
|
|
|
|
|
|
|
|
CASH
FLOWS FROM FINANCING ACTIVITIES
|
|
|
|
|
|
|
|
Proceeds
from issuance of notes payable and advances
|
|
|
4,610,474
|
|
|
8,108,719
|
|
Proceeds
from common stock issuances
|
|
|
1,760,000
|
|
|
2,713,902
|
|
Proceeds
from warrant repricing
|
|
|
-
|
|
|
770,314
|
|
Repayment
of amounts due to related parties
|
|
|
-
|
|
|
(1,267,682
|
)
|
Repayment
of notes payable and advances
|
|
|
(463,504
|
)
|
|
(1,900,134
|
)
|
Net
cash provided by financing activities
|
|
|
5,906,970
|
|
|
8,425,119
|
|
|
|
|
|
|
|
|
|
Net
decrease in cash
|
|
|
(21,681
|
)
|
|
(2,677,996
|
)
|
Cash
and cash equivalents at beginning of period
|
|
|
90,172
|
|
|
3,228,745
|
|
Cash
and cash equivalents at end of period
|
|
$
|
68,491
|
|
$
|
550,749
|
|
The
accompanying notes are an integral part of these consolidated financial
statements.
VoIP,
Inc.
Notes
to Consolidated Financial Statements
NOTE
A - ORGANIZATION AND DESCRIPTION OF BUSINESS
VoIP,
Inc. (the "Company") was incorporated on August 3, 1998 under its original
name
of Millennia Tea Masters under the laws of the State of Texas. In February
2004,
the Company exchanged 625,000 shares for the common stock of two start-up
telecommunication businesses, eGlobalphone, Inc. and VoIP Solutions, Inc. The
Company changed its name to VoIP, Inc. in April 2004 and acquired VCG
Technologies, Inc. d/b/a DTNet Technologies (“DTNet Technologies”), a hardware
supplier, and VoIP Americas, Inc. (“VoIP Americas”), in June and September,
respectively, of 2004. The Company decided to exit its former tea business
in
December 2004 and focus its efforts and resources in the Voice over Internet
Protocol (“VoIP”) telecommunications industry. In May 2005 the Company acquired
Caerus, Inc. (“Caerus”), a VoIP carrier and service provider. In October 2005
the Company purchased substantially all of the VoIP assets of WQN Inc., a
Delaware corporation (“WQN Delaware”). In April 2006 the Company sold DTNet
Technologies to a former officer of the Company. In October 2006 the Company
terminated its Marketing and Distribution Agreement with Phone House, Inc.,
a
wholesale prepaid telephone calling card business acquired in its WQN Delaware
acquisition. Effective June 27, 2007, having decided that this business was
not
in line with its present business strategy, the Company sold substantially
all
of the tangible operating assets utilized by its Dallas, Texas, subsidiary,
VoIP
Solutions, Inc., to WQN, Inc., a Texas corporation.
The
Company is an emerging global provider of advanced communications services
utilizing VoIP technology. VoIP telephony is the real time transmission of
voice
communications in the form of digitized "packets" of information over the
Internet or a private network, similar to the way in which e-mail and other
data
is transmitted. VoIP services are expected to allow consumers and businesses
to
communicate in the future at dramatically reduced costs compared to traditional
telephony networks.
The
Company owns its network and its technology and offers the ability to provide
complete product and service solutions, including wholesale carrier services
for
call routing and termination. The Company is a certified Competitive Local
Exchange Carrier (“CLEC”) and Interexchange Carrier (“IXC”). The Company offers
a portfolio of advanced telecommunications technologies, enhanced service
solutions and broadband products. Current and targeted customers include
regional bell operating companies (“RBOCs”), CLECs, IXCs, wireless carriers,
resellers, Internet service providers, cable multiple system operators and
other
providers of telephony services.
The
Company's operations formerly consisted of three segments: Telecommunication
Services, Hardware Sales and Calling Card Sales. However, with the Company's
sale of DTNet Technologies, the termination of its Marketing and Distribution
Agreement with Phone House, Inc., and the sale of its Dallas tangible assets,
all referred to above, these former segments are being accounted for as
discontinued operations as discussed more fully in Note L, and prior period
financial statements have been appropriately reclassified. Also as a result
of
these discontinued operations, the Company's operations currently consist of
one
segment, Telecommunication Services. Therefore, separate segmented financial
results are not presented.
The
financial information presented herein should be read in conjunction with the
consolidated financial statements for the year ended December 31, 2006. The
accompanying consolidated financial statements for the three and nine months
ended September 30, 2007 and 2006 are unaudited but, in the opinion of
management, include all adjustments (which are normal and recurring in nature)
necessary for a fair presentation of the financial position, results of
operations and cash flows for the interim periods presented. Interim results
are
not necessarily indicative of results for a full year. Therefore, the results
of
operations for the three and nine months ended September 30, 2007 are not
necessarily indicative of operating results to be expected for the full year
or
future interim periods.
NOTE B
- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Significant
accounting policies are detailed in the Company's annual report on Form 10-K
for
the year ended December 31, 2006, as amended. All intercompany accounts and
transactions have been eliminated in consolidation. Certain reclassifications
have been made to the 2006 financial statements to conform to the 2007
presentation.
Reverse
Stock Split
On
August
13, 2007 the Company's shareholders approved a 1-for-20 reverse split of its
common stock, which became effective on August 16, 2007. As such, each
shareholder received one share of the Company's common stock for every twenty
shares held just prior to the effective date. Fractional shares resulting from
the reverse split were rounded up to the nearest whole share. Following the
effective date of the reverse split, the par value of the common stock remained
at $0.001 per share. As required by Financial Accounting Standard No. 128,
all
share and per-share information in these consolidated financial statements
have
been appropriately restated. In addition, the common stock in the Company's
consolidated balance sheets was reduced by a factor of twenty, with
corresponding increases in additional paid-in capital.
Accounting
for Warrants
Due
to
the Company's 2006 financing agreements, the number of common shares issuable
upon the exercise of outstanding warrant agreements, when combined with existing
outstanding common shares, options, and shares issuable upon the conversion
of
applicable notes payable (“diluted shares”), exceeded the Company's
then-authorized common shares. Therefore, as required by Emerging Issues Task
Force Issue No. 00-19 (“EITF 00-19”), asset or liability classification of the
warrants was required (as opposed to permanent equity classification) for the
excess warrant shares. From January to May 2006, only a portion of the
Company's warrants were subject to liability classification and their values
accordingly marked-to-market, including a related charge of $1,281,278 to
earnings for the three months ended March 31, 2006. In May 2006, the Company
repriced certain of its warrants to $15.60 per share ($0.78 per share pre-split)
in conjunction with a financing transaction, which in turn triggered contractual
“favored nations” price ratchets on a number of its existing convertible debt
and warrant agreements, reducing their effective conversion and exercise prices
to $15.60 per share ($0.78 per share pre-split). The effect was to increase
the
number of fully diluted shares of common stock at the time to approximately
6.5
million (129 million pre-split), relative to the Company's then-authorized
100
million common shares. The Company's total warrants then outstanding were
approximately 1.4 million (28 million pre-split). As required by EITF 00-19,
the
Company classified all remaining warrants at that time as a liability,
transferring $5,406,284 from additional paid-in capital to fair value liability
for warrants on its consolidated balance sheet. This warrant liability, along
with the original earlier 2006 warrant liability discussed above, was
subsequently marked-to-market, resulting in a $5,102,731 fair value warrant
liability at December 31, 2006, and a credit to earnings for the nine
months ended September 30, 2006 of $6,743,453.
On
March
16, 2007, the Company obtained shareholder approval to increase its authorized
common stock to 400 million shares, sufficient to satisfy all of its outstanding
warrant obligations. The warrant liability was then marked-to-market, resulting
in a charge to earnings of $3,550,551 for the three months ended March 31,
2007.
The fair value of these warrants at that date was $10,209,324, and this amount
was transferred from the fair value liability for warrants to additional paid-in
capital on the Company's consolidated balance sheet as required by EITF 00-19,
and the related mark-to-market accounting was suspended.
Due
to
the June 14, 2007 financing agreements referred to in Note G which in turn
triggered favored nations price ratchets to $1.60 per share ($0.08 per share
pre-split) by June 25, 2007, the Company's diluted shares (pre-split) exceeded
its authorized 400 million common shares. Therefore, asset or liability
classification of (and related mark-to-market accounting for) the warrants
was
again required for the excess warrant shares. Between June 14, 2007 and June
25,
2007, the fair value of the Company's warrants, totaling $2,807,757, was
transferred from additional paid-in capital to fair value liability for warrants
on the Company's consolidated balance sheet. At June 30, 2007 these warrants
were marked-to-market, resulting in a $2,007,626 fair value warrant liability
at
June 30, 2007, and an $866,269 credit to earnings and a $2,684,282 charge
to earnings for the three and six months ended June 30, 2007,
respectively. The fair value of the Company's warrants is a function of the
market value of its underlying common stock.
As
described in the fourth preceding paragraph above, on August 16, 2007, the
Company effected a 1-for-20 reverse split of its common stock, which was again
sufficient to satisfy all of its warrant obligations. The warrant liability
was
then marked-to-market, resulting in a credit to earnings of $1,487,514 for
the
three months ended September 30, 2007. The fair value of these warrants at
that
date was $694,450, and this amount was transferred from the fair value liability
for warrants to additional paid-in capital on the Company's consolidated balance
sheet as required by EITF 00-19, and the related mark-to-market accounting
was
suspended.
Should
the Company again in the future have insufficient common shares to satisfy
all
of its warrant and convertible debt obligations, it will again be subject to
noncash mark-to-market income or expense to the extent that the fair value
of
these warrants changes, which is in turn primarily dependent upon the Company's
common stock market price per share.
Restricted
Cash and Letters of Credit
Certain
cash is restricted to support standby letters of credit which, in turn, support
operating license bonds required by several states' regulatory agencies. These
standby letters of credit are generally in force for one year with automatic
one-year extensions. Maximum draws available to the beneficiary as of September
30, 2007 were $60,000.
NOTE
C - LIQUIDITY, CAPITAL RESOURCES, AND GOING CONCERN
This
Note
C should be reviewed in conjunction with Notes F, G, H, J, K and Q to the
Company's consolidated financial statements.
The
accompanying consolidated financial statements have been prepared in conformity
with accounting principles generally accepted in the United States of America,
which contemplate continuation of the Company as a going concern. The Company
has incurred operating losses and negative cash flows from operations since
inception of its current business in 2004, has been dependent on issuances
of
debt and equity instruments to fund its operations and capital expenditures,
and
is in violation of most of its financing covenants. The Company's independent
auditors have added an explanatory paragraph to their opinion on the Company's
consolidated financial statements for the year ended December 31, 2006, based
on
substantial doubt about the Company's ability to continue as a going
concern.
At
September 30, 2007, the Company's contractual obligations for debt, leases
and
capital expenditures totaled $31.7 million. See Note G for a description
of the Company's convertible notes issued from July 2005 through September
2007.
As explained below and in Note G, the subscription agreements for many of these
notes contain provisions that could impact the Company's future capital raising
efforts and its capital structure:
|
·
|
The
Company is required to file registration statements to register amounts
ranging up to 200% of the shares issuable upon conversion of these
notes,
and all of the shares issuable upon exercise of the warrants issued
in
connection with these notes. Certain registration statements were
filed,
but have since become either ineffective or withdrawn. Until sufficient
registration statements are declared effective by the Securities
and
Exchange Commission (the “SEC”), the Company is liable for liquidated
damages totaling $1,016,053 through September 30, 2007, and will
continue
to incur additional liquidated damages of $55,379 per month until
December
31, 2007. Additionally, since the required shares and warrants
related to the Company’s September 2007 financing were not registered by
November 11, 2007, monthly liquidated damages of $135,095 have begun
to
accrue.
|
|
·
|
Unless
consent is obtained from the note holders, the Company may not issue
new
financing, file any new registration statements, or amend any existing
registrations until the sooner of (a) 60 to 365 days following the
effective date of the notes registration statement or (b) all the
notes
have been converted into shares of the Company's common stock and
such
shares of common stock and the shares of common stock issuable upon
exercise of the warrants have been sold by the note
holders.
|
|
·
|
Since
October 2005, the Company has been in violation of certain requirements
of
most of its convertible notes. While the investors have not declared
these
notes currently in default, the full amount of the notes at September
30,
2007 has been classified as current. (See Note Q for subsequent default
and waiver agreement.)
|
In
connection with a private placement memorandum dated May 20, 2005, the Company
issued 112,125 shares of its common stock for $16.00 per share, and warrants
to
purchase 110,388 common shares at prices from $32.00 to $44.60 per share. As
required by the subscription agreements, a portion of the shares was registered
with the SEC in October 2005, but that registration became ineffective in July
2006. Non-registration liquidated damages accrued until September 2006, when
all
related shares and warrants became substantially tradable under Rule 144 and,
in
accordance with the terms of the subscription agreements, accrual of liquidated
damages ceased. Based on subsequent agreements with the investors, during the
three months ended June 30, 2007, the Company issued 74,470 of its common
shares, warrants to purchase 16,670 of its common shares at $3.60 per share,
and
repriced 96,325 of the above-referenced originally issued warrants to $3.60
per
share, in substantial settlement of the related liquidated damages owed.
In
connection with a subscription agreement dated August 26, 2005 and amended
on
November 16, 2005, the Company issued 68,750 shares of its common stock for
$16.00 per share, and warrants to purchase 111,250 common shares at prices
ranging from $27.40 to $32.00 per share. The investor also received “favored
nations” rights such that for future securities offerings by the Company at a
price per share less than the per share purchase price or warrant exercise
prices, the investor's effective per share purchase price and warrant exercise
price would be adjusted to the lower offering price. As a result of this favored
nations provision and the February 2007 financing agreements described in Note
G, coupled with the settlement agreement noted below, the subscription
agreement's per share purchase price and the warrants' exercise prices were
reduced to $3.60 per share. The Company also agreed to register a total of
292,500 common shares and warrants related to this agreement by January 17,
2006. Since a related registration statement was not declared effective by
the
SEC, the Company was contractually liable for liquidated damages. On May 25,
2007, the parties entered into a settlement agreement whereby on
June 18, 2007 the Company issued to the investor 625,000 shares of its
common stock.
The
Company needs to continue to raise additional debt or equity capital to provide
the funds necessary to restructure or repay its debt obligations, meet its
other
contractual commitments, and continue its operations. The Company is actively
seeking to raise this additional capital but may not be successful in obtaining
the imminently-required debt or equity financing. The accompanying financial
statements do not include any adjustments relating to the recoverability and
classification of asset amounts or the amounts and classification of liabilities
that might be necessary should the Company be unable to continue as a going
concern.
The
Company's authorized common stock consisted of 400,000,000 shares at September
30, 2007, of which 11,372,700 common shares were then issued and outstanding,
and $52,569,360 additional shares were contingently issuable upon the
exercise of stock options and warrants, and conversion of convertible
securities. An additional 20,188,313 common shares were required to be reserved
under our various existing financing agreements. As of September 30, 2007 the
Company was also contractually obligated to register approximately 51 million
shares, warrants and options. There is no assurance that sufficient registration
statements can be filed or declared effective by the SEC, in which case the
Company would continue to be unable to satisfy its contractual obligations
to
register shares of its common stock.
The
Company’s preferred stock consisted of 25,000,000 shares at September 30, 2007,
of which none were issued or outstanding.
NOTE
D - PROPERTY AND EQUIPMENT, NET
At
September 30, 2007 and December 31, 2006, property and equipment consisted
of
the following:
|
|
September
30,
|
|
December
31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Equipment
|
|
$
|
8,409,323
|
|
$
|
8,370,279
|
|
Furniture
& Fixtures
|
|
|
85,397
|
|
|
85,397
|
|
Software
|
|
|
666,842
|
|
|
666,842
|
|
Vehicles
|
|
|
15,269
|
|
|
15,269
|
|
Leasehold
improvements
|
|
|
95,414
|
|
|
95,414
|
|
Total
property and equipment
|
|
|
9,272,245
|
|
|
9,233,201
|
|
Less
accumulated depreciation
|
|
|
(3,853,101
|
)
|
|
(2,628,916
|
)
|
Total
property and equipment, net
|
|
$
|
5,419,144
|
|
$
|
6,604,285
|
|
Depreciation
expense for the nine months ended September 30, 2007 and 2006 amounted to
$1,224,185 and $1,422,165, respectively.
The
amount of equipment held under capital leases, included above and net of
accumulated amortization, was $179,086 and $224,959 at September 30, 2007 and
December 31, 2006, respectively.
NOTE
E - GOODWILL AND OTHER INTANGIBLE ASSETS
The
Company's balance sheet at September 30, 2007 includes approximately $16.8
million in goodwill and approximately $7.2 million in other intangible assets,
recorded primarily in connection with its acquisition in May 2005 of Caerus
and
its subsidiaries.
In
accordance with SFAS 142, management tests the carrying value of its goodwill
and other intangible assets for impairment at least annually by comparing the
fair values of these assets to their carrying values. During the year ended
December 31, 2005 the Company recorded an impairment charge to its operating
results of approximately $4.2 million relating to goodwill previously recorded
for an acquisition. During the three months ended March 31, 2006, the Company
recorded an impairment charge of $839,101 as a result of selling the Company's
interest in its subsidiary, DTNet Technologies in April 2006. During the three
months ended June 30, 2007, the Company also wrote off $6,448,838 of goodwill
and other intangible assets related to the sale of operating assets utilized
by
its Dallas, Texas, subsidiary. All of these asset impairment charges and
write-offs are now classified with results of discontinued operations. The
Company may be required to record additional intangible asset impairment charges
in the future, which could materially adversely affect its financial condition
and results of operations. If the traded market price of the Company's common
stock declines further, a material goodwill impairment charge in the future
is
possible.
As
of
September 30, 2007 and December 31, 2006, goodwill and other intangible assets
consisted of the following:
|
|
|
|
September 30,
|
|
December 31,
|
|
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
|
|
Goodwill
|
|
|
|
|
$
|
16,826,301
|
|
$
|
16,826,301
|
|
|
|
|
|
|
|
|
|
|
|
|
Other
intangible assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Useful Life
(Years)
|
|
|
|
|
|
|
|
Technology
|
|
|
4.0
|
|
$
|
6,000,000
|
|
$
|
6,000,000
|
|
Customer
relationships
|
|
|
5.0
- 6.0
|
|
|
5,800,000
|
|
|
5,800,000
|
|
Trade
names
|
|
|
9.0
|
|
|
1,300,000
|
|
|
1,300,000
|
|
Non-compete
agreement
|
|
|
1.0
|
|
|
500,000
|
|
|
500,000
|
|
Other
intangible assets
|
|
|
Indefinite
|
|
|
200,000
|
|
|
200,000
|
|
Subtotal
|
|
|
|
|
|
13,800,000
|
|
|
13,800,000
|
|
Accumulated
amortization
|
|
|
|
|
|
(6,592,604
|
)
|
|
(4,634,267
|
)
|
Other
intangible assets, net
|
|
|
|
|
|
7,207,396
|
|
|
9,165,733
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
goodwill and other intangible assets
|
|
|
|
|
$
|
24,033,697
|
|
$
|
25,992,034
|
|
Amortization
expense for the nine months ended September 30, 2007 and 2006 amounted to
$1,958,337 and $2,166,668, respectively.
NOTE
F - LOANS PAYABLE
At
September 30, 2007 and December 31, 2006, loans payable consisted of the
following:
|
|
September
30,
|
|
December
31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Note
payable to a lending institution
|
|
$
|
-
|
|
$
|
2,381,085
|
|
Note
payable to Black Forest International (see Note K)
|
|
|
300,000
|
|
|
-
|
|
Demand
notes (see Note G, footnote 9)
|
|
|
20,000
|
|
|
-
|
|
Other
notes payable
|
|
|
193,750
|
|
|
193,750
|
|
|
|
|
|
|
|
|
|
Total
loans payable
|
|
$
|
513,750
|
|
$
|
2,574,835
|
|
The
Company as of December 31, 2006 owed $2.4 million to Cedar Boulevard Lease
Funding LLC (“Cedar”) pursuant to a subordinated loan and security agreement
(the “Loan Agreement”). Under the Loan Agreement, Cedar was granted a perfected,
first-priority security interest in all of the Company's assets. This loan
bears
interest at 17.5%, and the remaining balance was due in May 2007.
On
February 1, 2007 Cedar assigned its rights under the Loan Agreement, including
the note payable (the “Note”) with a principal balance at the time of
$1,917,581, and the related security interest, to a group of institutional
investors (the “Investors”). In conjunction with this assignment, the
Company paid a fee of $200,000 to Cedar. Also following the assignment, the
Note's terms were amended to allow conversion of any unpaid principal balance
into the Company's restricted common stock at $5.20 per share. The Note was
also
amended to include “favored nations” rights such that for future securities
offerings by the Company at a price per share less than this $5.20 per share,
the Note's conversion rate would be adjusted to the lower offering price. In
conjunction with the Company's default and waiver agreement discussed in Note
Q,
on October 31, 2007 the Note's common stock conversion rate was reduced to
the
lesser of: (i) $0.50 per share; or (b) 70% of the three lowest closing bid
prices for the ten days prior to the conversion date. Interest expensed
and paid under this debt facility during the nine months ended September 30,
2007 and 2006 was $11,575, and $361,653, respectively.
Due
to
the Note's amendment discussed in the preceding paragraph allowing its
conversion into the Company's common stock, the balance owing at September
30,
2007 has been reclassified from loans payable to convertible notes payable
on
the Company's consolidated balance sheet at September 30, 2007 (see Note G).
The
Company was in violation of certain requirements of this Loan Agreement at
September 30, 2007. However, the Investors had currently not declared this
loan in default. As a result, the full amount of the loan at September 30,
2007 has been classified as current. (See Note Q for subsequent default and
waiver agreement.)
The
other
notes payable at September 30, 2007 and December 31, 2006 were previously
classified as common stock and additional paid-in capital, because related
notes
payable were converted to common stock in 2005. According to the terms of a
November 2006 settlement agreement between the Company and the convertible
note
holders, the note holders returned the common stock to the Company, and the
convertible debt was reclassified to loans payable, and are payable on
demand.
NOTE
G - CONVERTIBLE NOTES AND WARRANTS PAYABLE
At
September 30, 2007 and December 31, 2006, convertible notes payable and the
fair
value liability for related warrants consisted of the following:
|
|
Convertible Notes Payable
|
|
Fair Value Liability for Warrants (14)
|
|
|
|
September 30,
|
|
December 31,
|
|
September 30,
|
|
December 31,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
Payable
to accredited investors:
|
|
|
|
|
|
|
|
|
|
July
& October 2005 (1)
|
|
$
|
396,408
|
|
$
|
488,543
|
|
$
|
-
|
|
$
|
441,313
|
|
January
& February 2006 (2)
|
|
|
6,809,956
|
|
|
8,353,102
|
|
|
-
|
|
|
980,409
|
|
October
2006 (3)
|
|
|
2,905,875
|
|
|
2,905,875
|
|
|
-
|
|
|
1,971,844
|
|
"Cedar"
notes (4)
|
|
|
851,522
|
|
|
-
|
|
|
-
|
|
|
-
|
|
February
2007 (5)
|
|
|
3,808,990
|
|
|
-
|
|
|
-
|
|
|
-
|
|
April
2007 (6)
|
|
|
412,500
|
|
|
-
|
|
|
-
|
|
|
-
|
|
June
2007 (7)
|
|
|
200,000
|
|
|
-
|
|
|
-
|
|
|
-
|
|
July
2007 (8) and (9)
|
|
|
325,000
|
|
|
-
|
|
|
-
|
|
|
-
|
|
August
2007 (10)
|
|
|
275,000
|
|
|
-
|
|
|
-
|
|
|
-
|
|
September
2007 (11) and (12)
|
|
|
6,948,482
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
May
2005 private placement (13)
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
58,510
|
|
August
2005 subscription agreement (13)
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
400,500
|
|
Other
- see Note N
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
1,250,155
|
|
Subtotal
|
|
|
22,933,733
|
|
|
11,747,520
|
|
|
-
|
|
|
5,102,731
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less
discounts
|
|
|
(9,250,752
|
)
|
|
(5,845,303
|
)
|
|
-
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
13,682,981
|
|
$
|
5,902,217
|
|
$
|
-
|
|
$
|
5,102,731
|
|
(1)
|
In
July and October 2005 the Company issued and sold $3,085,832 in principal
amount of convertible notes to institutional investors at a discount,
receiving net proceeds of $2,520,320. These notes are immediately
convertible at the option of the note holders into shares of the
Company's
common stock, at an original conversion rate of $16.00 per share.
These
investors also received five-year warrants to purchase 48,216 shares
of
the Company's common stock for an original $27.52 per share, five-year
warrants to purchase 48,216 shares of the Company's common stock
for
$33.01 per share, and one-year warrants to purchase 96,432 shares
of the
Company's common stock for $32.00 per share. The investors also received
“favored nations” rights such that for future securities offerings by the
Company at a price per share less than the above conversion rate
or
warrant exercise prices, the investors' conversion rate and warrant
exercise price would be adjusted to the lower offering price. These
notes
are secured by a subordinated lien on the Company's assets, and the
notes
bear interest at an effective annual rate of approximately 20%. The
principal balance of these notes was $396,408 and $488,543 at September
30, 2007 and December 31, 2006, respectively. All of these notes
were due and payable at September 30, 2007 in cash or, at the option
of
the Company, in registered common stock at the original conversion
price
of $16.00 per share. As a result of the October 31, 2007 default
and
waiver agreement described in Note Q and the favored nations provision
discussed above, the notes' conversion rate and the exercise price
of
outstanding warrants were effectively reduced to the lesser of: (i)
$0.50
per share; or (b) 70% of the three lowest closing bid prices for
the ten
days prior to the conversion or exercise date. The Company was also
in
violation of certain other covenants at September 30, 2007. While
the
investors have not declared the convertible notes currently in default,
the full amount of the notes has been classified as current. The
July 2005
and October 2005 conversion shares became Rule 144(k) eligible in
July and
October 2007, respectively, and the Company discontinued accrual
of
associated liquidated damages on those dates. (See also Note H for
nonregistration damages paid on September 12, 2007.)
|
(2)
|
In
January and February 2006, the Company issued and sold $11,959,666
in
principal amount of convertible notes to institutional investors
at a
discount, receiving net proceeds of $9,816,662. These notes are
immediately convertible at the option of the note holders into shares
of
the Company's common stock at an original conversion rate of $26.36
per
share. These investors also received five-year warrants to purchase
226,853 shares of the Company's common stock for $29.18 per share,
and
one-year warrants to purchase 226,853 shares of the Company's common
stock
for an original $31.83 per share. The investors also received “favored
nations” rights. Of the total initial principal, $8,318,284 of the notes
are secured by a subordinated lien on the Company's assets. The principal
balance of the notes was $6,809,956 and $8,353,102 at September 30,
2007
and December 31, 2006, respectively, and all the notes bear interest
at an
effective annual rate of approximately 20%. The unsecured portion
of these
notes became payable beginning in July 2006 over two years in cash
or, at
the option of the Company, in registered common stock at the original
conversion price of $26.36 per share. As a result of a May 2006 warrant
restructure, the secured portion of these notes became payable beginning
in August 2006 over two years in cash or, at the option of the
Company, in registered common stock at the lesser of $20.00 per share
or
85% of the weighted average price of the stock on the OTCBB, but
not less
than $16.00 per share. As a result of the October 31, 2007 default
and
waiver agreement described in Note Q and the favored nations provision
discussed above, the notes' conversion rate and the exercise price
of
outstanding warrants were effectively reduced to the lesser of: (i)
$0.50
per share; or (b) 70% of the three lowest closing bid prices for
the ten
days prior to the conversion or exercise date. At September 30, 2007,
the
Company had not made scheduled principal payments of $3,572,757 on
these
notes. Beginning April and May 2006, the Company was in violation
of the
registration requirements of the secured and unsecured notes,
respectively. In May 2006, the Company issued an aggregate of 8,318
shares
to the secured investors in satisfaction of their then-existing
non-registration liquidated damages. (See also Note H for nonregistration
damages paid on September 12, 2007.) The Company owed additional
liquidated damages of $901,242 at September 30, 2007, and will
incur additional damages of $55,379 per month until the required
shares
and warrants are registered, or until the conversion and warrant
shares
become Rule 144(k) eligible in January 2008. The Company was also
in
violation of certain other covenants at September 30, 2007. While
the
investors have not declared the convertible notes currently in default,
the full amount of the notes has been classified as
current.
|
(3)
|
On
October 17, 2006, the Company issued and sold $2,905,875 in secured
convertible notes to institutional investors at a discount, for a
net
purchase price of $2,324,700. Proceeds of approximately $1,436,900
(before
closing costs of $308,748) were paid in cash to the Company at closing,
and $887,800 of the proceeds were used to repay three outstanding
promissory notes held by three of the investors in the private placement.
The investors also received five-year warrants to purchase a total
of
518,906 shares of the Company's common stock at an original exercise
price
of $8.14 per share. The principal balance of the notes was $2,905,875
at
September 30, 2007 and December 31, 2006. These convertible notes
are
secured by a subordinated lien on the Company's assets, are not interest
bearing, and are due on December 31, 2007. The note holders may at
their
election convert all or part of the convertible notes into shares
of the
Company's common stock at an original conversion rate of $5.60 per
share.
The investors also received “favored nations” rights which, when coupled
with the October 31, 2007 default and waiver agreement described
in Note
Q, effectively reduced the notes' conversion rate and the exercise
price
of outstanding warrants to the lesser of: (i) $0.50 per share; or
(b) 70%
of the three lowest closing bid prices for the ten days prior to
the
conversion or exercise date. Beginning December 2006 and January
2007, the
Company was in violation of the nonreservation and nonregistration
requirements, respectively, of the related subscription agreement.
(The
share reservation requirement was satisfied in August 2007.) Failing
either of these, the convertible note holders are entitled to liquidated
damages that accrued at the rate of two percent per month of the
amount of
the purchase price of the outstanding convertible notes during such
default. See Note H for related liquidated damages paid on September
12,
2007, in settlement of the Company’s related reservation and registration
requirements. The Company was also in violation of certain other
covenants
at September 30, 2007. While the investors have not declared the
convertible notes currently in default, the full amount of the notes
has
been classified as current.
|
(4)
|
See
Note F for a discussion of the Cedar note and related loan
agreement.
|
(5)
|
On
February 16, 2007, the Company issued and sold $3,462,719 in secured
convertible notes (the “Convertible Notes”) to institutional investors at
a discount, for a net purchase price of $2,770,175. $900,000 of the
proceeds (before closing costs of $67,512) were paid in cash to the
Company at closing, and $1,870,175 of the proceeds were used to repay
fourteen outstanding promissory notes (including related accrued
interest
and a 10% premium on the promissory notes' total principal of $1,666,667)
held by five of the investors in the private placement. The investors
also
received five-year warrants to purchase a total of 961,866 shares
of the
Company's common stock at an original effective exercise price of
$3.60
per share. The Convertible Notes are secured by a subordinated lien
on the
Company's assets, are not interest bearing, and are due on February
16,
2008. The note holders may at their election convert all or part
of the
Convertible Notes into shares of the Company's common stock at the
original conversion rate of $3.60 per share. The investors also received
“favored nations” rights which, when coupled with the October 31, 2007
default and waiver agreement described in Note Q, effectively reduced
the
notes' conversion rate and the exercise price of outstanding warrants
to
the lesser of: (i) $0.50 per share; or (b) 70% of the three lowest
closing
bid prices for the ten days prior to the conversion or exercise date.
Pursuant to the related subscription agreement, two of the investors
received due diligence fees totaling $346,271, in the form of convertible
notes (the “Due Diligence Notes”) having the same terms and conversion
features as the Convertible Notes. Also pursuant to the subscription
agreement, the Company issued a total of 200,000 common shares in
April
2007 to the former holders of the above-referenced promissory notes,
in
lieu of and in payment for accrued damages associated with these
promissory notes. Also pursuant to the subscription agreement, the
Company
was to obtain the authorization and reservation of its common stock
on
behalf of the investors of not less than 200% of the common shares
issuable upon the conversion of the Convertible Notes and Due Diligence
Notes, and 100% of the common shares issuable upon the exercise of
the
warrants by April 15, 2007. Failing this, the note holders are
entitled to liquidated damages at the rate of two percent per month
of the
amount of the purchase price of the outstanding convertible notes
during
such default. On August 16, 2007, the Company obtained sufficient
authorization and reservation of its common stock as the result of
its
1-for-20 reverse stock split. See Note H for related liquidated damages
paid on September 12, 2007, in settlement of the Company’s accrued
liquidated damages. The Company was also in violation of certain
other
covenants at September 30, 2007. While the investors have not declared
the
notes currently in default, the full amount of the notes has been
classified as current.
|
(6)
|
On
April 6, 2007, the Company issued and sold $375,000 in secured convertible
notes (the “Convertible Notes”) to two institutional investors at a
discount, for a net purchase price of $300,000. The investors also
received five-year warrants to purchase a total of 104,167 shares
of the
Company's common stock at an original exercise price of $3.60 per
share. The Company received an unsecured advance of $300,000 on
February 23, 2007 from these investors, and these funds were credited
to
the purchase price of the Convertible Notes. The Convertible Notes
are
secured by a subordinated lien on the Company's assets, are not interest
bearing, and are due on February 23, 2008. The note holders may at
their
election convert all or part of the Convertible Notes into shares
of the
Company's common stock at the original conversion rate of $3.60 per
share.
Pursuant to the related subscription agreement, one of the investors
received a due diligence fee of $37,500 in the form of a convertible
note
(the "Due Diligence Note") having the same terms and conversion features
as the Convertible Notes. The investors also received “favored nations”
rights which, when coupled with the October 31, 2007 default and
waiver
agreement described in Note Q, effectively reduced the notes' conversion
rate and the exercise price of outstanding warrants to the lesser
of: (i)
$0.50 per share; or (b) 70% of the three lowest closing bid prices
for the
ten days prior to the conversion or exercise date. Also pursuant
to the
subscription agreement, the Company must reserve its common stock
on
behalf of the investors of not less than 200% of the common shares
issuable upon the conversion of the notes and 100% of the common
shares
issuable upon the exercise of the warrants by April 15, 2007. Failing
this, the holders of the notes will be entitled to liquidated damages
that
will accrue at the rate of two percent per month of the amount of
the
purchase price of the outstanding notes during such default. On August
16,
2007, the Company obtained sufficient authorization and reservation
of its
common stock as the result of its 1-for-20 reverse stock split. See
Note H
for related liquidated damages paid on September 12, 2007, in settlement
of the Company’s accrued liquidated damages. The Company was also in
violation of certain other covenants at September 30, 2007. While
the
investors have not declared the notes currently in default, the full
amount of the notes has been classified as
current.
|
(7)
|
Between
June 14, 2007 and June 19, 2007, the Company issued and sold convertible
promissory notes to four institutional investors in private placements,
for a net purchase price of $275,000. These convertible notes are not
interest bearing, and were due on June 25, 2007. These notes are
repayable
at the investors' election in cash for $366,667, reflecting a 33%
premium
(the “Premium”). The investors may also at their election convert all or
part of these notes into shares of the Company's common stock at
the
original conversion rate of $2.40 per share. Per the terms of these
notes,
since the Company did not repay the notes on June 25, 2007, the above
common stock conversion rate was adjusted to $1.60 per share. If
the
investors elect to convert these notes at $1.60 per share, they have
agreed to waive the Premium. The investors also received “favored nations”
rights which, when coupled with the October 31, 2007 default and
waiver
agreement described in Note Q, effectively reduced the notes' conversion
rate to the lesser of: (i) $0.50 per share; or (b) 70% of the three
lowest
closing bid prices for the ten days prior to the conversion date.
$75,000
of these convertible notes were repaid in conjunction with the September
12, 2007 financing described
below.
|
(8)
|
On
July 27, 2007, the Company issued and sold $250,000 in secured convertible
notes to two institutional investors at a discount, for a net purchase
price of $200,000. The investors also received five year warrants
to
purchase a total of 156,250 shares of the Company's common stock,
par
value $0.001 per share, at an exercise price of $1.60 per share.
$125,000
of these convertible notes were repaid in conjunction with the September
12, 2007 financing described below. These convertible notes are not
interest bearing, and are due on July 27, 2008. The note holders
may at
their election convert all or part of the notes into shares of the
Company's common stock at the original conversion rate of $1.60 per
share.
The investors also received “favored nations” rights which, when coupled
with the October 31, 2007 default and waiver agreement described
in Note
Q, effectively reduced the notes' conversion rate and the exercise
price
of outstanding warrants to the lesser of: (i) $0.50 per share; or
(b) 70%
of the three lowest closing bid prices for the ten days prior to
the
conversion or exercise date. Also pursuant to the related subscription
agreement, the Company must reserve its common stock on behalf of
the
investors of not less than 200% of the common shares issuable upon
the
conversion of the notes and 100% of the common shares issuable upon
the
exercise of the warrants.
|
(9)
|
On
July 31, 2007, the Company issued and sold $200,000 in secured convertible
notes to two accredited investors in a private placement. The investors
also received 10,000 shares of the Company's common stock; three-year
warrants to purchase a total of 218,750 shares of the Company's common
stock at an original exercise price of $1.60 per share; and unsecured
promissory demand notes totaling $20,000, and bearing interest at
10%
(classified with loans payable at September 30, 2007). The convertible
notes are secured by a subordinated lien on the Company's assets,
bear
interest at 10%, and are due at the earlier of: (a) January 31, 2008;
or
(b) the Company's closing of a financing transaction of $20 million
or
more (the “Closing”). These note holders may at their election
convert all or part of the convertible notes into shares of the Company's
common stock at the original conversion rate of $1.60 per share.
These
note holders may also at their election receive a credit of 125%
of the
amount payable against the purchase price of a financing transaction
of
$20 million or more. The investors also received “favored nations” rights
which, when coupled with the October 31, 2007 default and waiver
agreement
described in Note Q, effectively reduced the notes' conversion rate
and
the exercise price of outstanding warrants to the lesser of: (i)
$0.50 per
share; or (b) 70% of the three lowest closing bid prices for the
ten days
prior to the conversion or exercise date. Also pursuant to the related
subscription agreement, within 120 days of the Closing, the Company
must
file a registration statement on behalf of the investors registering
the
common stock, as well as the common shares issuable upon conversion
of the
convertible notes and the exercise of the warrants. Said registration
statement must also be declared effective within 180 days of the
Closing.
Failing either of these, these investors will be entitled to liquidated
damages that will accrue at the rate of 1.5% per month of the amount
of
the purchase price of the convertible notes during such default,
up to a
total of 18%.
|
(10)
|
On
August 17, 2007, the Company issued and sold a $250,000 unsecured
promissory note to an accredited investor at a discount, for a net
purchase price of $200,000. The investor also received an unsecured
promissory note for $25,000 as a placement fee (combined, the “Notes”).
The Notes are not interest bearing, and were due on September 1,
2007. The
investor also received five-year warrants to purchase a total of
156,250
shares of the Company's common stock at an original exercise price
of
$1.60 per share. The investors also received “favored nations” rights
which, when coupled with the October 31, 2007 default and waiver
agreement
described in Note Q, effectively reduced the exercise price of outstanding
warrants to the lesser of: (i) $0.50 per share; or (b) 70% of the
three
lowest closing bid prices for the ten days prior to the exercise
date.
Since the Notes were not paid when due , the investor formally declared
the Company to be in default thereunder, and in accordance with the
terms
of the Notes, on September 17, 2007 elected to convert the Notes
into
free-trading shares of the Company's common stock at $0.767 per share.
Accordingly, 358,540 unrestricted common shares were issued to the
investor pursuant to Section 3(a)(10) of the Act on October 16,
2007.
|
(11)
|
On
September 12, 2007, pursuant to the terms of a subscription agreement
and
an intercreditor agreement, the Company issued and sold $1,844,581
in
secured convertible notes (the “Financing Notes”) to several institutional
investors at a discount, for a net purchase price of $1,374,999.
Pursuant
to the related agreements, the Financing Notes are secured by a
subordinated lien on the Company's assets, bear interest at the rate
of 8%
per annum, and are due by September 12, 2008. In addition, 15% of
the
Company's future net financings are required to be used to repay
the
Financing Notes. The note holders may at their election convert all
or
part of the Financing Notes into shares of the Company's common stock
at
the original conversion rate of $0.75 per share. The investors also
received five-year warrants to purchase a total of 2,459,442 shares
of the
Company's common stock, par value $0.001 per share, at an exercise
price
of $0.75 per share (the “Financing Warrants”).
|
|
Pursuant
to a related intercreditor agreement, $1,576,278 principal amount
of the
Company's existing secured convertible notes were also reassigned
among
the parties to this agreement. That amount, plus $268,303 of the
Waiver
Notes (defined below), plus $1,646,589 principal amount of the Company's
other existing secured convertible notes, are referred to herein
as Super
Senior Secured Debt (the “SSS Debt”). The SSS Debt is repayable at the
rate of $250,000 every 45 days following September 12, 2007 (the
“Amortization Payments”), with all amounts outstanding in connection with
the SSS Debt payable by May 31, 2008. In the event that the Company
fails
to make any of the Amortization Payments, the note holders may elect
to
trigger a reduction of the related effective notes' conversion rate
to an
amount equal to 70% of the Company's average of the three lowest
closing
bid prices of its common stock for the 10 days prior to the date
a note
holder converts its note.
|
|
Also
pursuant to the related intercreditor agreement, the Company issued
(i)
$2,417,651 in secured convertible notes (the “Damages Notes”) to the
investors as settlement of all liquidated damages accrued to date
related
to notes previously issued to these investors by the Company; and
(ii)
$2,000,000 in secured convertible notes (the “Waiver Notes”) to the
investors in consideration for their waiving certain existing events
of
default and up to six months of future liquidated damages related
to
nonregistration events pertaining to financing agreements the Company
entered into with them prior to September 12, 2007. The Company also
issued to the investors five-year warrants to purchase a total of
4,870,075 shares of the Company's common stock as further consideration
for the waivers (the “Waiver Warrants”). The Damages Notes, Waiver Notes
and Waiver Warrants contain terms substantially similar to the Financing
Notes and Financing Warrants.
|
|
Also
on September 12, 2007, the Company signed an agreement to issue a
$400,000
secured convertible note (the “Bristol Note”) to Bristol Investment Fund,
Ltd. (“Bristol”), for a net purchase price of $200,000 plus additional
noncash consideration, in a private placement. The Bristol Note is
secured
by a subordinated lien on the Company's assets, bears interest at
the rate
of 8% per annum, and is due on September 12, 2008. Bristol may at
its
election convert all or part of the Bristol Note into shares of the
Company's common stock at the original conversion rate of $0.75 per
share.
|
|
The
investors in the Financing Notes, Financing Warrants, Damages Notes,
Waiver Notes, Waiver Warrants and Bristol Note also received “favored
nations” rights which, when coupled with the October 31, 2007 default and
waiver agreement described in Note Q, effectively reduced the notes'
conversion rate and the exercise price of outstanding warrants to
the
lesser of: (i) $0.50 per share; or (b) 70% of the three lowest closing
bid
prices for the ten days prior to the conversion or exercise date.
The
Company was also in violation of certain other covenants at September
30,
2007. While the investors have not declared the Notes currently in
default, the full amount of the Notes has been classified as
current.
|
(12)
|
On
September 26, 2007, the Company issued and sold a $250,000 secured
convertible note (the “Note”) to an accredited investor in a private
placement for a net purchase price of $200,000. The Note is secured
by a
certain receivable of the Company and is due on October 4, 2007.
In the
event of the Company's default under the terms of the Note, the unpaid
portion of the Note becomes convertible into free-trading shares
of the
Company's common stock, par value $0.001 per share, at a 30% discount
to
the average of the closing market price of the Company's common stock
over
the five trading days immediately preceding such conversion, subject
to a
conversion price floor of $0.75 per share. The investor also received
a
$36,250 fee in the form of an unsecured convertible note (the “Fee Note”)
due on October 4, 2007 and convertible in the event of default under
the
same terms and conditions as those set forth in the
Note.
|
(13)
|
See
Note C for a discussion of the May 2005 private placement and the
August
2005 subscription agreement.
|
(14)
|
See
Note B for a discussion of the accounting for the fair value liability
for
warrants.
|
During
the nine months ended September 30, 2007 and 2006, the Company converted
$6,401,341 and $4,682,010, respectively, of its notes payable to common
stock.
No
interest was paid on any of the convertible notes described above during the
nine months ended September 30, 2007 and 2006.
NOTE
H - FINANCING PENALTIES AND OTHER STOCK-BASED PAYABLES
At
September 30, 2007 and December 31, 2006, financing penalties and other
stock-based payables consisted of the following:
|
|
September
30,
|
|
December
31,
|
|
|
|
2007
|
|
2006
|
|
Nonregistration
penalties payable:
|
|
|
|
|
|
In
cash
|
|
$
|
901,242
|
|
$
|
1,658,858
|
|
In
common stock and warrants
|
|
|
114,811
|
|
|
1,342,299
|
|
Loan
default penalties payable (see Note K)
|
|
|
482,140
|
|
|
-
|
|
Common
stock payable to officer
|
|
|
947,972
|
|
|
732,678
|
|
Common
stock payable to directors
|
|
|
27,300
|
|
|
210,000
|
|
Common
stock payable to investors
|
|
|
840,068
|
|
|
365,345
|
|
Common
stock payable for other services rendered
|
|
|
770,532
|
|
|
439,200
|
|
|
|
|
|
|
|
|
|
Total
financing penalties and other stock-based payables
|
|
$
|
4,084,065
|
|
$
|
4,748,380
|
|
|
|
|
|
|
|
|
|
As
discussed in Note G, the Company is in violation of the registration
requirements of a number of its existing financing agreements.
Pursuant
to the September 12, 2007 financing agreements referred to in Note G, the
Company issued (i) $2,417,651 in secured convertible notes (the “Damages Notes”)
to those related investors as settlement of all liquidated damages accrued
to
date related to notes previously issued to these investors by the Company;
and
(ii) $2,000,000 in secured convertible notes (the “Waiver Notes”) to these
investors in consideration for their waiving certain existing events of default
and up to six months of future liquidated damages related to nonregistration
events pertaining to financing agreements the Company entered into with them
prior to September 12, 2007. The Company also issued to the investors five-year
warrants to purchase a total of 4,870,075 shares of the Company's common stock
as further consideration for the waivers (the “Waiver Warrants”). The Damages
Notes, Waiver Notes and Waiver Warrants contain terms substantially similar
to
the Financing Notes and Financing Warrants discussed in Note G. As a result,
liquidated damages payable in a combination of stock and cash amounted to
$1,016,053 and $3,001,157 as of September 30, 2007 and December 31, 2006,
respectively.
As
discussed in Note M, the Company's Chief Operating Officer exercised options
to
purchase 150,000 shares of common stock. Since the Company had insufficient
authorized common shares at December 31, 2006, only 48,239 shares were issued
in
2006, and the balance of 101,761 shares (originally valued at $732,678) were
issued on April 2, 2007 following the Company's March 16, 2007 shareholder
approval of sufficient increased authorized common shares.
On
September 6, 2007 the Company executed a 12-month consulting agreement with
CEOcast, Inc. (the “Consulting Agreement”), whereby CEOcast provides certain
investor relations services in return for 400,000 immediately issuable shares
of
the Company’s restricted common stock (with piggyback registration rights), plus
cash payments of $10,000 per month. Based on the Company’s common stock market
price at September 6, 2007, $504,000 is included in common stock payable for
other services rendered at September 30, 2007, and that amount was
correspondingly charged to operations in the three and nine months ended
September 30, 2007.
NOTE
I - LITIGATION
MCI
Beginning
April 8, 2005, the Company's subsidiary, Volo Communications, Inc. (“Volo”) was
involved in litigation as both plaintiff and counterclaim-defendant with MCI
WorldCom Network Services, Inc. d/b/a UUNET (now Verizon Business Network
Services, Inc.) ("MCI WorldCom"). Volo alleged that MCI WorldCom engaged in
a
pattern and practice of over-billing Volo for the telecommunications services
it
provided pursuant to the parties' Services Agreement, and that MCI WorldCom
refused to negotiate such overcharges in good faith. MCI WorldCom counterclaimed
that Volo owed a past due amount of $8,365,980, and further asserted third
party
claims against Volo's parent corporation, Caerus, Inc. (“Caerus”). Caerus, in
turn, asserted counterclaims against MCI WorldCom. Extensive discovery has
since
taken place.
The
parties to the litigation engaged in settlement discussions in February and
March 2007, which ultimately led to a confidential settlement agreement (the
“Settlement Agreement”) executed by the parties on May 17, 2007. The terms of
the Settlement Agreement include the following provisions:
1. |
Beginning
May 2007, Volo and Caerus will pay a total of $2.2 million (the
“Payments”) to MCI WorldCom in monthly installments through November,
2009;
|
2. |
The
Company issued a guarantee of Payments under the Settlement Agreement,
secured by all of the Company's
assets;
|
3.
|
The
Company effectively transferred its 60,000 shares of common stock,
par
value $0.001, that were held in escrow pursuant to the merger
of Caerus
and the Company in 2005, into a new escrow account as security
for the
Payments; and
|
4. |
Volo
and Caerus are contingently liable to MCI WorldCom for $8.0 million
(less
amounts paid by the Company under #1 above), in the event of
their default
under the Settlement Agreement that is not cured pursuant to
its
terms.
|
In
conjunction with the Settlement Agreement, the Company recognized a related
gain
of approximately $4.0 million in the second quarter of 2007, representing the
excess of the liability previously accrued on the Company's consolidated balance
sheet over the expected cash payments in #1 above. As of September 30, 2007,
$1,905,000 was owed under #1 above, and is included in accrued litigation
charges on the Company's consolidated balance sheet.
Cross
Country Capital Partners, L.P.
On
September 25, 2006, Cross Country Capital Partners, L.P. (“Cross Country”) filed
suit against the Company, asserting a claim for breach of contract in connection
with a securities purchase agreement entered into with the Company dated August
26, 2005 (the “Securities Purchase Agreement”). Pursuant to a settlement
agreement dated May 23, 2007 (the “Settlement Agreement”), the Company on June
18, 2007 issued to Cross Country 625,000 unrestricted shares of its common
stock, par value $0.001 (the “Settlement Shares”), issued pursuant to Section
3(a)(10) of the Act. With respect to 50% of the Settlement Shares, during any
90
day period Cross Country may only sell an amount of these shares in an aggregate
amount up to 1% of the Company's outstanding common stock. The remaining
Settlement Shares may be disposed of by Cross Country at such time or times
thereafter, as it deems appropriate. The Company had previously issued to Cross
Country warrants to purchase 111,250 of the Company's common shares at prices
originally ranging from $27.40 to $32.00 per share, which were subsequently
repriced to $3.60 per share as a result of a “favored nations” pricing
provision. The Settlement Agreement affirmed the $3.60 exercise price. In
conjunction with the Settlement Agreement, the Company recognized a related
expense of $1,273,870 in the nine months ended September 30, 2007,
representing the shortfall in the liability previously accrued on the Company's
consolidated balance sheet compared to the value of the stock issuance
above.
On
September 20, 2007, Cross Country filed suit against the Company in
160th
District
Court in Dallas County, Texas, asserting separate claims for breach of contract
in connection with the Securities Purchase Agreement. Cross Country claims
unspecified damages relating to the “favored nations” pricing provision of the
Securities Purchase Agreement, which it claims survived the Settlement
Agreement, coupled with the Company’s security issuances subsequent to the
Settlement Agreement at prices less than the above $3.60 per share. On October
26, 2007 the Company filed an Answer and Affirmative Defenses denying Cross
Country’s claims. The Company is currently unable to assess the outcome of this
litigation or its potential impact on the Company's financial condition and
results of operations.
Other
The
Company and Mr. Ivester, a shareholder and former Chief Executive Officer of
the
Company, entered into a 3-year consulting agreement on October 18, 2005, which
the Company terminated in October 2006. Pursuant to the consulting agreement,
Mr. Ivester provided general business strategy, financing and product
development advice. Mr. Ivester received $200,000 per year for his services
under the consulting agreement, as well as a $2,500 per month vehicle allowance.
The Company also owed Mr. Ivester $305,212 as of December 31, 2006 under a
demand note payable bearing interest at 3.75%. On March 16, 2007, the Company
agreed to settle all of Mr. Ivester's claims under his consulting agreement
and
his demand note payable, in return for cash payments totaling $75,000, and
a
combination of cash and common shares totaling a minimum value of $125,000.
In
conjunction with this settlement agreement, the Company recognized a related
expense of $73,467 in the nine months ended September 30, 2007, representing
the
shortfall in the liability previously accrued on the Company's consolidated
balance sheet compared to the value of the settlement.
In
March
2007, the Company settled claims against it brought by a former employee and
two
investors, requiring cash payments totaling $132,000, and the issuance of 23,750
shares of the Company's common stock.
In
June
2007, the Company settled claims against it brought by an investor, requiring
the issuance of approximately 150,000 unrestricted shares issued pursuant to
Section 3(a)(10) of the Act, the specific amount being subject to a minimum
value of $150,000 as determined by the future market price of the Company's
common stock, as defined.
In
February 2006, the Company settled claims against it pertaining to the exchange
of its common shares for Caerus shares pursuant to the Caerus merger agreement
dated May 31, 2005. The settlement required a cash payment of $710,000, which
was recognized as a litigation charge during the six months ended June 30,
2006.
The
Company is currently a defendant in other lawsuits and disputes arising in
the
ordinary course of business. The Company
believes
that resolution of all known contingencies is uncertain, and there can be no
assurance that future costs related to such litigation would not exceed the
amounts accrued in its consolidated financial statements, which may in turn
materially adversely affect the Company's financial position or results of
operations. The Company expenses all legal costs associated with lawsuits and
other disputes as incurred.
NOTE
J - NOTES AND ADVANCES FROM INVESTORS
Notes
and
advances from investors represent funds loaned to or deposited with the Company
in anticipation of the issuance of future notes payable. No funds were so
advanced at September 30, 2007. The $616,667 at December 31, 2006
represents funds advanced to the Company in November and December 2006, in
anticipation of the issuance of convertible notes payable, which were issued
in
February 2007 (see Note G).
These
notes and advances were unsecured. The $616,667 notes at December 31, 2006
bore
interest at 18%.
NOTE
K - RELATED PARTY TRANSACTIONS
As
of
September 30, 2007 and December 31, 2006, the amount due from related parties
of
$0 and $31,227, respectively, consisted of advances to Shawn M. Lewis, the
Company's Chief Operating Officer.
On
March
29, 2007, the Company issued an unsecured promissory note in the principal
amount of $300,000 (the “Note”) to Shawn M. Lewis, the Company's Chief Operating
Officer, classified as a note payable – related party at September 30,
2007. The Note and related accrued interest at 10% per annum was payable upon
demand. The cash proceeds to the Company were $252,000 net of related closing
costs and expense reimbursements of $48,000, $30,000 of which was paid to
Mr. Lewis. On May 29, 2007, Mr. Lewis issued the Company a formal demand for
payment, and on June 8, 2007 declared the Company in default. Under the terms
of
the note, in addition to the principal balance of $300,000 plus accrued
interest, the Company was obligated to pay $750,000 as liquidated damages,
of
which $67,860 was paid by September 30, 2007 (excluding the $300,000 note
assumed as mentioned below). On June 14, 2007, Mr. Lewis waived this default
in
return for, among other things, a waiver fee of $100,000 payable by June 21,
2007, and full payment of the Note and accrued interest by June 29, 2007. The
Note and $100,000 waiver fee not having been paid, the Note automatically became
in default. To partially address this, on August 8, 2007 the Company assumed
Mr.
Lewis's personal obligations under a $300,000 note payable to Black Forest
International, LLC (“BFI”), due on September 30, 2007 (the “Assumed Note”) and
bearing interest at 12% retroactive to March 29, 2007. The Assumed Note is
classified with loans payable, and the remaining liquidated damages and waiver
fees were classified with financing penalties and other stock-based payables,
at
September 30, 2007. Full default settlement negotiations with Mr. Lewis are
currently underway. In addition, the Company having not paid the Assumed Note
when due, BFI declared the Company in default, and settlement negotiations
are
underway.
NOTE
L - DISCONTINUED OPERATIONS
On
April
19, 2006, the Company sold its wholly-owned subsidiary, DTNet Technologies,
to
the Company's former Chief Operating Officer (the “Purchaser”) pursuant to a
stock purchase agreement. The consideration for the sale consisted primarily
of
(1) the return for cancellation of warrants to purchase 10,000 shares of the
Company's common stock held by the Purchaser; and (2) the return for
cancellation of 10,000 shares of the Company's common stock held by the
Purchaser. Because DTNet Technologies' operations were the primary component
of
the Company's former hardware sales business segment, the Company recorded
an
impairment charge of $839,101 in its statement of operations for the three
months ended March 31, 2006. The remaining $198,000 of goodwill for this former
segment approximated the excess of the sales proceeds received over DTNet
Technologies' carrying value (excluding goodwill) and was written off in
conjunction with the sale of DTNet Technologies.
Effective
October 12, 2006, the Company terminated its Marketing and Distribution
Agreement with Phone House, Inc. dated September 1, 2004 and amended February
16, 2006, effectively discontinuing this business segment. The Agreement called
for the wholesale distribution, marketing and selling of prepaid telephone
calling cards by Phone House, Inc., under license from the Company. The Company
recognized a related impairment loss of $936,122 in the third quarter of 2006,
primarily related to inventory and accounts receivable write-offs, and filed
suit in Los Angeles County against the primary Phone House, Inc. employee to
recover same. On April 4, 2007, a settlement was reached with the Phone House,
Inc. employee recovering most of the assets. Accordingly, the above impairment
loss was reduced by $665,221 through a credit to earnings in the three months
ended March 31, 2007.
Effective
June 27, 2007, the Company and WQN, Inc., a Texas corporation (the "Purchaser")
executed an Asset Purchase Agreement (the "Purchase Agreement"), pursuant to
which the Company sold substantially all of the tangible operating assets
utilized by its Dallas, Texas subsidiary, VoIP Solutions, Inc. (the "Assets"),
to the Purchaser. The Company's patents were not sold. Pursuant to the
Purchase Agreement, the Purchaser acquired the Assets for a purchase price
consisting of (1) a cash payment of $400,000; (2) 4% of the defined monthly
revenues related to the Assets in excess of $200,000 during the first year
following execution of the Purchase Agreement; (3) 3% of the defined monthly
revenues related to the Assets in excess of $150,000 during the second year
following execution of the Purchase Agreement; and (4) 2% of the defined monthly
revenues related to the Assets in excess of $100,000 during the third year
following execution of the Purchase Agreement. In conjunction with a settlement
agreement dated October 3, 2007, the Purchaser also effectively agreed to assume
certain trade accounts payable related to the Dallas, Texas operations of VoIP
Solutions, Inc., in return for $290,000 of the Company’s free trading common
shares, subject to a floor price of $0.75 per share, with any difference made
up
for in cash. Accordingly, on October 17, 2007, the Company issued 386,666
unrestricted shares issued pursuant to Section 3(a)(10) of the Act, and the
Company agreed to pay a cash amount of $73,467 to the Purchaser.
The
following summarizes the combined operating results of DTNet Technologies,
the
calling card business of Phone House, Inc., and the Dallas, Texas assets
of VoIP
Solutions, Inc. for the nine and three months ended September 30, 2007 and
2006
(through the respective dates of sale or termination), and their respective
financial position as of September 30, 2007 and December 31, 2006, classified
as
discontinued operations for all periods presented.
Statement of Operations
|
|
Nine Months Ended September 30
|
|
Three Months Ended September 30
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
2,596,007
|
|
$
|
20,866,536
|
|
$
|
10,731
|
|
$
|
5,623,843
|
|
Cost
of sales
|
|
|
1,780,178
|
|
|
18,640,433
|
|
|
-
|
|
|
4,753,629
|
|
Gross
profit
|
|
|
815,829
|
|
|
2,226,103
|
|
|
10,731
|
|
|
870,214
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Compensation
and benefits
|
|
|
172,534
|
|
|
784,484
|
|
|
-
|
|
|
200,502
|
|
Asset
impairment charges
|
|
|
-
|
|
|
839,101
|
|
|
-
|
|
|
-
|
|
Litigation
credit
|
|
|
(665,221
|
)
|
|
-
|
|
|
-
|
|
|
-
|
|
Other
operating expenses
|
|
|
500,537
|
|
|
1,504,983
|
|
|
62,298
|
|
|
472,709
|
|
Interest
expense
|
|
|
97,040
|
|
|
368,700
|
|
|
-
|
|
|
47,100
|
|
Impairment
loss for contract cancellation
|
|
|
-
|
|
|
1,043,683
|
|
|
-
|
|
|
1,043,683
|
|
Loss
on sale of assets (1)
|
|
|
6,282,165
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Net
loss
|
|
$
|
(5,571,226
|
)
|
$
|
(2,314,848
|
)
|
$
|
(51,567
|
)
|
$
|
(893,780
|
)
|
|
(1)
|
Includes
the write-off of $6,448,838 of goodwill and other intangible asset
values
associated with the sale of the Company's Dallas, Texas operating
assets.
|
Balance
Sheet
|
|
September 30, 2007
|
|
December 31, 2006
|
|
|
|
|
|
|
|
Current
assets
|
|
$
|
10,731
|
|
$
|
406,315
|
|
Property
and equipment, net
|
|
|
-
|
|
|
255,948
|
|
Goodwill
and other intangible assets
|
|
|
-
|
|
|
6,695,788
|
|
Other
assets
|
|
|
-
|
|
|
5,281
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
|
10,731
|
|
|
7,363,332
|
|
Less
current liabilities
|
|
|
(120,728
|
)
|
|
(4,996,325
|
)
|
|
|
|
|
|
|
|
|
Net
assets (liabilities) of discontinued operations
|
|
$
|
(109,997
|
)
|
$
|
2,367,007
|
|
NOTE
M - STOCK BASED COMPENSATION
A
total
of 200,000 shares of common stock were reserved for issuance under the Company's
2004 Employee Stock Option Plan (the “2004 Plan”), which were registered under
the Company's S-8 Registration Statement filed January 26, 2005. In addition,
on
March 16, 2007 the Company obtained shareholder approval of the Company's 2006
Equity Incentive Plan (the “2006 Plan”), which were registered under the
Company's S-8 Registration Statement filed May 11, 2007. The 2006 Plan provides
that key employees, consultants and non-employee directors of the Company or
an
affiliate may be granted: (1) options to acquire up to 500,000 shares of the
Company's common stock; (2) shares of restricted common stock; (3) stock
appreciation rights; (4) performance-based awards; (5) “Dividend Equivalents”;
and (6) other stock-based awards. The activity in the 2004 Plan and the 2006
Plan for the nine months ended September 30, 2007 is as follows:
|
|
Number
|
|
Exercise Price
Range
|
|
Wtd. Avg.
Exercise Price
|
|
|
|
|
|
|
|
|
|
Options
outstanding at December 31, 2006
|
|
|
32,218
|
|
|
|
|
$
|
22.20
|
|
Options
returned to the plan due
|
|
|
|
|
|
|
|
|
|
|
to
employee terminations
|
|
|
(32,218
|
)
|
|
|
|
$
|
22.20
|
|
Options
granted
|
|
|
1,158,333
|
|
|
$1.20
- $3.60
|
|
$
|
2.15
|
|
Options
expired
|
|
|
(187,500
|
)
|
|
$3.60
|
|
$
|
3.60
|
|
Options
exercised
|
|
|
(970,833
|
)
|
|
$1.20
- $3.60
|
|
$
|
1.87
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
outstanding at September 30, 2007
|
|
|
-
|
|
|
N/A
|
|
|
N/A
|
|
In
September 2006, the Company entered into employment agreements with its Chief
Executive Officer (“CEO”) and Chief Operating Officer (“COO”). These agreements,
as subsequently amended by the Company's board of directors, provided for,
among
other things, the award of 500,000 common shares each. In addition, on May
4,
2007, the Company amended its employment agreement with its Chief Accounting
Officer (“CAO”), providing for the award of 100,000 shares of the Company's
common stock. All such shares were issued during the nine months ended September
30, 2007. The CEO and COO are also to receive sufficient additional common
shares to assure that they maintain a minimum of 5% and 8% beneficial ownership,
respectively, of the Company's issued and outstanding common stock, before
considering stock sales. Subject to board approval, the Company has also
executed contracts whereby these 5% and 8% calculations will be made based
on
the Company's fully diluted common shares. Based on these fully diluted share
assumptions, the CEO and COO were owed 2,392,847 and 3,692,269 shares of common
stock, respectively, at September 30, 2007.
On November
8, 2006, the Company's COO was granted options to purchase 150,000 shares of
the
Company's common stock at $7.20 per share (closing market price on November
6,
2006, adjusted for the August 2007 1-for-20 reverse split) under the Company's
2004 Stock Option Plan. On November 9, 2006, the Company settled claims the
COO
had against the Company for alleged breaches of his employment agreement, and
for nonregistration of the Company's common shares he holds pursuant to the
Caerus merger agreement dated May 31, 2005, for $1,080,000. Also on November
9,
2006, the COO exercised his options to purchase 150,000 common shares, and
the
proceeds were credited toward the settlement of his claims. The $1,080,000
settlement expense was recognized in the Company's results of operations as
compensation expense in the fourth quarter of 2006.
On
September 24, 2007, the Company entered into an Advisory Services Agreement
(the
“Agreement”) with Piter Korompis, an individual (the “Consultant”), to provide
the Company with, among other things, advice regarding strategic planning,
organizational and corporate structure, and overall business analysis. In
connection with the Agreement, the Consultant received the following
consideration:
|
1.
|
A
cash fee equal to $490,000 paid by September 29,
2007;
|
|
2.
|
An
option to purchase 500,000 of the Company's common shares at $1.20
per
share, exercisable through September 24, 2008, such option to be
issued under the 2006 Plan; and
|
|
3.
|
An
option to purchase 200,000 of the Company's common shares at $1.20
per
share, exercisable through September 24, 2008, such option to be
issued under the 2004 Plan.
|
On
September 24, 2007, the Consultant exercised his above-referenced options and
offset his related $840,000 payment against his $490,000 fee, with the Company
receiving net proceeds of $350,000.
Separate
from the CEO, COO and Consultant options noted in the preceding paragraphs,
at
September 30, 2007 the Company did not have any outstanding commitments to
issue
stock options under either the 2004 Plan or the 2006 Plan.
See
Note
H for a discussion of the Company’s common shares to be issued to CEOcast, Inc.
for consulting services.
The
Company recorded compensation expense of $5,459,294 and $10,383,504 for the
nine
months ended September 30, 2007 and 2006, respectively, in connection with
options, warrants and stock granted to employees and consultants. As of
September 30, 2007, approximately $14.7 million in total compensation cost
related to options, warrants and stock grants remains to be expensed in future
periods.
NOTE
N - WARRANTS
Through
September 30, 2007 the Company has issued to employees, institutional investors,
and financial services firms warrants to purchase the Company's common stock.
During the nine months ended September 30, 2007 and 2006, the Company issued
361,330 and 441,330 shares, respectively, of common stock in exchange for these
warrants. As of September 30, 2007, the Company had outstanding 795,342
warrants, excluding those warrants issued in conjunction with convertible debt
and common stock issuances discussed in Notes C and G, to purchase its common
stock exercise prices ranging from $1.60 to $52.00 per share, and at a weighted
average exercise price of $17.58 per share.
The
value
of options and warrants was estimated using the Black-Scholes pricing model.
The
Black-Scholes pricing calculations were made using trailing historical measures
corresponding to the time to expiration, and risk-free rates as determined
by
the nearest maturity Treasury yield as of respective valuation
dates.
NOTE
O – COMMITMENTS AND CONTINGENCIES
Leases
The
Company is obligated under non-cancelable operating leases for its office
facilities, and apartments used for business purposes by its employees. Future
minimum lease payments under the Company's non-cancelable operating leases
as of
September 30, 2007 are as follows:
Year
ending December 31,
|
|
|
|
2007
(three months)
|
|
$
|
52,296
|
|
2008
|
|
|
34,864
|
|
2009
|
|
|
-
|
|
Total
|
|
$
|
87,160
|
|
Rent
expense for these leases for the nine months ended September 30, 2007 and 2006
was $119,593 and 147,177, respectively.
Vendor
Disputes
Transport
and termination costs incurred by the Company are generally recorded at vendor
invoice amount less any amounts that have been formally disputed, and for which
the Company expects to receive a credit. Disputed amounts are based upon
management's detailed review of vendor call records and contract provisions;
accordingly, the recorded transport and termination costs represent management's
estimates of what is ultimately due and payable. During the nine and three
months ended September 30, 2007, $427,322 and $99,428, respectively, of such
vendor charges were formally disputed. As of September 30, 2007, approximately
$547,383 remained in dispute and therefore are not included in the accompanying
financial statements. Differences between the disputed amounts and final
settlements, if any, are recognized in operations in the year of
settlement.
Other
Telecommunications
industry revenues are subject to statutory and regulatory changes,
interpretations of contracts, etc., all of which could materially affect the
Company’s revenues. Generally, the Company’s customers have sixty days from the
invoice date to dispute any billed charges. Management reviews all billings
for
compliance with applicable rules, regulations and contract terms and believes
that it is in compliance therewith; accordingly, no allowance has been recorded
in the accompanying financial statements for potential disputed
charges.
NOTE
P - INCOME TAXES
The
components of the Company's consolidated income tax provision are as
follows:
|
|
Nine months ended September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Current
benefit
|
|
$
|
888,234
|
|
$
|
8,759,062
|
|
Deferred
benefit (expense)
|
|
|
1,407,277
|
|
|
(176,448
|
)
|
Subtotal
|
|
|
2,295,511
|
|
|
8,582,614
|
|
Less
valuation allowances
|
|
|
(2,295,511
|
)
|
|
(8,582,614
|
)
|
Net
income tax provision
|
|
$
|
-
|
|
$
|
-
|
|
The
reconciliation of the income tax provision at the statutory rate to the reported
income tax expense is as follows:
|
|
Nine months ended September 30,
|
|
|
|
2007
|
|
2006
|
|
Computed
at statutory rate
|
|
|
34
|
%
|
|
34
|
%
|
Options,
warrants and stock-related expenses
|
|
|
-18
|
%
|
|
-7
|
%
|
Goodwill
impairments and intangible asset amortization
|
|
|
-9
|
%
|
|
-
|
|
Change
in fair value liability for warrants
|
|
|
-1
|
%
|
|
-
|
|
Valuation
allowance
|
|
|
-6
|
%
|
|
-27
|
%
|
Total
|
|
|
-
|
|
|
-
|
|
At
September 30, 2007, the Company's net deferred tax assets consisted of the
following:
Net
operating loss carryforwards
|
|
$
|
15,592,017
|
|
Excess
tax over book depreciation expense
|
|
|
379,033
|
|
Excess
book over tax amortization of debt discounts
|
|
|
4,858,423
|
|
Discontinued
operations impairment charge
|
|
|
92,106
|
|
Noncash
litigation credits, net
|
|
|
(613,804
|
)
|
Subtotal
|
|
|
20,307,775
|
|
Less
valuation allowances
|
|
|
(20,307,775
|
)
|
Total
|
|
$
|
-
|
|
The
Company's net operating loss carryforwards for federal income tax purposes
were
approximately $45,900,000 as of September 30, 2007. These
carryforwards expire in 2018 ($4,200,000), 2019 ($20,600,000), 2020
($18,400,000), and 2021 ($2,700,000), respectively.
NOTE
Q - SUBSEQUENT EVENTS
Effective
October 15, 2007, the Company issued and sold a $185,000 unsecured convertible
note (the “Note”) to an accredited investor, for a net purchase price of
$150,000 (reflecting an 18.92% original issue discount) in a private placement.
The Note bears interest at the rate of 6% per annum, and is due by October
5,
2010. The note holder may at his election convert all or part of the Note plus
accrued interest into shares of the Company's common stock at the conversion
rate of the lesser of: (a) $0.85 per share, or (b) 70% of the average of the
three lowest closing bid prices in the 10 trading days prior to the conversion,
subject to a floor price of $0.75 per share. The note holder also received
“favored nations” rights such that for future securities offerings by the
Company at a price per share less than the above-referenced $0.75 per share
conversion rate floor, then the note holder's conversion rate floor would be
adjusted to the lower offering price. Further, if the Company's common share
market price is less than $0.75 per share at the time the note holder elects
to
convert the Note, the note holder may alternatively elect to demand full
repayment of the Note. If the Company is unable to repay the Note within seven
days of such demand, then the above-referenced conversion floor price would
be
eliminated. The Note is also personally guaranteed by the Company's Chief
Executive Officer.
On
August
17, 2007 the Company issued and sold a $250,000 unsecured promissory note to
an
accredited investor, for a net purchase price of $200,000 (after a 20% original
issue discount), in a private placement. In addition, this investor received
a
financing fee of $25,000 in the form of a second note with substantially the
same terms as the $250,000 note (collectively, the “Notes”). The Notes were due
on September 1, 2007, however the Company failed to repay the Notes when due.
Pursuant to litigation subsequently filed by the investor against the Company,
on October 8, 2007 the parties entered into a settlement agreement whereby
on
October 16, 2007 the Company issued to the investor 358,540 unrestricted shares
of its common stock, par value $0.001, issued pursuant to Section 3(a)(10)
of
the Act.
On
June
27, 2007 the Company and WQN, Inc., a Texas corporation (the "Purchaser")
executed an Asset Purchase Agreement (the "Purchase Agreement"), pursuant to
which the Company sold substantially all of the tangible operating assets
utilized by its Dallas, Texas, division, to the Purchaser. Pursuant to the
Purchase Agreement, the Company was to retain the liabilities for the Dallas
trade accounts payable existing as of June 27, 2007. Pursuant to litigation
subsequently filed by the Purchaser against the Company for nonpayment of
certain of these accounts payable, on October 3, 2007 the parties entered into
a
settlement agreement whereby on October 17, 2007 the Company issued 386,666
unrestricted shares of its common stock, par value $0.001, issued pursuant
to
Section 3(a)(10) of the Act. In addition, the Company agreed to pay a cash
amount of $73,467 to the Purchaser.
Beginning
October 26, 2007, two of the Company’s investors, representing principal
balances of $6.7 million of the Company’s convertible notes, gave notice that
the Company was in default on a number of related financing agreements. On
October 31, 2007, all of the investors related to the affected financing
agreements agreed to waive the defaults and violations, in return for the
Company agreeing to immediately adjust the conversion price of all of these
investors’ outstanding convertible notes to the lesser of: (i) $0.50 per share;
or (b) 70% of the three lowest closing bid prices for the ten days prior to
the
conversion or exercise date, and the exercise price of all of their outstanding
warrants to $0.50 per share. The Company also agreed to file a registration
statement by December 30, 2007 to register all of the shares underlying the
Investors' outstanding warrants, with this registration to be effective no
later
than February 28, 2008.
ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF
OPERATIONS
General
The
following discussion should be read in conjunction with the unaudited
consolidated financial statements and the notes thereto and the other financial
information appearing elsewhere in this Form 10-Q. Certain statements contained
in this Form 10-Q and other written material and oral statements made from
time
to time by us do not relate strictly to historical or current facts. As such,
they are considered "forward-looking statements" that provide current
expectations or forecasts of future events. Such statements are typically
characterized by terminology such as "believe," "anticipate," "should,"
"intend," "plan," "will," "expect," "estimate," "project," "strategy," and
“may,” and similar expressions. Our forward-looking statements generally relate
to the prospects for future sales of our products, the success of our marketing
activities, and the success of our strategic corporate relationships. These
statements are based upon assumptions and assessments made by our management
in
light of its experience and its perception of historical trends, current
conditions, expected future developments and other factors our management
believes to be appropriate. These forward-looking statements are subject to
a
number of risks and uncertainties, including the following: our ability to
achieve profitable operations and to maintain sufficient cash to operate our
business and meet our liquidity requirements; our ability to obtain financing,
if required, on terms acceptable to it, if at all; the success of our research
and development activities; competitive developments affecting our current
products; our ability to successfully attract strategic partners and to market
both new and existing products; exposure to lawsuits and regulatory proceedings;
our ability to protect our intellectual property; governmental laws and
regulations affecting operations; our ability to identify and complete
diversification opportunities; and the impact of acquisitions, divestitures,
restructurings, product withdrawals and other unusual items. A further list
and
description of these risks, uncertainties and other matters can be found
elsewhere in our Form 10-K for the year ended December 31, 2006. Except as
required by applicable law, we undertake no obligation to update any
forward-looking statements, whether as a result of new information, future
events or otherwise.
Reverse
Stock Split
On
August
13, 2007 our shareholders approved a 1-for-20 reverse split of our common stock,
which became effective on August 16, 2007. As such, each shareholder
received one share of the Company's common stock for every twenty shares held
just prior to the effective date. Fractional shares resulting from the reverse
split were rounded up to the nearest whole share. Following the effective date
of the reverse split, the par value of the common stock remained at $0.001
per
share. Accordingly, all share and per-share information in this Quarterly Report
have been appropriately restated. In addition, the common stock in the Company's
consolidated balance sheets was reduced by a factor of twenty, with
corresponding increases in additional paid-in capital.
Financial
Summary
|
|
September
30,
|
|
December
31,
|
|
|
|
2007
|
|
2006
(1)
|
|
|
|
|
|
|
|
Goodwill
and other intangible assets
|
|
$
|
24,033,697
|
|
$
|
25,992,034
|
|
Total
assets
|
|
|
31,158,672
|
|
|
35,928,963
|
|
Notes
and loans payable, current
|
|
|
14,496,731
|
|
|
9,093,719
|
|
Total
liabilities
|
|
|
28,114,141
|
|
|
32,884,147
|
|
Shareholders'
equity
|
|
|
3,044,531
|
|
|
3,044,816
|
|
Statement
of Operations Data:
|
|
For the Nine Months Ended September 30,
|
|
For the Three Months Ended September 30,
|
|
|
|
2007
|
|
2006
(1)
|
|
2007
|
|
2006
(1)
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
6,229,058
|
|
$
|
4,775,489
|
|
$
|
2,579,542
|
|
$
|
598,170
|
|
Cost
of sales
|
|
|
6,036,130
|
|
|
6,769,876
|
|
|
1,909,676
|
|
|
943,375
|
|
Gross
profit (loss)
|
|
|
192,928
|
|
|
(1,994,387
|
)
|
|
669,866
|
|
|
(345,205
|
)
|
Operating
expenses
|
|
|
14,514,440
|
|
|
21,102,806
|
|
|
5,183,150
|
|
|
8,421,193
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
from continuing operations
|
|
|
(14,321,512
|
)
|
|
(23,097,193
|
)
|
|
(4,513,284
|
)
|
|
(8,766,398
|
)
|
Other
expenses, net
|
|
|
15,165,758
|
|
|
5,899,399
|
|
|
5,053,967
|
|
|
2,652,529
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
before discontinued operations
|
|
|
(29,487,270
|
)
|
|
(28,996,592
|
)
|
|
(9,567,251
|
)
|
|
(11,418,927
|
)
|
Loss
from discontinued operations
|
|
|
(5,571,226
|
)
|
|
(2,314,848
|
)
|
|
(51,567
|
)
|
|
(893,780
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(35,058,496
|
)
|
$
|
(31,311,440
|
)
|
$
|
(9,618,818
|
)
|
$
|
(12,312,707
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Per
common share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
before discontinued operations
|
|
$
|
(3.87
|
)
|
$
|
(8.50
|
)
|
$
|
(0.92
|
)
|
$
|
(3.24
|
)
|
Net
loss
|
|
$
|
(4.60
|
)
|
$
|
(9.18
|
)
|
$
|
(0.93
|
)
|
$
|
(3.49
|
)
|
(1) |
Adjusted
to reflect discontinued operations classification pertaining to the
sale
of our DTNet Technologies subsidiary in April 2006, the October 2006
termination of our Marketing and Distribution Agreement with Phone
House,
Inc., and the June 2007 sale of the operating assets of our Dallas,
Texas
subsidiary.
|
Revenues
Our
consolidated revenues for the nine months ended September 30, 2007 and 2006
were
$6.2 million and $4.8 million, respectively. The 30% increase in revenues from
2006 to 2007 is due primarily to a higher volume of traffic sold to a new major
customer in 2007. Our
consolidated net loss was $34.6 million ($4.54 per share) for the nine months
ended September 30, 2007 as compared to a net loss of $31.3 million ($9.18
per
share) for the corresponding 2006 period.
Our
consolidated revenues for the three months ended September 30, 2007 and 2006
were $2.6 million and $0.6 million, respectively. The 331% ($2.0 million)
increase in revenues from 2006 to 2007 is due primarily to a higher volume
of
traffic sold to a new major customer in 2007. Our consolidated net loss was
$9.1
million ($0.88 per share) for the three months ended September 30, 2007 as
compared to a net loss of $12.3 million ($3.49 per share) for the corresponding
2006 period.
Cost
of Sales and Gross Profit (Loss)
Consolidated
cost of sales was $6.0 million and $6.8 million for the nine months ended
September 30, 2007 and 2006, respectively, reflecting costs paid to third party
vendors related to the revenues we charged to terminate the calls of our
customers. Our gross profit for the nine months ended September 30, 2007 was
$193 thousand (3% of revenues) in 2007. This compares to a negative gross profit
of $2.0 million (42% of revenues) in the same period of 2006, reflecting costs
paid to third party vendors that exceeded our related revenues. The gross profit
improvement in 2007 was achieved by using lower cost routes and negotiating
more
favorable vendor pricing, coupled with higher margin revenues associated with
a
new major customer. In addition, telecommunication vendor dispute credits of
$121,435 were recognized in the nine months ended September 30, 2007, the
related costs for which were originally recognized in the fourth quarter of
2006.
Consolidated
cost of sales was $1.9 million and $0.9 million for the three months ended
September 30, 2007 and 2006, respectively, reflecting costs paid to third party
vendors related to the revenues we charged to terminate the calls of our
customers. Our gross profit for the three months ended September 30, 2007 was
$670 thousand (26% of revenues) in 2007. This compares to a negative gross
profit of $345 thousand (58% of revenues) in the same period of 2006, reflecting
costs paid to third party vendors that exceeded our related revenues. The gross
profit improvement in 2007 was achieved primarily by using lower cost routes
and
negotiating more favorable vendor pricing, coupled with higher margin revenues
associated with a new major customer. In addition, telecommunication vendor
dispute credits of $303,349 were recognized in the third quarter of 2007, the
related costs for which were originally recognized in prior quarters.
We
generally record transport and termination costs at the vendor invoice amount
less any amounts that have been formally disputed, and for which we expect
to
receive a credit. Disputed amounts are based upon our detailed review of vendor
call records and contract provisions; accordingly, the recorded transport and
termination costs represent management's estimates of what is ultimately due
and
payable. During the nine and three months ended September 30, 2007, $427,322
and
$99,428, respectively, of such vendor charges were formally disputed. As of
September 30, 2007, approximately $547,383 remained in dispute and are,
therefore, not included in the accompanying financial statements. Differences
between the disputed amounts and final settlements, if any, are reported in
operations in the year of settlement.
Operating
Expenses
Consolidated
operating expenses were $14.5 million and $21.1 million for the nine months
ended September 30, 2007 and 2006, respectively. Compensation and related
expenses accounted for $6.1 million of the decrease from 2006, primarily due
to
accelerated recognition of vested noncash stock and warrant compensation in
the
2006 period pertaining to the employment termination of the Company's former
officers.
Consolidated
operating expenses were $5.2 million and $8.4 million for the three months
ended
September 30, 2007 and 2006, respectively. Compensation and related expenses
accounted for $3.0 million of the decrease from 2006, primarily due to
accelerated recognition of vested noncash stock and warrant compensation in
the
2006 period pertaining to the employment termination of the Company's former
officers.
On
September 6, 2007 we executed a 12-month consulting agreement with CEOcast,
Inc.
(the “Consulting Agreement”), whereby CEOcast provides certain investor
relations services in return for 400,000 immediately issuable shares of the
Company’s restricted common stock (with piggyback registration rights), plus
cash payments of $10,000 per month. Based on the Company’s common stock market
price at September 6, 2007, $504,000 is included in common stock payable for
other services rendered at September 30, 2007, and that amount was
correspondingly charged to operating expenses in the three and nine months
ended
September 30, 2007.
Other
Expenses, Net
Consolidated
net other expenses were $15.2 million and $5.9 million for the nine months
ended
September 30, 2007 and 2006, respectively. Interest expense, consisting
primarily of debt discount amortization, increased by $3.7 million in 2007,
reflecting our significantly higher convertible note balances in 2007 used
to
finance our operations, all which were issued at significant discounts as part
of our fund raising activities. Financing penalties and expenses increased
by
$0.8 million in 2007, reflecting our lack of compliance with the securities
registration requirements in many of our financing agreements as discussed
in
Notes G and H to our consolidated financial statements. In addition, the 2007
amount includes $850 thousand of default penalties associated with the note
payable to our Chief Operating Officer as described in Note K to our
consolidated financial statements. Of the $7.6 million financing penalties
and
expenses during the nine months ended September 30, 2007, $6.6 million was
paid
or is payable in our common stock or warrants. Litigation charges decreased
by
$3.2 million, due primarily to settlement in May 2007 of MCI WorldCom litigation
as discussed in Note I to our consolidated financial statements.
Consolidated
net other expenses were $5.1 million and $2.7 million for the three months
ended
September 30, 2007 and 2006, respectively. Interest expense, consisting
primarily of debt discount amortization, increased by $1.6 million in 2007,
reflecting our significantly higher convertible note balances in 2007 used
to
finance our operations, all which were issued at significant discounts as part
of our fund raising activities. Financing penalties and expenses decreased
by
$1.1 million in 2007, reflecting significant penalty expense related to our
debt
restructure and Section 3(a)(10) settlements in the 3rd
quarter
of 2006. Of the $3.1 million financing penalties and expenses during the three
months ended September 30, 2007, $3.0 million was paid or is payable in our
common stock or warrants.
Due
to
our 2006 financing agreements, the number of common shares issuable upon the
exercise of outstanding warrant agreements, when combined with existing
outstanding common shares, options, and shares issuable upon the conversion
of
applicable notes payable (“diluted shares”), exceeded our then-authorized common
shares. Therefore, as required by Emerging Issues Task Force Issue No. 00-19
(“EITF 00-19”), asset or liability classification of the warrants was required
(as opposed to permanent equity classification) for the excess warrant
shares. From January to May 2006, only a portion of our warrants were
subject to liability classification and their values accordingly
marked-to-market, including a related charge of $1,281,278 to earnings for
the
three months ended March 31, 2006. In May 2006, we repriced certain of our
warrants to $15.60 per share ($0.78 per share pre-split) in conjunction with
a
financing transaction, which in turn triggered contractual “favored nations”
price ratchets on a number of our existing convertible debt and warrant
agreements, reducing their effective conversion and exercise prices to $15.60
per share ($0.78 per share pre-split). The effect was to increase the number
of
fully diluted shares of common stock at the time to approximately 6.5 million
(129 million pre-split), relative to our then-authorized 100 million common
shares. Our total warrants then outstanding were approximately 1.4 million
(28
million pre-split). As required by EITF 00-19, we classified all remaining
warrants at that time as a liability, transferring $5,406,284 from additional
paid-in capital to fair value liability for warrants on our consolidated balance
sheet. This warrant liability, along with the original earlier 2006 warrant
liability discussed above, was subsequently marked-to-market, resulting in
a
$5,102,731 fair value warrant liability at December 31, 2006, and a credit
to
earnings for the six months ended June 30, 2006 of
$3,372,162.
On
March
16, 2007, we obtained shareholder approval to increase our authorized common
stock to 400 million shares, sufficient at that time to satisfy all of our
outstanding warrant obligations. The warrant liability was then
marked-to-market, resulting in a charge to earnings of $3,550,551 for the three
months ended March 31, 2007. The fair value of these warrants at that date
was
$10,209,324, and this amount was transferred from the fair value liability
for
warrants to additional paid-in capital on our consolidated balance sheet as
required by EITF 00-19, and the related mark-to-market accounting was
suspended.
Due
to
the June 14, 2007 financing agreements referred to in Note G which in turn
triggered favored nations price ratchets to $1.60 per share by June 25, 2007,
our diluted shares exceeded our authorized 400 million common shares. Therefore,
asset or liability classification of (and related mark-to-market accounting
for)
the warrants was again required for the excess warrant shares. Between June
14,
2007 and June 25, 2007, the fair value of our warrants, totaling $2,807,757,
was
transferred from additional paid-in capital to fair value liability for warrants
our consolidated balance sheet. At June 30, 2007 these warrants were
marked-to-market, resulting in a $2,007,626 fair value warrant liability at
June
30, 2007, and an $866,269 credit to earnings and a $2,684,282 charge to earnings
for the three and six months ended June 30, 2007, respectively. The fair value
of our warrants is a function of the market value of our underlying common
stock.
As
described above, on August 16, 2007 we effected a 1-for-20 reverse split of
our
common stock, which was sufficient to satisfy all of our warrant obligations,
and the related mark-to-market accounting then ceased. The warrant liability
was
then marked-to-market, resulting in a credit to earnings of $1,487,514 for
the
three months ended September 30, 2007. The fair value of these warrants at
that
date was $694,450, and this amount was transferred from the fair value liability
for warrants to additional paid-in capital on our consolidated balance sheet
as
required by EITF 00-19, and the related mark-to-market accounting was suspended.
However, should we in the future have insufficient common shares to satisfy
all
of our warrant and convertible debt obligations, we will be subject to noncash
mark-to-market income or expense to the extent that the fair value of these
warrants changes, which is in turn primarily dependent upon our common stock
market price per share.
In
accordance with SFAS No. 142, we are required to periodically evaluate the
carrying value of our goodwill and other intangible assets. During the three
months ended March 31, 2006, we recognized an impairment expense of $839,101
related to goodwill recorded for our former hardware sales business segment.
During the three months ended June 30, 2007, we also wrote off $6,448,838 of
goodwill and other intangible assets related to the sale of operating assets
utilized by our Dallas, Texas, subsidiary. These asset impairment charges and
write-offs are now classified with results of discontinued operations. If in
the
future the remaining carrying value of our goodwill exceeds its fair market
value, we will be required to record an additional impairment charge in our
statement of operations. Such an impairment charge could have a significant
adverse impact on both our operating results and financial condition. If the
traded market price of our common stock declines further, a material goodwill
impairment charge in the future is possible.
Discontinued
Operations
On
April
19, 2006, we sold our wholly-owned subsidiary, DTNet Technologies, to our former
Chief Operating Officer (the “Purchaser”) pursuant to a stock purchase
agreement. The consideration for the sale consisted primarily of (1) the return
for cancellation of warrants to purchase 10,000 shares of our common stock
held
by the Purchaser; and (2) the return for cancellation of 10,000 shares of our
common stock held by the Purchaser. Because DTNet Technologies' operations
were
the primary component of our former hardware sales business segment, we recorded
an impairment charge of $839,101 in our statement of operations for the three
months ended March 31, 2006.
Effective
October 12, 2006, we terminated our Marketing and Distribution Agreement with
Phone House, Inc. dated September 1, 2004 and amended February 16, 2006,
effectively discontinuing this business segment. The Agreement called for the
wholesale distribution, marketing and selling of prepaid telephone calling
cards
by Phone House, Inc., under license from us. We recognized a related impairment
loss of $936,122 for the year ended December 31, 2006, primarily related to
inventory and accounts receivable write-offs, and filed suit in Los Angeles
County against the primary Phone House, Inc. employee to recover same. On April
4, 2007 we settled this suit, recovering assets and limiting our liabilities.
Accordingly, a gain of $665,221 was recognized for the three months ended March
31, 2007.
Effective
June 27, 2007, we executed an Asset Purchase Agreement (the "Purchase
Agreement") with WQN, Inc., a Texas corporation (the "Purchaser"), pursuant
to
which we sold substantially all of the tangible operating assets utilized by
our
Dallas, Texas subsidiary, VoIP Solutions, Inc. (the "Assets"), to the
Purchaser. Our patents and other intangible assets were not sold. Pursuant
to the Purchase Agreement, the Purchaser acquired the Assets for a purchase
price consisting of (1) a cash payment of $400,000; (2) 4% of the defined
monthly revenues related to the Assets in excess of $200,000 during the first
year following execution of the Purchase Agreement; (3) 3% of the defined
monthly revenues related to the Assets in excess of $150,000 during the second
year following execution of the Purchase Agreement; and (4) 2% of the defined
monthly revenues related to the Assets in excess of $100,000 during the third
year following execution of the Purchase Agreement. In conjunction with a
settlement agreement dated October 3, 2007, the Purchaser also effectively
agreed to assume certain trade accounts payable related to the Dallas, Texas
operations of VoIP Solutions, Inc., in return for $290,000 of our free trading
common shares, subject to a floor price of $0.75 per share, with any difference
made up for in cash. Accordingly, on October 17, 2007, we issued 386,666
unrestricted shares issued pursuant to Section 3(a)(10) of the Act. In addition,
we agreed to pay a cash amount of $73,467 to the Purchaser.
The
following summarizes the combined operating results of DTNet Technologies,
the
calling card business of Phone House, Inc., and the Dallas, Texas assets of
VoIP
Solutions, Inc. for the nine and three months ended September 30, 2007 and
2006
(through the respective dates of sale or termination), and their respective
financial position as of September 30, 2007 and December 31, 2006, classified
as
discontinued operations for all periods presented.
|
|
Nine Months Ended September 30
|
|
Three Months Ended September 30
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
2,596,007
|
|
$
|
20,866,536
|
|
$
|
10,731
|
|
$
|
5,623,843
|
|
Cost
of sales
|
|
|
1,780,178
|
|
|
18,640,433
|
|
|
-
|
|
|
4,753,629
|
|
Gross
profit
|
|
|
815,829
|
|
|
2,226,103
|
|
|
10,731
|
|
|
870,214
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Compensation
and benefits
|
|
|
172,534
|
|
|
784,484
|
|
|
-
|
|
|
200,502
|
|
Asset
impairment charges
|
|
|
-
|
|
|
839,101
|
|
|
-
|
|
|
-
|
|
Litigation
credit
|
|
|
(665,221
|
)
|
|
-
|
|
|
-
|
|
|
-
|
|
Other
operating expenses
|
|
|
500,537
|
|
|
1,504,983
|
|
|
62,298
|
|
|
472,709
|
|
Interest
expense
|
|
|
97,040
|
|
|
368,700
|
|
|
-
|
|
|
47,100
|
|
Impairment
loss for contract cancellation
|
|
|
-
|
|
|
1,043,683
|
|
|
-
|
|
|
1,043,683
|
|
Loss
on sale of assets (1)
|
|
|
6,282,165
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Net
loss
|
|
$
|
(5,571,226
|
)
|
$
|
(2,314,848
|
)
|
$
|
(51,567
|
)
|
$
|
(893,780
|
)
|
|
(1) |
Includes
the write-off of $6,448,838 of goodwill and other intangible asset
values
associated with the sale of our Dallas, Texas operating
assets.
|
|
|
September
30, 2007
|
|
December
31, 2006
|
|
|
|
|
|
|
|
Current
assets
|
|
$
|
10,731
|
|
$
|
406,315
|
|
Property
and equipment, net
|
|
|
-
|
|
|
255,948
|
|
Goodwill
and other intangible assets
|
|
|
-
|
|
|
6,695,788
|
|
Other
assets
|
|
|
-
|
|
|
5,281
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
|
10,731
|
|
|
7,363,332
|
|
Less
current liabilities
|
|
|
(120,728
|
)
|
|
(4,996,325
|
) |
|
|
|
|
|
|
|
|
Net
assets (liabilities) of discontinued operations
|
|
$
|
(109,997
|
)
|
$
|
2,367,007
|
|
Assets
Total
assets (adjusted for discontinued operations classification) at September 30,
2007 were $31.2 million, down $4.7 million from $35.9 million at December 31,
2006. The $2.4 million of net assets from discontinued operations at December
31, 2006 primarily represent the net assets of our Dallas operations which
were
sold on June 27, 2007. Goodwill and other intangible assets comprised 77% of
our
consolidated total assets at September 30, 2007, attributable primarily to
the
acquisition of Caerus.
Liquidity
and Capital Resources
Cash
and
cash equivalents were approximately $68 thousand at September 30, 2007, of
which
$60 thousand is restricted. Our consolidated net cash used in operating
activities for the nine months ended September 30, 2007, was $5.9 million,
due
primarily to the losses described above. We funded our operating activities
principally through financing activities that generated net proceeds of $6.4
million ($5.9 million net of debt repayments) during the nine months ended
September 30, 2007. At September 30, 2007 our negative working capital was
$26.3
million, and our contractual obligations for debt, leases and capital
expenditures totaled approximately $31.7 million.
Since
inception of business in 2004 we have never been profitable. We have experienced
negative cash flows from operations, and have been dependent on the issuances
of
debt and common stock in private transactions to fund our operations and capital
expenditures. Our independent auditors have added an explanatory paragraph
to
their opinion on our consolidated financial statements for the year ended
December 31, 2006, based on substantial doubt about our ability to continue
as a
going concern.
At
September 30, 2007 and December 31, 2006, convertible notes payable, loans
payable and note payable-related party consisted of the following:
|
|
September
30,
|
|
December
31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
July
& October 2005 (1)
|
|
|
396,408
|
|
$
|
488,543
|
|
January
& February 2006 (2)
|
|
|
6,809,956
|
|
|
8,353,102
|
|
October
2006 (3)
|
|
|
2,905,875
|
|
|
2,905,875
|
|
"Cedar"
notes (4)
|
|
|
851,522
|
|
|
-
|
|
February
2007 (5)
|
|
|
3,808,990
|
|
|
-
|
|
April
2007 (6)
|
|
|
412,500
|
|
|
-
|
|
June
2007 (7)
|
|
|
200,000
|
|
|
-
|
|
July
2007 (8) and (9)
|
|
|
325,000
|
|
|
-
|
|
August
2007 (10)
|
|
|
275,000
|
|
|
-
|
|
September
2007 (11) and (12)
|
|
|
6,948,482
|
|
|
-
|
|
Loans
payable (13)
|
|
|
513,750
|
|
|
2,574,835
|
|
Note
payable - related party (14)
|
|
|
300,000
|
|
|
-
|
|
|
|
|
|
|
|
|
|
Subtotal
- principal
|
|
|
23,747,483
|
|
|
14,322,355
|
|
|
|
|
|
|
|
|
|
Less
discounts
|
|
|
(9,250,752
|
)
|
|
(5,845,303
|
)
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
14,496,731
|
|
$
|
8,477,052
|
|
(1)
July and October 2005 Financing
In
July
and October 2005 we issued and sold $3,085,832 in principal amount of
convertible notes to institutional investors at a discount, receiving net
proceeds of $2,520,320. These notes are immediately convertible at the option
of
the note holders into shares of our common stock, at an original conversion
rate
of $16.00 per share. These investors also received five-year warrants to
purchase 48,216 shares of our common stock for an original $27.52 per share,
five-year warrants to purchase 48,216 shares of our common stock for $33.01
per
share, and one-year warrants to purchase 96,432 shares of our common stock
for
$32.00 per share. The investors also received “favored nations” rights such that
for our future securities offerings at a price per share less than the above
conversion rate or warrant exercise prices, the investors' conversion rate
and
warrant exercise price would be adjusted to the lower offering price. These
notes are secured by a subordinated lien on our assets, and the notes bear
interest at an effective annual rate of approximately 20%. The principal balance
of these notes was $396,409 and $488,543 at September 30, 2007 and
December 31, 2006, respectively. All of these notes were due and
payable at September 30, 2007 in cash or, at our option, in registered common
stock at the original conversion price of $16.00 per share. As a result of
the
October 31, 2007 default and waiver agreement described in Note Q and the
favored nations provision discussed above, the notes' conversion rate and the
exercise price of outstanding warrants were effectively reduced to the lesser
of: (i) $0.50 per share; or (b) 70% of the three lowest closing bid prices
for
the ten days prior to the conversion or exercise date. We were also in violation
of certain other covenants at September 30, 2007. While the investors have
not
declared the convertible notes currently in default, the full amount of the
notes has been classified as current. The July 2005 and October 2005 conversion
shares became Rule 144(k) eligible in July and October 2007, respectively,
and
we discontinued accrual of associated liquidated damages on those dates. (See
also Note H for nonregistration damages paid on September 12,
2007.)
(2)
January and February 2006 Financing
In
January and February 2006, we issued and sold $11,959,666 in principal amount
of
convertible notes to institutional investors at a discount, receiving net
proceeds of $9,816,662. These notes are immediately convertible at the option
of
the note holders into shares of our common stock at an original conversion
rate
of $26.36 per share. These investors also received five-year warrants to
purchase 226,853 shares of our common stock for $29.18 per share, and one-year
warrants to purchase 226,853 shares of our common stock for an original $31.83
per share. The investors also received “favored nations” rights. Of the total
initial principal, $8,318,284 of the notes are secured by a subordinated lien
on
our assets. The principal balance of the notes was $6,809,956 and $8,353,102
at
September 30, 2007 and December 31, 2006, respectively, and all the notes bear
interest at an effective annual rate of approximately 20%. The unsecured portion
of these notes became payable beginning in July 2006 over two years in cash
or,
at our option, in registered common stock at the original conversion price
of
$26.36 per share. As a result of a May 2006 warrant restructure, the secured
portion of these notes became payable beginning in August 2006 over two
years in cash or, at our option, in registered common stock at the lesser of
$20.00 per share or 85% of the weighted average price of the stock on the OTCBB,
but not less than $16.00 per share. As a result of the October 31, 2007 default
and waiver agreement described in Note Q and the favored nations provision
discussed above, the notes' conversion rate and the exercise price of
outstanding warrants were effectively reduced to the lesser of: (i) $0.50 per
share; or (b) 70% of the three lowest closing bid prices for the ten days prior
to the conversion or exercise date. At September 30, 2007, we had not made
scheduled principal payments of $3,572,757 on these notes. Beginning April
and
May 2006, we were in violation of the registration requirements of the secured
and unsecured notes, respectively. In May 2006, we issued an aggregate of 8,318
shares to the secured investors in satisfaction of their then-existing
non-registration liquidated damages. (See also Note H for nonregistration
damages paid on September 12, 2007.) We owed additional liquidated damages
of
$901,242 at September 30, 2007, and will incur additional damages of
$55,379 per month until the required shares and warrants are registered, or
until the conversion and warrant shares become Rule 144(k) eligible in January
2008. We were also in violation of certain other covenants at September 30,
2007. While the investors have not declared the convertible notes currently
in
default, the full amount of the notes has been classified as
current.
(3)
October 2006 Financing
On
October 17, 2006, we issued and sold $2,905,875 in secured convertible notes
to
institutional investors at a discount, for a net purchase price of $2,324,700.
Proceeds of approximately $1,436,900 (before closing costs of $308,748) were
paid in cash to us at closing, and $887,800 of the proceeds were used to repay
three outstanding promissory notes held by three of the investors in the private
placement. The investors also received five-year warrants to purchase a total
of
518,906 shares of our common stock at an original exercise price of $8.14 per
share. The principal balance of the notes was $2,905,875 at September 30, 2007
and December 31, 2006. These convertible notes are secured by a subordinated
lien on our assets, are not interest bearing, and are due on December 31, 2007.
The note holders may at their election convert all or part of the convertible
notes into shares of our common stock at an original conversion rate of $5.60
per share. The investors also received “favored nations” rights which, when
coupled with the October 31, 2007 default and waiver agreement described in
Note
Q, effectively reduced the notes' conversion rate and the exercise price of
outstanding warrants to the lesser of: (i) $0.50 per share; or (b) 70% of the
three lowest closing bid prices for the ten days prior to the conversion or
exercise date. Beginning December 2006 and January 2007, we were in violation
of
the nonreservation and nonregistration requirements, respectively, of the
related subscription agreement. (The share reservation requirement was satisfied
in March 2007.) Failing either of these, the convertible note holders are
entitled to liquidated damages that accrued at the rate of two percent per
month
of the amount of the purchase price of the outstanding convertible notes during
such default. See Note H for related liquidated damages paid on September 12,
2007, in settlement of our related reservation and registration requirements.
We
were also in violation of certain other covenants at September 30, 2007. While
the investors have not declared the convertible notes currently in default,
the
full amount of the notes has been classified as current.
(4)
February 2007 Cedar Financing
As
of
December 31, 2006 we owed $2.4 million to Cedar Boulevard Lease Funding LLC
(“Cedar”) pursuant to a subordinated loan and security agreement (the “Loan
Agreement”). Under the Loan Agreement, Cedar was granted a perfected,
first-priority security interest in all of our assets. This loan bears interest
at 17.5%, and the remaining balance was due in May 2007. On February 1, 2007
Cedar assigned its rights under the Loan Agreement, including the note payable
(the “Note”) with a principal balance at the time of $1,917,581, and the related
security interest, to a group of institutional investors (the “Investors”).
In conjunction with this assignment, we paid a fee of $200,000 to Cedar. Also
following the assignment, the Note's terms were amended to allow conversion
of
any unpaid principal balance into our restricted common stock at $5.20 per
share. The Note was also amended to include “favored nations” rights such that
for future securities offerings by us at a price per share less than this $5.20
per share, the Note's conversion rate would be adjusted to the lower offering
price. In conjunction with our default and waiver agreement discussed in Note
Q,
on October 31, 2007 the Note's common stock conversion rate was reduced to
the
lesser of: (i) $0.50 per share; or (b) 70% of the three lowest closing bid
prices for the ten days prior to the conversion date. Interest expensed
and paid under this debt facility during the nine months ended September 30,
2007 and 2006 was $11,575, and $361,653, respectively. Due to the Note's
amendment discussed in the preceding paragraph allowing its conversion into
our
common stock, the balance owing at September 30, 2007 has been reclassified
from
loans payable to convertible notes payable on our consolidated balance sheet
at
September 30, 2007 (see Note G). We were in violation of certain requirements
of
this Loan Agreement at September 30, 2007. However, the Investors had
currently not declared this loan in default. As a result, the full amount of
the
loan at September 30, 2007 has been classified as current. (See Note Q for
subsequent default and waiver agreement.)
(5)
February 2007 Convertible Note and Warrant Financing
On
February 16, 2007, we issued and sold $3,462,719 in secured convertible notes
(the “Convertible Notes”) to institutional investors at a discount, for a net
purchase price of $2,770,175. $900,000 of the proceeds (before closing costs
of
$67,512) were paid in cash to us at closing, and $1,870,175 of the proceeds
were
used to repay fourteen outstanding promissory notes (including related accrued
interest and a 10% premium on the promissory notes' total principal of
$1,666,667) held by five of the investors in the private placement. The
investors also received five-year warrants to purchase a total of 961,866 shares
of our common stock at an original effective exercise price of $3.60 per share.
The Convertible Notes are secured by a subordinated lien on our assets, are
not
interest bearing, and are due on February 16, 2008. The note holders may at
their election convert all or part of the Convertible Notes into shares of
our
common stock at the original conversion rate of $3.60 per share. The investors
also received “favored nations” rights which, when coupled with the October 31,
2007 default and waiver agreement described in Note Q, effectively reduced
the
notes' conversion rate and the exercise price of outstanding warrants to the
lesser of: (i) $0.50 per share; or (b) 70% of the three lowest closing bid
prices for the ten days prior to the conversion or exercise date. Pursuant
to
the related subscription agreement, two of the investors received due diligence
fees totaling $346,271, in the form of convertible notes (the “Due Diligence
Notes”) having the same terms and conversion features as the Convertible Notes.
Also pursuant to the subscription agreement, we issued a total of 200,000 common
shares in April 2007 to the former holders of the above-referenced promissory
notes, in lieu of and in payment for accrued damages associated with these
promissory notes. Also pursuant to the subscription agreement, we were to obtain
the authorization and reservation of our common stock on behalf of the investors
of not less than 200% of the common shares issuable upon the conversion of
the
Convertible Notes and Due Diligence Notes, and 100% of the common shares
issuable upon the exercise of the warrants by April 15, 2007. Failing this,
the note holders are entitled to liquidated damages at the rate of two percent
per month of the amount of the purchase price of the outstanding convertible
notes during such default. On August 16, 2007, we obtained sufficient
authorization and reservation of our common stock as the result of our 1-for-20
reverse stock split. See Note H for related liquidated damages paid on September
12, 2007, in settlement of our accrued liquidated damages. We were also in
violation of certain other covenants at September 30, 2007. While the investors
have not declared the Convertible Notes currently in default, the full amount
of
the notes has been classified as current.
(6)
April 2007 Financing
On
April
6, 2007, we issued and sold $375,000 in secured convertible notes (the
“Convertible Notes”) to two institutional investors at a discount, for a net
purchase price of $300,000. The investors also received five-year warrants
to
purchase a total of 104,167 shares of our common stock at an original exercise
price of $3.60 per share (the “Class D Warrants”). We received an unsecured
advance of $300,000 on February 23, 2007 from these investors, and these funds
were credited to the purchase price of the Convertible Notes. The Convertible
Notes are secured by a subordinated lien on our assets, are not interest
bearing, and are due on February 23, 2008. The note holders may at their
election convert all or part of the Convertible Notes into shares of our common
stock at the original conversion rate of $3.60 per share. Pursuant to the
related subscription agreement, one of the investors received a due diligence
fee of $37,500 in the form of a convertible note having the same terms and
conversion features as the Convertible Notes. The investors also received
“favored nations” rights which, when coupled with the October 31, 2007 default
and waiver agreement described in Note Q, effectively reduced the notes'
conversion rate and the exercise price of outstanding warrants to the lesser
of:
(i) $0.50 per share; or (b) 70% of the three lowest closing bid prices for
the
ten days prior to the conversion or exercise date. Also pursuant to the
subscription agreement, we must reserve our common stock on behalf of the
investors of not less than 200% of the common shares issuable upon the
conversion of the Convertible Notes and 100% of the common shares issuable
upon
the exercise of the Class D Warrants by April 15, 2007. Failing this, the
holders of the Convertible Notes will be entitled to liquidated damages that
will accrue at the rate of two percent per month of the amount of the purchase
price of the outstanding Convertible Notes during such default. On August 16,
2007, we obtained sufficient authorization and reservation of our common stock
as the result of our 1-for-20 reverse stock split. See Note H for related
liquidated damages paid on September 12, 2007, in settlement of our accrued
liquidated damages. We were also in violation of certain other covenants at
September 30, 2007. While the investors have not declared the Convertible Notes
currently in default, the full amount of the notes has been classified as
current.
(7)
June 2007 Financing
Between
June 14, 2007 and June 19, 2007, we issued and sold convertible promissory
notes
to four institutional investors in private placements, for a net purchase price
of $275,000. These convertible notes are not interest bearing, and were due
on
June 25, 2007. These notes are repayable at the investors' election in cash
for
$366,667, reflecting a 33% premium (the “Premium”). The investors may also at
their election convert all or part of these notes into shares of our common
stock at the original conversion rate of $2.40 per share. Per the terms of
these
notes, since we did not repay the notes on June 25, 2007, the above common
stock conversion rate was adjusted to $1.60 per share. If the investors elect
to
convert these notes at $1.60 per share, they have agreed to waive the Premium.
The investors also received “favored nations” rights which, when coupled with
the October 31, 2007 default and waiver agreement described in Note Q,
effectively reduced the notes' conversion rate to the lesser of: (i) $0.50
per
share; or (b) 70% of the three lowest closing bid prices for the ten days prior
to the conversion date. $75,000 of these convertible notes were repaid in
conjunction with the September 12, 2007 financing described below.
(8)
First July 2007 Financing
On
July
27, 2007, we issued and sold $250,000 in secured convertible notes to two
institutional investors at a discount, for a net purchase price of $200,000.
The
investors also received five-year warrants to purchase a total of 156,250 shares
of our common stock, par value $0.001 per share, at an exercise price of $1.60
per share. $125,000 of these convertible notes were repaid in conjunction with
the September 12, 2007 financing described below. These convertible notes are
not interest bearing, and are due on July 27, 2008. The note holders may at
their election convert all or part of the notes into shares of our common stock
at the original conversion rate of $1.60 per share. The investors also received
“favored nations” rights which, when coupled with the October 31, 2007 default
and waiver agreement described in Note Q, effectively reduced the notes'
conversion rate and the exercise price of outstanding warrants to the lesser
of:
(i) $0.50 per share; or (b) 70% of the three lowest closing bid prices for
the
ten days prior to the conversion or exercise date. Also pursuant to the related
subscription agreement, we must reserve our common stock on behalf of the
investors of not less than 200% of the common shares issuable upon the
conversion of the notes and 100% of the common shares issuable upon the exercise
of the warrants.
(9)
Second July 2007 Financing
On
July
31, 2007, we issued and sold $200,000 in secured convertible notes to two
accredited investors in a private placement. The investors also received 10,000
shares of our common stock; three-year warrants to purchase a total of 218,750
shares of our common stock at an original exercise price of $1.60 per share;
and
unsecured promissory demand notes totaling $20,000, and bearing interest at
10%
(classified with loans payable at September 30, 2007). The convertible notes
are
secured by a subordinated lien on our assets, bear interest at 10%, and are
due
at the earlier of: (a) January 31, 2008; or (b) our closing of a financing
transaction of $20 million or more (the “Closing”). These note holders may
at their election convert all or part of the convertible notes into shares
of
our common stock at the original conversion rate of $1.60 per share. These
note
holders may also at their election receive a credit of 125% of the amount
payable against the purchase price of a financing transaction of $20 million
or
more. The investors also received “favored nations” rights which, when coupled
with the October 31, 2007 default and waiver agreement described in Note Q,
effectively reduced the notes' conversion rate and the exercise price of
outstanding warrants to the lesser of: (i) $0.50 per share; or (b) 70% of the
three lowest closing bid prices for the ten days prior to the conversion or
exercise date. Also pursuant to the related subscription agreement, within
120
days of the Closing, we must file a registration statement on behalf of the
investors registering the common stock, as well as the common shares issuable
upon conversion of the convertible notes and the exercise of the warrants.
Said
registration statement must also be declared effective within 180 days of the
Closing. Failing either of these, these investors will be entitled to liquidated
damages that will accrue at the rate of 1.5% per month of the amount of the
purchase price of the convertible notes during such default, up to a total
of
18%.
(10)
August 2007 Financing
On
August
17, 2007, we issued and sold a $250,000 unsecured promissory note to an
accredited investor at a discount, for a net purchase price of $200,000. The
investor also received an unsecured promissory note for $25,000 as a placement
fee (combined, the “Notes”). The Notes are not interest bearing, and were due on
September 1, 2007. The investor also received five-year warrants to purchase
a
total of 156,250 shares of our common stock at an original exercise price of
$1.60 per share. The investors also received “favored nations” rights which,
when coupled with the October 31, 2007 default and waiver agreement described
in
Note Q, effectively reduced the exercise price of outstanding warrants to the
lesser of: (i) $0.50 per share; or (b) 70% of the three lowest closing bid
prices for the ten days prior to the exercise date. Since the Notes were not
paid when due , the investor formally declared us to be in default thereunder,
and in accordance with the terms of the Notes, on September 17, 2007 elected
to
convert the Notes into free-trading shares of our common stock at $0.767 per
share. Accordingly, 358,540 unrestricted common shares were issued to the
investor pursuant to Section 3(a)(10) of the Act on October 16,
2007.
(11)
First September 2007 Financing
On
September 12, 2007, pursuant to the terms of a subscription agreement and an
intercreditor agreement, we issued and sold $1,844,581 in secured convertible
notes (the “Financing Notes”) to several institutional investors at a discount,
for a net purchase price of $1,374,999. Pursuant to the related agreements,
the
Financing Notes are secured by a subordinated lien on our assets, bear interest
at the rate of 8% per annum, and are due by September 12, 2008. In addition,
15%
of our future net financings are required to be used to repay the Financing
Notes. The note holders may at their election convert all or part of the
Financing Notes into shares of our common stock at the original conversion
rate
of $0.75 per share. The investors also received five-year warrants to purchase
a
total of 2,459,442 shares of our common stock, par value $0.001 per share,
at an
exercise price of $0.75 per share (the “Financing Warrants”).
Pursuant
to a related intercreditor agreement, $1,576,278 principal amount of our
existing secured convertible notes were also reassigned among the parties to
this agreement. That amount, plus $268,303 of the Waiver Notes (defined below),
plus $1,646,589 principal amount of our other existing secured convertible
notes, are referred to herein as Super Senior Secured Debt (the “SSS Debt”). The
SSS Debt is repayable at the rate of $250,000 every 45 days following September
12, 2007 (the “Amortization Payments”), with all amounts outstanding in
connection with the SSS Debt payable by May 31, 2008. In the event that we
fail
to make any of the Amortization Payments, the note holders may elect to trigger
a reduction of the related effective notes' conversion rate to an amount equal
to 70% of the average of the three lowest closing bid prices of our common
stock
for the 10 days prior to the date a note holder converts its note.
Also
pursuant to the related intercreditor agreement, we issued (i) $2,417,651 in
secured convertible notes (the “Damages Notes”) to the investors as settlement
of all liquidated damages accrued to date related to notes previously issued
to
these investors by us; and (ii) $2,000,000 in secured convertible notes (the
“Waiver Notes”) to the investors in consideration for their waiving certain
existing events of default and up to six months of future liquidated damages
related to nonregistration events pertaining to financing agreements the Company
entered into with them prior to September 12, 2007. We also issued to the
investors five-year warrants to purchase a total of 4,870,075 shares of our
common stock as further consideration for the waivers (the “Waiver Warrants”).
The Damages Notes, Waiver Notes and Waiver Warrants contain terms substantially
similar to the Financing Notes and Financing Warrants.
Also
on
September 12, 2007, we signed an agreement to issue a $400,000 secured
convertible note (the “Bristol Note”) to Bristol Investment Fund, Ltd.
(“Bristol”), for a net purchase price of $200,000 plus additional noncash
consideration, in a private placement. The Bristol Note is secured by a
subordinated lien on our assets, bears interest at the rate of 8% per annum,
and
is due on September 12, 2008. Bristol may at its election convert all or part
of
the Bristol Note into shares of our common stock at the original conversion
rate
of $0.75 per share.
Also
pursuant and subject to the terms of the subscription agreement, we have
agreed
to file a registration statement covering the resale of 150% of the shares
of
common stock that may be issuable upon conversion of all the Financing Notes,
Waiver Notes, Damage Notes, and Bristol Note (the "Notes") and 100% of the
shares of common stock issuable upon the exercise of the Financing Warrants
and
Waiver Warrants. The registration statement must be filed by November 11,
2007,
and declared effective by January 10, 2008. In the event that this registration
statement is not timely filed or declared effective by these dates, liquidated
damages will accrue at the rate of 2% per month of the purchase price of
the
outstanding Notes and purchase price of the common shares issued upon conversion
of the Notes, up to a maximum of 24%.
The
investors in the Financing Notes, Financing Warrants, Damages Notes, Waiver
Notes, Waiver Warrants and Bristol Note also received “favored nations” rights
which, when coupled with the October 31, 2007 default and waiver agreement
described in Note Q, effectively reduced the notes' conversion rate and the
exercise price of outstanding warrants to the lesser of: (i) $0.50 per share;
or
(b) 70% of the three lowest closing bid prices for the ten days prior to the
conversion or exercise date. We were also in violation of certain other
covenants at September 30, 2007. While the investors have not declared the
Notes
currently in default, the full amount of the Notes has been classified as
current.
(12)
Second September 2007 Financing
On
September 26, 2007, we issued and sold a $250,000 secured convertible note
(the
“Note”) to an accredited investor in a private placement for a net purchase
price of $200,000. The Note is secured by a certain receivable of ours, and
is
due on October 4, 2007. In the event of our default under the terms of the
Note,
the unpaid portion of the Note becomes convertible into free-trading shares
of
our common stock, par value $0.001 per share, at a 30% discount to the average
of the closing market price of our common stock over the five trading days
immediately preceding such conversion, subject to a conversion price floor
of
$0.75 per share. The investor also received a $36,250 fee in the form of an
unsecured convertible note due on October 4, 2007 and convertible in the event
of default under the same terms and conditions as those set forth in the
Note.
(13)
Loans Payable
See
Note
F to our consolidated financial statements.
(14)
March 2007 Note Payable - Related Party
On
March
29, 2007, we issued an unsecured promissory note in the principal amount of
$300,000 (the “Note”) to Shawn M. Lewis, our Chief Operating Officer, classified
as a note payable – related party at September 30, 2007. The Note and
related accrued interest at 10% per annum was payable upon demand. Our cash
proceeds were $252,000 net of related closing costs and expense
reimbursements of $48,000, $30,000 of which was paid to Mr. Lewis. On May
29, 2007, Mr. Lewis issued the Company a formal demand for payment, and on
June
8, 2007 declared the Company in default. Under the terms of the note, in
addition to the principal balance of $300,000 plus accrued interest, the Company
was obligated to pay $750,000 as liquidated damages, of which $67,860 was paid
by September 30, 2007 (excluding the $300,000 note assumed as mentioned below).
On June 14, 2007, Mr. Lewis waived this default in return for, among other
things, a waiver fee of $100,000 payable by June 21, 2007, and full payment
of
the Note and accrued interest by June 29, 2007. The Note and $100,000 waiver
fee
not having been paid, the Note automatically became in default. To partially
address this, on August 8, 2007 the Company assumed Mr. Lewis's personal
obligations under a $300,000 note payable to Black Forest International, LLC
(“BFI”), due on September 30, 2007 (the “Assumed Note”) and bearing interest at
12% retroactive to March 29, 2007. The Assumed Note is classified with loans
payable, and the remaining liquidated damages and waiver fees were classified
with financing penalties and other stock-based payables, at September 30, 2007.
Full default settlement negotiations with Mr. Lewis are currently underway.
In
addition, the Company having not paid the Assumed Note when due, BFI declared
us
in default, and settlement negotiations are underway.
October
2007 Financing
Effective
October 15, 2007, we issued and sold a $185,000 unsecured convertible note
(the
“Note”) to an accredited investor, for a net purchase price of $150,000
(reflecting an 18.92% original issue discount) in a private placement. The
Note
bears interest at the rate of 6% per annum, and is due by October 5, 2010.
The
note holder may at his election convert all or part of the Note plus accrued
interest into shares of our common stock at the conversion rate of the lesser
of: (a) $0.85 per share, or (b) 70% of the average of the three lowest closing
bid prices in the 10 trading days prior to the conversion, subject to a floor
price of $0.75 per share. The note holder also received “favored nations” rights
such that for our future securities offerings at a price per share less than
the
above-referenced $0.75 per share conversion rate floor, then the note holder's
conversion rate floor would be adjusted to the lower offering price. Further,
if
our common share market price is less than $0.75 per share at the time the
note
holder elects to convert the Note, the note holder may alternatively elect
to
demand full repayment of the Note. If we are unable to repay the Note within
seven days of such demand, then the above-referenced conversion floor price
would be eliminated. The Note is also personally guaranteed by the Company's
Chief Executive Officer.
Many
of
the subscription agreements for our financing transactions discussed above
contain the following provisions that could impact our future capital raising
efforts and capital structure:
|
·
|
We
are required to file registration statements to register amounts
ranging
up to 200% of the shares issuable upon conversion of these notes,
and all
of the shares issuable upon exercise of the warrants issued in
connection
with these notes. Certain registration statements were filed, but
have
since become either ineffective or withdrawn. Until sufficient
registration statements are declared effective by the Securities
and
Exchange Commission (the “SEC”), we are liable for liquidated damages
totaling $1,016,053 through September 30, 2007, and will continue
to incur
additional liquidated damages of $55,379 per month until December
31,
2007. Additionally, if the required shares and warrants related
to our
September 2007 financing are not otherwise registered by November
11,
2007, monthly liquidated damages of $135,095 will begin to
accrue.
|
|
·
|
Unless
consent is obtained from the note holders, we may not issue new
financing,
file any new registration statements, or amend any existing registrations
until the sooner of (a) 60 to 365 days following the effective
date of the
notes registration statement or (b) all the notes have been converted
into
shares of our common stock and such shares of common stock and
the shares
of common stock issuable upon exercise of the warrants have been
sold by
the note holders.
|
|
·
|
Since
October 2005, we have been in violation of certain requirements
of most of
our convertible notes. While the investors have not declared these
notes
currently in default, the full amount of the notes at September
30, 2007
has been classified as current. (See Note Q for subsequent default
and
waiver agreement.)
|
We
have
also settled a number a claims through the issuance of our common stock,
as
follows:
September
2006 Settlement
In
September 2006 certain of the July and October 2005 and the January and February
2006 convertible note holders filed actions against us claiming a breach
of
contract related to the notes. In settlement of these actions, the parties
entered into settlement agreements pursuant to which, among other things:
1) interest and liquidated damages due under the notes were set at $242,149
and $415,353, respectively; 2) the note holders exchanged the interest and
liquidated damages due, along with $3,899,803 in principal, and a discount
of
$881,155, for 1,045,858 shares of the our common stock through the issuance
of
freely trading securities issued pursuant to Section 3(a)(10) of the Securities
Act; 3) the conversion rate for the remaining principal balance due under
the notes was reset to $5.20; 4) the exercise price of the outstanding
warrants purchased by the note holders in connection with the January and
February 2006 notes was reduced to $9.50; and 5) certain investors agreed
to surrender their claims associated with warrants issued in May 2006 in
exchange for 125,000 shares of our common stock through the issuance of freely
trading securities issued pursuant to Section 3(a)(10) of the Securities
Act.
May
2007 Settlement
In
connection with a subscription agreement dated August 26, 2005 and amended
on
November 16, 2005, we issued 68,750 shares of our common stock for $16.00
per
share, and warrants to purchase 111,250 common shares at prices ranging from
$27.40 to $32.00 per share. The investor also received “favored nations” rights
such that for our future securities offerings at a price per share less than
the
per share purchase price or warrant exercise prices, the investor's effective
per share purchase price and warrant exercise price would be adjusted to
the
lower offering price. As a result of this favored nations provision and the
February 2007 financing agreements described in Note G, coupled with the
settlement agreement noted below, the subscription agreement's per share
purchase price and the warrants' exercise prices were reduced to $3.60 per
share. We also agreed to register a total of 292,500 common shares and warrants
related to this agreement by January 17, 2006. Since a related registration
statement was not declared effective by the SEC, we were contractually liable
for liquidated damages. On May 25, 2007, the parties entered into a settlement
agreement whereby on June 18, 2007 we issued to the investor 625,000
shares of its common stock.
June
2007 Settlement
In
connection with a private placement memorandum dated May 20, 2005, we issued
112,125 shares of our common stock for $16.00 per share, and warrants to
purchase 110,388 common shares at prices from $32.00 to $44.60 per share.
As
required by the subscription agreements, a portion of the shares was registered
with the SEC in October 2005, but that registration became ineffective in
July
2006. Non-registration liquidated damages accrued until September 2006,
when all related shares and warrants became substantially tradable under
Rule
144 and, in accordance with the terms of the subscription agreements, accrual
of
liquidated damages ceased. Based on subsequent agreements with the investors,
during the three months ended June 30, 2007, we issued 74,470 of our common
shares, warrants to purchase 16,670 of our common shares at $3.60 per share,
and
repriced 96,325 of the above-referenced originally issued warrants to $3.60
per
share, in substantial settlement of the related liquidated damages owed.
October
2007 Settlement
As
previously disclosed, including in our Form 8-K filed on July 3, 2007, on June
27, 2007 the Company and WQN, Inc., a Texas corporation (the "Purchaser")
executed an Asset Purchase Agreement (the "Purchase Agreement"), pursuant to
which we sold substantially all of the tangible operating assets utilized by
our
Dallas, Texas, division, to the Purchaser. Pursuant to the Purchase
Agreement, we were to retain the liabilities for the Dallas trade accounts
payable existing as of June 27, 2007. Pursuant to litigation subsequently filed
by the Purchaser against the Company for nonpayment of certain of these accounts
payable, on October 3, 2007 the parties entered into a settlement agreement
whereby on October 17, 2007 we issued 386,666 unrestricted shares of our common
stock, par value $0.001, issued pursuant to Section 3(a)(10) of the Act. In
addition we agreed to pay a cash amount of $73,467 to the
Purchaser.
We
anticipate that we will continue to report net losses and experience negative
cash flows from operations. We need to urgently continue to raise additional
debt or equity capital to provide the funds necessary to restructure or repay
our debt obligations, meet our other contractual commitments, and continue
our
operations. We are actively seeking to raise this additional capital but may
not
be successful in obtaining the imminently-required debt or equity
financing.
Our
authorized shares of stock consist of 400,000,000 shares of common stock. As
of
November 9, 2007 (adjusted for the Company's 1-for-20 reverse stock split),
13.2
million common shares were issued and outstanding, and approximately 145.4
million additional shares were issuable upon the conversion of all convertible
debt, and the exercise of all options and warrants. We are also obligated to
issue 56.2 million shares under various agreements, including penalty shares
for
nonregistration of securities. We are also required to reserve an additional
90.7 million common shares under our various financing agreements and stock
option plans. Also, if significant numbers of additional common shares are
issued as allowed for above or in conjunction with new financing, our current
shareholders would experience significant dilution of their ownership, and
our
stock price per share could decline substantially. The following table specifies
as of November 9, 2007, for each listed obligation, the common shares issuable
upon the conversion of all convertible debt and the exercise of all options
and
warrants, additional reservation requirements, and planned common share
issuances.
|
|
Additional Common Stock Outstanding
|
|
Reservation
|
|
Current
|
|
Minimim Total
|
|
|
|
Upon Conversion/Exercise 1
|
|
Requirements 2
|
|
Obligations
|
|
Additional
|
|
|
|
Convertible
|
|
|
|
|
|
|
|
Convertible
|
|
|
|
|
|
To Issue
|
|
Authorized
|
|
|
|
Notes
|
|
Warrants
|
|
Options
|
|
Subtotal
|
|
Notes
|
|
Options
|
|
Subotal
|
|
Shares 3
|
|
Shares Required
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
May
2005 private placement
|
|
|
-
|
|
|
128,605
|
|
|
-
|
|
|
128,605
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
5,000
|
|
|
133,605
|
|
July
and October 2005 convertible notes and warrants
|
|
|
2,387,995
|
|
|
71,880
|
|
|
-
|
|
|
2,459,875
|
|
|
6,022,963
|
|
|
-
|
|
|
6,022,963
|
|
|
3,634,968
|
|
|
12,117,806
|
|
January
and February 2006 convertible notes and warrants
|
|
|
39,593,762
|
|
|
260,540
|
|
|
-
|
|
|
39,854,302
|
|
|
13,301,872
|
|
|
-
|
|
|
13,301,872
|
|
|
26,915,599
|
|
|
80,071,773
|
|
November
2005 financing agreement
|
|
|
-
|
|
|
111,250
|
|
|
-
|
|
|
111,250
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
111,250
|
|
October
06 convertible notes and warrants
|
|
|
17,505,271
|
|
|
288,326
|
|
|
-
|
|
|
17,793,597
|
|
|
17,505,271
|
|
|
-
|
|
|
17,505,271
|
|
|
-
|
|
|
35,298,868
|
|
Feb
07 Cedar convertible notes
|
|
|
5,129,650
|
|
|
-
|
|
|
-
|
|
|
5,129,650
|
|
|
6,932,686
|
|
|
-
|
|
|
6,932,686
|
|
|
1,803,036
|
|
|
13,865,372
|
|
Feb-Aug
07 convertible notes
|
|
|
29,707,773
|
|
|
1,318,185
|
|
|
-
|
|
|
31,025,958
|
|
|
26,183,676
|
|
|
-
|
|
|
26,183,676
|
|
|
-
|
|
|
57,209,634
|
|
Sept
07 convertible notes
|
|
|
40,133,932
|
|
|
7,407,644
|
|
|
-
|
|
|
47,541,576
|
|
|
20,066,966
|
|
|
-
|
|
|
20,066,966
|
|
|
-
|
|
|
67,608,542
|
|
Nov/Dec
06 & Jan 07 bridge notes
|
|
|
-
|
|
|
121,094
|
|
|
-
|
|
|
121,094
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
121,094
|
|
2004
Stock Option Plan
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
200,000
|
|
|
200,000
|
|
|
-
|
|
|
200,000
|
|
2006
Stock Option Plan
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
500,000
|
|
|
500,000
|
|
|
-
|
|
|
500,000
|
|
Securities
owned by consulting and other professional firms
|
|
|
-
|
|
|
266,842
|
|
|
325,000
|
|
|
591,842
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
400,000
|
|
|
991,842
|
|
Current
and former officer and employee securities
4
|
|
|
-
|
|
|
375,000
|
|
|
78,125
|
|
|
453,125
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
23,458,584
|
|
|
23,911,709
|
|
Securities
owned by or owed to shareholders
|
|
|
-
|
|
|
175,381
|
|
|
15,282
|
|
|
190,663
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
190,663
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Totals
|
|
|
134,458,383
|
|
|
10,524,747
|
|
|
418,407
|
|
|
145,401,537
|
|
|
90,013,434
|
|
|
700,000
|
|
|
90,713,434
|
|
|
56,217,187
|
|
|
292,332,158
|
|
1
These
columns represent common shares issuable upon the hypothetical conversion of
outstanding convertible debt, and the exercise of all outstanding warrants
and
options.
2
These
columns represent contractual requirements to reserve specified or computed
numbers of common shares from our authorized capital, in addition to the
conversion/exercise amounts referred to in footnote 1.
3
These
are common shares that are contractually owing to various individuals or
firms.
4
Included
in "Current Obligations to Issue Shares" are shares sufficient to maintain
the
common share ownership of our Chief Executive Officer and Chief Operating
Officer at 5% and 8%, respectively, of fully diluted common stock (as required
by their respective employment agreements). Issuance of the "fully diluted"
portion of common shares is subject to board approval.
Capital
Expenditure Commitments
We
did
not have any substantial outstanding commitments to purchase capital equipment
at September 30, 2007.
Payments
Due by Period
The
following table illustrates our outstanding debt, purchase obligations, and
related payment projections as of September 30, 2007:
|
|
|
|
Less than
|
|
|
|
|
|
Contractual
Obligations
|
|
Total
|
|
1 Year
|
|
1-3 Years
|
|
3-5 Years
|
|
|
|
|
|
|
|
|
|
|
|
Convertible
notes (principal)
|
|
$
|
22,933,733
|
|
$
|
22,933,733
|
|
$
|
-
|
|
$
|
-
|
|
Loans
payable
|
|
|
513,750
|
|
|
513,750
|
|
|
-
|
|
|
-
|
|
Advances
from investors
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Financing
penalties and other stock-based payables
|
|
|
4,084,065
|
|
|
4,084,065
|
|
|
-
|
|
|
-
|
|
Accrued
litigation charges
|
|
|
1,905,000
|
|
|
1,905,000
|
|
|
-
|
|
|
-
|
|
Note
payable - related party
|
|
|
300,000
|
|
|
300,000
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
1,839,133
|
|
|
1,679,565
|
|
|
159,568
|
|
|
-
|
|
Subtotal
|
|
|
31,575,681
|
|
|
31,416,113
|
|
|
159,568
|
|
|
-
|
|
Purchase
obligations
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Operating
leases
|
|
|
87,160
|
|
|
87,160
|
|
|
-
|
|
|
-
|
|
Total
|
|
$
|
31,662,841
|
|
$
|
31,503,273
|
|
$
|
159,568
|
|
$
|
-
|
|
ITEM
3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET
RISK
Due
to
our 2006 financing agreements, the number of common shares issuable upon the
exercise of outstanding warrant agreements, when combined with existing
outstanding common shares, options, and shares issuable upon the conversion
of
applicable notes payable (“diluted shares”), exceeded our then-authorized common
shares. Therefore, as required by Emerging Issues Task Force Issue No. 00-19
(“EITF 00-19”), asset or liability classification of the warrants was required
(as opposed to permanent equity classification) for the excess warrant
shares. From January to May 2006, only a portion of our warrants were
subject to liability classification and their values accordingly
marked-to-market, including a related charge of $1,281,278 to earnings for
the
three months ended March 31, 2006. In May 2006, we repriced certain of our
warrants to $15.60 per share in conjunction with a financing transaction, which
in turn triggered contractual “favored nations” price ratchets on a number of
our existing convertible debt and warrant agreements, reducing their effective
conversion and exercise prices to $15.60 per share. The effect was to increase
the number of fully diluted shares of common stock at the time to approximately
6.5 million, relative to our then-authorized, split-adjusted 5 million common
shares. Our total warrants then outstanding were approximately 1.4 million.
As
required by EITF 00-19, we classified all remaining warrants at that time as
a
liability, transferring $5,406,284 from additional paid-in capital to fair
value
liability for warrants on our consolidated balance sheet. This warrant
liability, along with the original earlier 2006 warrant liability discussed
above, was subsequently marked-to-market, resulting in a $5,102,731 fair value
warrant liability at December 31, 2006, and a credit to earnings for the six
months ended June 30, 2006 of $3,372,162.
On
March
16, 2007, we obtained shareholder approval to increase our authorized common
stock to a split-adjusted 20 million shares, sufficient to satisfy all of our
outstanding warrant obligations. The warrant liability was then
marked-to-market, resulting in a charge to earnings of $3,550,551 for the three
months ended March 31, 2007. The fair value of these warrants at that date
was
$10,209,324, and this amount was transferred from the fair value liability
for
warrants to additional paid-in capital on our consolidated balance sheet as
required by EITF 00-19, and the related mark-to-market accounting was
suspended.
Due
to
the June 14, 2007 financing agreements referred to in Note G to our consolidated
financial statements, which in turn triggered favored nations price ratchets
to
$1.60 per share by June 25, 2007, our diluted shares exceeded our authorized,
split-adjusted 20 million common shares. Therefore, asset or liability
classification of (and related mark-to-market accounting for) the warrants
was
again required for the excess warrant shares. Between June 14, 2007 and June
25,
2007, the fair value of our warrants, totaling $2,807,757, was transferred
from
additional paid-in capital to fair value liability for warrants on our
consolidated balance sheet. At June 30, 2007 these warrants were
marked-to-market, resulting in a $2,007,626 fair value warrant liability at
June
30, 2007, and an $866,269 credit to earnings and a $2,684,282 charge to earnings
for the three and six months ended June 30, 2007, respectively. The fair value
of our warrants is a function of the market value of our underlying common
stock.
On
August
16, 2007 we effected a 1-for-20 reverse split of our common stock, which was
sufficient to satisfy all of our warrant obligations. The warrant liability
was
then marked-to-market, resulting in a credit to earnings of $1,487,514 for
the
three months ended September 30, 2007. The fair value of these warrants at
that
date was $694,450, and this amount was transferred from the fair value liability
for warrants to additional paid-in capital on our consolidated balance sheet
as
required by EITF 00-19, and the related mark-to-market accounting was suspended.
However, should we in the future have insufficient common shares to satisfy
all
of our warrant and convertible debt obligations, we will again be subject to
noncash mark-to-market income or expense to the extent that the fair value
of
these warrants changes, which is in turn primarily dependent upon our common
stock market price per share.
We
are
not exposed to significant interest rate or foreign currency exchange rate
risk.
ITEM
4. CONTROLS AND PROCEDURES
Evaluation
of Controls and Procedures
As
required by Rule 13a-15(b) under the Securities Exchange Act, as amended
(the “Exchange Act”), as of September 30, 2007, our management conducted an
evaluation with the participation of our Chief Executive Officer and Chief
Accounting Officer (collectively, the “Certifying Officers”) regarding the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Exchange Act).
Our management, with the participation of the Certifying Officers, also
conducted an evaluation of our internal control over financial reporting and
identified three significant control deficiencies, which in combination resulted
in a material weakness.
A
significant deficiency is a control deficiency, or combination of control
deficiencies, that adversely affects a company's ability to initiate, authorize,
record, process or report external financial data reliably in accordance with
generally accepted accounting principles, such that there is more than a remote
likelihood that a misstatement of our annual or interim financial statements
that is more than inconsequential will not be prevented or detected. A material
weakness is a significant deficiency, or combination of significant
deficiencies, that results in more than a remote likelihood that a material
misstatement of a company's annual or interim financial statements will not
be
prevented or detected, as of September 30, 2007. The control
deficiencies identified by our management and the Certifying Officers, which
in
combination resulted in a material weakness, were (a) insufficient
accounting personnel resources; (b) a lack of independent verification of
amounts billed to certain customers; and (c) travel advances to an executive
officer.
Based
on
this evaluation and in accordance with the requirements of Auditing Standard
No.
2 of the Public Company Accounting Oversight Board, our Certifying Officers
concluded that our disclosure controls and procedures were ineffective as of
September 30, 2007.
Our
management, including the Certifying Officers, does not expect that our
disclosure controls and procedures will prevent all errors and all improper
conduct. A control system, no matter how well conceived and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control system are met. Further, a design of a control system must reflect
the
fact that there are resource constraints, and the benefits of controls must
be
considered relative to their costs. Because of the inherent limitations in
all
control systems, no evaluation of controls can provide absolute assurance that
all control issues and instances of improper conduct, if any, have been
detected. These inherent limitations include the realities that judgments and
decision-making can be faulty, and that breakdowns can occur because of simple
error or mistake. Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more persons, or by management
override of the control. Further, the design of any system of controls is also
based in part upon assumptions about the likelihood of future events, and there
can be no assurance that any design will succeed in achieving its stated goals
under all potential future conditions. Over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the policies
or procedures may deteriorate. Because of the inherent limitations and a
cost-effective control system, misstatements due to error or fraud may occur
and
may not be detected.
Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rule 13a-15(f)
under the Exchange Act. Our internal control over financial reporting is a
process designed to provide reasonable assurance regarding the reliability
of
financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles, and
includes those policies and procedures that:
|
·
|
Pertain
to the maintenance of records that, in reasonable detail accurately
and
fairly reflect the transactions and dispositions of our
assets;
|
|
·
|
Provide
reasonable assurance that transactions are recorded as necessary
to permit
preparation of financial statements in accordance with generally
accepted
accounting principles, and that our receipts and expenditures are
being
made only in accordance with authorization of our management and
directors; and
|
|
·
|
Provide
reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of our assets that could
have
a material effect on the financial
statements.
|
Our
management, including the Certifying Officers, assessed the effectiveness of
our
internal control over financial reporting as of September 30, 2007, and
concluded that we had the following control deficiencies as of
September 30, 2007, that, when combined, resulted in a material
weakness:
|
a.
|
We
do not have sufficient accounting personnel resources at corporate
headquarters. Our management, with the participation of the Certifying
Officers, determined that the potential magnitude of a misstatement
arising from this deficiency is more than inconsequential to the
annual
and/or interim financial
statements.
|
|
b.
|
The
amounts invoiced to our wholesale telecommunications customers are
calculated by our engineering department. This billing process is
overseen
solely by the head of that department, our Chief Technology Officer
and
Chief Operating Officer. We do not presently employ a separate revenue
assurance process whereby these bills would be recalculated and
independently verified by a department other than engineering. Our
management, with the participation of the Certifying Officers, determined
that the potential magnitude of a misstatement arising due to this
deficiency is more than inconsequential to the annual and/or interim
financial statements.
|
|
c.
|
Section
402 of the Sarbanes-Oxley Act of 2002 prohibits personal loans to
or for
any of our directors or executive officers. As of September 30, 2007,
and
contrary to our formal policy, we have paid outstanding travel advances
to
our Chief Executive Officer totaling $298,500, which may be in violation
of this prohibition. Related expense reports for approximately 42%
of this
amount have been received.
|
Management
has concluded that the above deficiencies when combined have resulted in a
material weakness in its internal control of financial reporting because the
quantitative effect of any errors resulting from these deficiencies when taken
together could result in a material misstatement of our interim and annual
financial reports. Based on this evaluation and in accordance with the
requirements of Auditing Standard No. 2 of the Public Company Accounting
Oversight Board, the Certifying Officers concluded that we did not maintain
effective internal control over financial reporting as of
September 30, 2007 based on the criteria in the Internal Control -
Integrated Framework.
Remediation
Steps to Address Control Deficiencies
We
are in
the process of addressing the identified material weakness by remediating the
control deficiencies in our internal control over financial reporting which
comprise this material weakness as follows:
|
a.
|
Funding
constraints have limited our ability to enhance our accounting personnel
resources. When and if our financial condition improves, we plan
to
enhance our accounting personnel.
|
|
b.
|
We
plan to design a revenue assurance process for the billing of our
wholesale telecommunications customers to provide independent
recalculation and verification of amounts billed in
2008.
|
|
c.
|
Beginning
in the second quarter of 2007, travel advances to directors and executive
officers were not allowed by policy. Compliance with this policy
will
continue to be emphasized.
|
As
a
non-accelerated filer, we are obligated to complete our assessment of the
effectiveness of our internal control over financial reporting pursuant to
Sarbanes-Oxley Section 404 in 2007. We began this assessment in October
2007.
Changes
in Control Over Financial Reporting
There
were no changes in our internal control over financial reporting identified
in
connection with the evaluation of such internal control that occurred during
our
last fiscal quarter that have materially affected, or are reasonably likely
to
materially affect, our internal control over financial reporting.
PART
II - OTHER INFORMATION
ITEM
1. LEGAL
PROCEEDINGS
We
are
involved from time to time in legal proceedings and litigation incidental to
the
conduct of our business. See Note I to our consolidated financial statements
for
a discussion of litigation.
ITEM
1.A RISK
FACTORS
In
addition to the risk factors set forth in our Annual Report on Form 10-K for
the
year ended December 31, 2006, we are subject to the risks described
below. If
any of
the following risks and uncertainties develops into actual events, our business,
financial condition or results of operations could be materially and adversely
affected. The risk factors below contain forward-looking statements regarding
our company. Actual results could differ materially from those set forth in
the
forward-looking statements. See also Management's Discussion and Analysis of
Financial Condition and Results of Operations.
A
$300,000 note payable to our Chief Operating Officer, and a $300,000 note
payable to Black Forest International, LLC, are both currently in default.
Per
Note
K to our consolidated financial statements, a $300,000 note payable to our
Chief
Operating Officer, and a $300,000 note payable to Black Forest International,
LLC, are both currently in default for nonpayment. We currently do not have
enough cash to repay these notes. If we are unable to either repay, refinance
or
renegotiate these notes, our ability to operate and continue our business
will
be materially impaired.
If
we fail to remain current on our reporting requirements, we could be removed
from the OTC Bulletin Board which would limit the ability of broker-dealers
to
sell our securities and the ability of stockholders to sell their securities
in
the secondary market.
Companies
trading on the OTC Bulletin Board, such as us, must be reporting issuers under
Section 13 or 15(d) of the Securities Exchange Act of 1934, as
amended, and must be current in their reports under Section 13, in order to
maintain price quotation privileges on the OTC Bulletin Board. If we fail to
remain current on our reporting requirements, we could be removed from the
OTC
Bulletin Board. As a result, the market liquidity for our securities could
be
severely adversely affected by limiting the ability of broker-dealers to sell
our securities and the ability of stockholders to sell their securities in
the
secondary market. There can be no assurance that in the future we will always
be
current in our reporting requirements.
Because
we are not subject to compliance with rules requiring the adoption of certain
corporate governance measures, our stockholders have limited protections against
interested director transactions, conflicts of interest and similar
matters.
The
Sarbanes-Oxley Act of 2002, as well as rule changes proposed and enacted by
the
Securities and Exchange Commission, the New York and American Stock Exchanges
and the NASDAQ Stock Market as a result of Sarbanes-Oxley, require the
implementation of various measures relating to corporate governance. These
measures are designed to enhance the integrity of corporate management and
the
securities markets and apply to securities which are listed on those exchanges
or the NASDAQ Stock Market. Because we are not presently required to comply
with
many of the corporate governance provisions and because we chose to avoid
incurring the substantial additional costs associated with such compliance
any
sooner than necessary, we have not yet adopted all of these measures. Until
we
comply with such corporate governance measures, regardless of whether such
compliance is required, the absence of such standards of corporate governance
may leave our stockholders without protections against interested director
transactions, conflicts of interest and similar matters, and investors may
be
reluctant to provide us with funds necessary to expand our
operations.
ITEM
2. UNREGISTERED
SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
See
descriptions of our issuance of freely trading securities pursuant to Section
3(a)(10) of the Securities Act on page 34, and in footnote 10 on page 31. Other
unregistered sales of equity securities have been previously reported on Form
8-Ks.
ITEM
3. DEFAULTS
UPON SENIOR SECURITIES
See
Note
K to our consolidated financial statements for a discussion of a note payable
to
our Chief Operating Officer, and a note payable to Black Forest International,
LLC, both of which are currently in default. Other defaults have been previously
reported on Form 8-Ks.
ITEM
4. SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS
At
our
shareholder meeting held on August 13, 2007, shareholders approved a proposal
to
amend the Amended and Restated Articles of Incorporation of VoIP, Inc. to give
effect to a one-for-twenty reverse split of our common stock. Said reserve
split
was then effective on August 16, 2007. Of the 204,692,663 shares of our common
stock of record and entitled to vote, 128,653,589 shares were voted in favor
of
the proposal, 22,696,318 shares were voted against, and 49,694 shares
abstained.
ITEM
5. OTHER
INFORMATION
See
descriptions of settlement agreements and our issuance of related freely trading
securities pursuant to Section 3(a)(10) of the Securities Act on page 34, and
in
footnote 10 on page 31.
ITEM
6. EXHIBITS
No.
|
|
Description
|
|
|
|
10.1
|
|
Consultant
Agreement dated September 6, 2007 between VoIP, Inc. and CEOCast,
Inc.
|
|
|
|
31.1
|
|
Certification
by Chief Executive Officer under SEC Rule 13a-14, as adopted pursuant
to
Section 302 of the Sarbanes-Oxley Act of 2002.
|
|
|
|
31.2
|
|
Certification
by Chief Accounting Officer under SEC Rule 13a-14, as adopted pursuant
to
Section 302 of the Sarbanes-Oxley Act of 2002.
|
|
|
|
32.1
|
|
Certification
by Chief Executive Officer pursuant to 18 USC Section 1350 as adopted
by
Section 906 of the Sarbanes-Oxley Act of 2002.
|
|
|
|
32.1
|
|
Certification
by Chief Accounting Officer pursuant to 18 USC Section 1350 as adopted
by
Section 906 of the Sarbanes-Oxley Act of
2002.
|
SIGNATURES
In
accordance with the requirements of the Exchange Act, the registrant caused
this
Quarterly Report on Form 10-Q for the period ended September 30, 2007 to be
signed on its behalf by the undersigned, thereunto duly authorized.
|
VoIP,
INC.
|
|
|
Date:
November 14, 2007
|
/s/
Robert V. Staats
|
|
Robert
V. Staats
|
|
Chief
Accounting Officer
|
EXHIBIT
INDEX
Exhibit
Number
10.1
|
Consultant
Agreement dated September 6, 2007 between VoIP, Inc. and CEOCast,
Inc.
|
|
|
31.1
|
Certification
by Chief Executive Officer under SEC Rule 13a-14, as adopted pursuant
to
Section 302 of the Sarbanes-Oxley Act of 2002.
|
|
|
31.2
|
Certification
by Chief Accounting Officer under SEC Rule 13a-14, as adopted pursuant
to
Section 302 of the Sarbanes-Oxley Act of 2002.
|
|
|
32.1
|
Certification
by Chief Executive Officer pursuant to 18 USC Section 1350 as adopted
by
Section 906 of the Sarbanes-Oxley Act of 2002.
|
|
|
32.1
|
Certification
by Chief Accounting Officer pursuant to 18 USC Section 1350 as adopted
by
Section 906 of the Sarbanes-Oxley Act of
2002.
|