Note 2 - Summary of Significant Accounting Policies

The accompanying unaudited financial statements have been prepared in accordance with US GAAP for interim financial information and Rule 8.03 of Regulation S-X. They do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation have been included. The results of operations for the periods presented are not necessarily indicative of the results to be expected for the full year. For further information, refer to our financial statements as of December 31, 2009 and 2008, and for the years then ended, including notes thereto in the Company’s Form 10-K.

Basis of Presentation – The consolidated financial statements include the accounts of NeoMedia Technologies, Inc. and our wholly-owned subsidiaries.  We operate as one reportable segment.  All significant intercompany accounts and transactions have been eliminated.

Use of Estimates – The preparation of consolidated financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.  Changes in facts and circumstances may result in revised estimates, which are recorded in the period in which they become known.

Basic and Diluted Net Income (Loss) Per Share – Basic net income (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of shares of common stock outstanding during the period. During the nine months ended September 30, 2010, we reported net income per share and included dilutive instruments in the fully diluted net income per share calculation. During the three months ended September 30, 2010, and the three and nine months ended September 30, 2009, we reported a net loss per share, and as such, basic and diluted loss per share were equivalent. We excluded all outstanding stock options, warrants, convertible debt and convertible preferred stock from the calculation of diluted net loss per share because these securities were anti-dilutive.

 

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The following is a reconciliation of the numerator and denominator of the basic and diluted net income (loss) per share calculations for each period:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2010				2009				2010				2009
		(in thousands except share and per share data)
Numerator:
Net income (loss)		$	(25,631	)		$	(13,566	)		$	41,495			$	(42,101	)
Adjustments to reconcile net income (loss) to income (loss) applicable to common stockholders:
Accretion of preferred stock dividends			-				(234	)			(2,500	)			(977	)
Numerator for basic earnings per share - income available to common stockholders		$	(25,631	)		$	(13,800	)		$	38,995			$	(43,078	)
Effect of dilutive securities:
Adjustment for change in fair value of derivative liability-Series C and D preferred stock and debentures			-				-				(31,263	)			-
Adjustment for change in fair value of derivative liability- warrants			-				-				(9,751	)			-
Adjustment for loss on extinguishment of debt (excluding non-dilutive instrument)			-				-				5,643				-
Adjustment for change in fair value of hybrid financial instruments			-				-				(12,611	)			-
Adjustment for interest expense related to convertible debt (excluding non-dilutive instrument)			-				-				1,515				-
			-				-				(46,467	)			-
Numerator for diluted earnings per share-income available for  common stockholders after assumed conversions of debentures and exercise of warrants		$	(25,631	)		$	(13,800	)		$	(7,472	)		$	(43,078	)
Denominator:
Weighted average shares used to compute basic EPS			22,678,877				19,578,409				22,470,014				17,132,131
Effect of dilutive securities:
Employee stock options											99,337				-
Convertible debentures											204,313,469				-
Convertible preferred stock											74,384,038				-
Dilutive potential common shares			-				-				278,796,844				-
Denominator for diluted earnings per share-adjusted weighted average shares and assumed conversions			22,678,877				19,578,409				301,266,858				17,132,131
Basic net income (loss) per share		$	(1.13	)		$	(0.70	)		$	1.74			$	(2.51	)
Fully diluted loss per share		$	(1.13	)		$	(0.70	)		$	(0.02	)		$	(2.51	)

As shown on the accompanying condensed consolidated statements of operations, our loss on extinguishment of debt for the nine months ended September 30, 2010 was approximately $6.0 million; however, the table above does not reflect losses of approximately $363,000 related to the extinguishment of the April 2010 promissory note since that note was not a dilutive instrument.

The above table includes only dilutive instruments and their effects on earnings per common share.

The following outstanding stock options, warrants, convertible debt and convertible preferred securities for the three and nine months ended September 30, 2010 and 2009, are anti-dilutive and therefore have been excluded from diluted net income (loss) per share:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2010				2009				2010				2009
Stock options			1,099,557				952,635				823,171				945,612
Warrants			17,621,125				10,061,958				14,412,242				10,061,958
Convertible debt			213,076,644				64,929,363				-				62,155,934
Convertible preferred stock			74,698,729				19,222,062				-				21,343,582
			306,496,055				95,166,018				15,235,413				94,507,086

 

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Inventories – Inventories are stated at the lower of cost or market and are comprised of barcode-reading equipment at our NeoMedia Europe location.  Cost is determined using the first-in, first-out method.

Recent Accounting Pronouncements - The following Accounting Standards Codification Updates have been issued, or will become effective, after the end of the period covered by this discussion:

Pronouncement		Issued		Title
ASU No. 2010-20		July  2010		Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses
ASU No. 2010-21		August  2010		Accounting for Technical Amendments to Various SEC Rules and Schedules Amendments to SEC Paragraphs Pursuant to Release No. 33-9026: Technical Amendments to Rules, Forms, Schedules and Codification of Financial Reporting Policies (SEC Update)
ASU No. 2010-22		August  2010		Accounting for Various Topics—Technical Corrections to SEC Paragraphs (SEC Update)
ASU No. 2010-23		August  2010		Health Care Entities (Topic 954): Measuring Charity Care for Disclosure—a consensus of the FASB Emerging Issues Task Force
ASU No. 2010-24		August  2010		Health Care Entities (Topic 954): Presentation of Insurance Claims and Related Insurance Recoveries (a consensus of the FASB Emerging Issues Task Force)
ASU No. 2010-25		September  2010		Plan Accounting—Defined Contribution Pension Plans (Topic 962): Reporting Loans to Participants by Defined Contribution Pension Plans (a consensus of the FASB Emerging Issues Task Force)
ASU No. 2010-26		October  2010		Financial Services—Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force)

To the extent appropriate, the guidance in the above Accounting Standards Codification Updates is already reflected in our consolidated financial statements and management does not anticipate that these accounting pronouncements will have any future effect on our consolidated financial statements.

Note 3 – Capital Stock

Common Stock – On March 30, 2010, we held a special meeting of our stockholders, at which our stockholders approved amendments to our certificate of incorporation as follows:

·

To effect a 1 share for 100 shares reverse stock split of our outstanding common stock; and

·

To fix the amount of authorized shares of common stock at 5,000,000,000 shares; and

·

To effect a change in our common stock par value from $0.01 to $0.001.

In accordance with FASB ASC 260, Earnings per Share, and SAB Topic 4.C, Changes in Capital Structure, all of the share and per share information related to our common stock included in these financial statements has been retroactively re-stated to reflect the above changes.

We filed an amendment to our certificate of incorporation on April 1, 2010 to reflect the above amendments. On April 19, 2010, we filed for, and were assigned a new CUSIP number 640505-301 in connection with the issuance of new common stock securities pursuant to the reverse stock split. On April 21, 2010 we filed a request for regulatory approval from the Financial Industry Regulatory Authority (“FINRA”). On May 7, 2010, final regulatory approval was granted and became effective on May 10, 2010.

 

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Holders of common stock are entitled to one vote for each share held of record on each matter submitted to a vote of shareholders. Holders of our common stock do not have a cumulative voting right, which means that the holders of more than one half of our outstanding shares of common stock, subject to the rights of the holders of preferred stock, can elect all of our directors, if they choose to do so. In this event, the holders of the remaining shares of common stock would not be able to elect any directors. Subject to the prior rights of any class or series of preferred stock which may from time to time be outstanding, if any, holders of common stock are entitled to receive ratably, dividends when, as, and if declared by our Board of Directors out of funds legally available for that purpose. Upon our liquidation, dissolution, or winding up, the holders are entitled to share ratably in all assets remaining after payment of liabilities and payment of accrued dividends and liquidation preferences on the preferred stock, if any. Holders of common stock have no preemptive rights, nor rights to convert their common stock into any other securities. Except as otherwise required by Delaware law, and subject to the rights of the holders of preferred stock, all stockholder action is taken by the vote of a majority of the outstanding shares of common stock present at a meeting of stockholders at which a quorum consisting of a majority of the outstanding shares of common stock is present in person or by proxy.  Shares repurchased are held as treasury shares and used for general corporate purposes including, but not limited to, satisfying obligations under our employee benefit plans. Treasury stock is recorded at cost.

Note 4 – Financing

At September 30, 2010, our financing transactions with YA Global, an accredited investor, included shares of our Series C Convertible Preferred Stock issued in February 2006, Series D Convertible Redeemable Preferred Stock issued in January 2010, a series of seventeen secured convertible debentures issued between August 2006 and September 2010 and various warrants to purchase shares of our common stock.

2010 Financing Transactions - On January 5, 2010, we entered into an investment agreement with YA Global which included (i) the issuance to YA Global of 25,000 shares of our $100 Series D Convertible Redeemable Preferred Stock (ii) the modification of the conversion terms of all of our outstanding secured convertible debentures and extension of their maturity dates to July 29, 2012 (iii) issuance of additional warrants to acquire 225,000 shares of our common stock and, (iv) modification of the terms of three outstanding warrants to acquire a total of 350,000 shares of our common stock. The gross amount of this transaction was $2.5 million and we received net proceeds of $1.9 million after fees of $100,000 and the redemption of a $500,000 promissory note issued to YA Global on December 23, 2009.

In addition, the January 5, 2010 investment agreement required us to seek shareholder approval to enact the following changes relating to our common stock, a 1 share for 100 shares reverse stock split, the fixing of our authorized shares at 5,000,000,000, and the reduction in the par value from $0.01 to $0.001. On March 30, 2010, we held a Special Meeting of our shareholders at which the shareholders approved amending the Company’s certificate of incorporation to reflect these changes. (See Note 3).

On May 27, 2010, we entered into a Securities Purchase Agreement to issue and sell a secured convertible debenture to YA Global in the principal amount of $2.0 million and we also entered into an agreement which amended certain terms of all previously issued and outstanding warrants between us and YA Global which changed the ownership limitation provision from 4.99% to 9.99%. On August 13, 2010 and September 29, 2010, we entered into additional Securities Purchase Agreements to issue and sell secured convertible debentures to YA Global in the principal amounts of $550,000 and $475,000.  In conjunction with the convertible debentures, we also issued warrants to YA Global to purchase 1,000,000 and 750,000 shares of common stock, respectively, for an exercise price of $0.20 per share for a period of five years.  Additional details related to these financings are disclosed below.

Subsequent to September 30, 2010, we entered into a Securities Purchase Agreement to issue and sell a secured convertible debenture to YA Global in the principal amount of $400,000.  The debenture, dated October 28, 2010, is convertible, at the option of the holder, at a conversion price equal to the lesser of (i) $0.20 or (ii) 95% of the lowest closing bid price of our common stock for the 60 trading days preceding the date of conversion. The stated maturity date of the debenture is July 29, 2012. In conjunction with the convertible debenture, we also issued a warrant to YA Global to purchase 600,000 shares of common stock for an exercise price of $0.20 per share for a period of five years.

 

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Series D Convertible Redeemable Preferred Stock - The Series D Convertible Redeemable Preferred Stock issued on January 5, 2010 has a stated value of $100 per share and provides for an 8% cumulative dividend, subject to Board declaration. Each share of Series D Preferred is convertible, at the option of the holder, at a conversion price equal to the lesser of (i) $2.00 or (ii) 97% of the lowest closing bid price of our common stock for the 125 trading days preceding the date of conversion, provided that no conversion will be at a price less than the par value of the common stock. The conversion price is subject to adjustment for down-round, anti-dilution protection. Accordingly, if we sell common stock or common share indexed financial instruments below the conversion price, the Series D Preferred conversion price adjusts to that lower amount. The Series D Preferred conversion price is also subject to adjustment for traditional equity restructuring and reorganizations. The Series D Preferred has a liquidation amount equal to $100 per share plus all declared and unpaid dividends and is redeemable by us, at our option, at an amount of $100 per share plus a redemption premium of 10%. The instrument is also redeemable at the holder’s option upon certain events of default, which include events and factors that are not related to interest or credit risk.

The Series D Preferred is a hybrid financial instrument that embodies the risks and rewards typically associated with both equity and debt instruments. Accordingly, we are required to evaluate the features of this contract to determine its nature as either an equity-type contract or a debt-type contract. We determined that the Preferred Stock is generally more akin to a debt-type contract, principally due to its variable conversion price and redemption features. This determination is subjective. However, in complying with the guidance provided in FASB ASC 815, we concluded, based upon the preponderance and weight of all terms, conditions and features of the host contracts, that the Series D Preferred was more akin to a debt instrument for purposes of considering the clear and close relationship of the embedded derivative features to the host contract. The principal accounting concept requires bifurcation in these instances when the embedded feature and the host contract have risks that are not clearly and closely related. Certain exemptions to this rule, such as the traditional conventional convertible exemption and the common-indexed exemption were not available to us because the Preferred Stock is not indexed, as that term is defined, only to our common stock. Accordingly, the conversion feature, along with certain other features that have risks of equity, required bifurcation and classification in liabilities as a compound embedded derivative financial instrument. Derivative financial instruments are required to be measured at fair value both at inception and on an ongoing basis.

As discussed in further detail below, the initial allocation of the basis in the Series D Preferred financing transaction resulted in no basis being ascribed to the redeemable preferred stock. According to FASB ASC 480-10, Distinguishing Liabilities from Equity, if the security is not currently redeemable and it is not probable that the security will be become redeemable, accretion to face value is not necessary.  The Series D Preferred is convertible upon inception and there was no persuasive evidence that the Preferred Stock would not be redeemed.  Based on this information, redemption could not be considered “not probable” of occurring and accretion was necessary. Redeemable preferred stock may be accreted to its redemption value through periodic charges to retained earnings or over the period from the date of issuance to the earliest redemption date. Because there was no term of redemption embodied in the contract, the issuance date was considered the earliest possible redemption date. As a result, a day-one deemed dividend of $2.5 million was recorded to accrete the Series D Preferred to its redemption value.

In conjunction with the Series D Preferred financing, we also issued warrants to acquire 225,000 shares of our common stock.   We evaluated the warrants for purposes of classification under FASB ASC 480 and determined the warrants require liability classification because they embody down-round anti-dilution that precludes the instrument from being considered indexed to the Company’s own stock.

Our accounting required the allocation of the proceeds to the individual financial instruments comprising the Series D Preferred financing.  Current accounting concepts generally provide that the allocation is made, first to the instruments that are required to be recorded at fair value; that is, the compound embedded derivative and the warrants, and the remainder to the host instrument. The fair value of the embedded conversion feature and the warrants exceeded the proceeds which resulted in a day-one derivative loss.

 

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The allocation of the basis arising from the issuance of Series D Preferred and warrants is summarized in the table below:

		Proceeds				Deemed				Total
		Allocation				Dividend				Allocation
		(in thousands)
Gross proceeds		$	2,500							$	2,500
Financing costs paid to investor			(100	)							(100	)
		$	2,400							$	2,400
Derivative liabilities:
Investor warrants		$	(2,431	)						$	(2,431	)
Compound derivative			(4,551	)							(4,551	)
Total derivative liabilities			(6,982	)							(6,982	)
Redeemable preferred stock:
Series D Preferred Stock			-				-				-
Deemed dividend			-			$	(2,500	)			(2,500	)
Total redeemable preferred stock			-				(2,500	)			(2,500	)
Accumulated deficit (deemed dividend)			-				2,500				2,500
Day-one derivative loss			4,582								4,582
		$	(2,400	)		$	-			$	(2,400	)

Series C Convertible Preferred Stock - On February 17, 2006, we issued 22,000 shares of $1,000 Series C 8% Convertible Preferred Stock, with a face value of $22.0 million, to YA Global. The Series C Preferred Stock was originally convertible into shares of common stock at the lower of $2.00 per share and 97% of the lowest closing bid price of the common stock for the 30 trading days immediately preceding the conversion date. On January 5, 2010, we entered into an amendment to the Series C Convertible Preferred Stock, which modified the conversion provisions to increase the look-back period in the variable conversion rate calculation to 125 days.

On September 15, 2010, YA Global converted 273 shares of our Series C preferred stock into 1,876,289 shares of our common stock. As of September 30, 2010, YA Global has converted a total of 13,631 shares of the original 22,000 shares of Series C Preferred stock into 12,240,428 share of our common stock, leaving 8,369 shares of Series C Preferred stock with a face value of $8.4 million outstanding.

Secured Convertible Debentures - The underlying agreements for each of the seventeen debentures issued to YA Global are essentially the same, except in regard to the interest rate, varying conversion prices per share, and the number of warrants that were issued in conjunction with each of the debentures. The debentures are convertible into our common stock, at the option of the holder, at the lower of a fixed conversion price per share or a percentage of the lowest volume-weighted average price (“VWAP”) for a specified number of days prior to the conversion (the “look-back period”). The conversion is limited such that the holder cannot exceed 9.99% ownership, unless the holder waives their right to such limitation. All of the convertible debentures are secured according to the terms of a Security Pledge Agreement dated August 23, 2006, which was entered into in connection with the first convertible debenture issued to YA Global and which provides YA Global with a security interest in substantially all of our assets.  The debentures are also secured by a Patent Security Agreement dated July 29, 2008. On August 13, 2010 our wholly owned subsidiary, NeoMedia Europe AG, became a guarantor of all outstanding financing transactions between us and YA Global, through pledges of their intellectual property and other movable assets. As security for our obligations to YA Global, all of our Pledged Property, Patent Collateral and other collateral is affirmed through the several successive Ratification Agreements which have been executed in connection with each of the 2010 financings.

 

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As discussed above, on January 5, 2010, the terms of all of the prior debentures were modified to extend the stated maturity date to July 29, 2012.  The January 5, 2010 amendments also increased the look-back period used to calculate the variable conversion price per share for all debentures to a period of 125 days and increased the fixed portion of the conversion price for certain of the debentures from $1.00 to $2.00 per share.

On May 27, 2010, we entered into a Securities Purchase Agreement to issue and sell a secured convertible debenture to YA Global in the principal amount of $2.0 million. The debenture bears interest at 14% and matures on July 29, 2012. The debenture provided net proceeds of $1.4 million after payment of $90,000 in fees and the use of $506,137 to repay the outstanding principal and interest on a promissory note dated April 1, 2010 owed to YA Global. In addition to the debenture, we also issued a warrant to YA Global to purchase 5,000,000 shares of common stock for an exercise price of $0.30 per share for a period of five years.  We have the right to redeem a portion or all amounts outstanding under the debenture at a redemption premium of 10%, plus accrued interest. YA Global may require cash redemption of all or a portion of the debenture at any time after August 26, 2010.

On August 13, 2010 and September 29, 2010, we entered into Securities Purchase Agreements to issue and sell secured convertible debentures to YA Global in the principal amount of $550,000 and $475,000, respectively. The debentures bear interest at 14% and mature on July 29, 2012. The debentures provided net proceeds of $980,000 after payment of $45,000 in fees. In addition to the August 13, 2010 and September 29, 2010 debentures, we also issued warrants to YA Global to purchase 1,000,000 and 750,000 shares of common stock, respectively, for an exercise price of $0.20 per share for a period of five years.  We have the right to redeem a portion or all amounts outstanding under the debenture at a redemption premium of 10%, plus accrued interest.

At inception, a summary of the allocation of the components of the new debentures and warrants issued this quarter was as follows:

		August 13, 2010 Convertible Debenture				September 29, 2010 Convertible Debenture
		(in thousands)
Gross proceeds		$	(550	)		$	(475	)
Structuring and due diligence fee			20				25
		$	(530	)		$	(450	)
Derivative liabilities:
Investor warrants		$	(233	)		$	(167	)
Compound derivative			(704	)			(493	)
Total derivative liabilities			(937	)			(660	)
Day one derivative loss			407				210
Convertible debenture-initial carrying value			-				-
		$	(530	)		$	(450	)

 

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The compound derivatives were valued using the Monte Carlo Simulation valuation method. Significant assumptions used to value the compound derivatives as of inception of the financings included exercise estimates/behaviors and the following significant estimates:

		August 13, 2010 Embedded Conversion Feature				September 29, 2010 Embedded Conversion Feature
Conversion price		$	0.1425			$	0.1520
Equivalent volatility			181	%			166	%
Equivalent interest risk			13.12	%			13.30	%
Equivalent credit risk			8.13	%			7.79	%

The warrants are valued using the Black-Scholes-Merton valuation methodology. Significant assumptions used to value the warrants as of their inception included the following significant estimates:

		August 13, 2010 Warrants				September 29, 2010 Warrants
Exercise price		$	0.20			$	0.20
Expected life		5 years				5 years
Estimated volatility			156	%			155	%
Risk free rate of return			1.47	%			1.27	%
Dividend yield			—				—

For the risk-free rates of return, we use the published yields on zero-coupon Treasury Securities with maturities consistent with the term of the warrants and volatility is based upon our expected stock price volatility over the term of the warrants.

The table below summarizes the significant terms of each of the debentures as of September 30, 2010:

															Conversion Price – Lower of Fixed Price or Percentage of
											Default				VWAP for Preceding Period
		Face					Interest				Interest				Fixed								Default			Preceding
Debenture Issue Date		Amount			Maturity		Rate				Rate				Price				%				%			Period
August 24, 2006		$	5,000,000		7/29/2012			10	%			n/a			$	2.00				90	%			n/a		125 Days
December 29, 2006		$	2,500,000		7/29/2012			10	%			n/a			$	2.00				90	%			n/a		125 Days
March 27, 2007		$	7,458,651		7/29/2012			13	%			n/a			$	2.00				90	%			n/a		125 Days
August 24, 2007		$	1,775,000		7/29/2012			14	%			n/a			$	2.00				80	%			n/a		125 Days
April 11, 2008		$	390,000		7/29/2012			15	%			24	%		$	1.50				80	%			75	%	125 Days
May 16, 2008		$	500,000		7/29/2012			15	%			24	%		$	1.50				80	%			50	%	125 Days
May 29, 2008		$	790,000		7/29/2012			15	%			24	%		$	1.00				80	%			50	%	125 Days
July 10, 2008		$	137,750		7/29/2012			15	%			24	%		$	1.00				80	%			50	%	125 Days
July 29, 2008		$	2,325,000		7/29/2012			14	%			24	%		$	2.00				95	%			50	%	125 Days
October 28, 2008		$	2,325,000		7/29/2012			14	%			20	%		$	2.00				95	%			50	%	125 Days
May 1, 2009		$	294,000		7/29/2012			14	%			20	%		$	2.00				95	%			50	%	125 Days
June 5, 2009		$	715,000		7/29/2012			14	%			20	%		$	2.00				95	%			50	%	125 Days
July 15, 2009		$	535,000		7/29/2012			14	%			20	%		$	2.00				95	%			50	%	125 Days
August 14, 2009		$	475,000		7/29/2012			14	%			20	%		$	2.00				95	%			50	%	125 Days
May 27, 2010		$	2,006,137		7/29/2012			14	%			20	%		$	0.30				95	%			50	%	60 Days
August 13, 2010		$	550,000		7/29/2012			14	%			20	%		$	0.20				95	%			50	%	60 Days
September 29, 2010		$	475,000		7/29/2012			14	%			20	%		$	0.20				95	%			50	%	60 Days

 

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All debentures with YA Global contain provisions for acceleration of principal and interest upon default. Certain debentures also contain default interest rates and conversion prices, as reflected in the table above.

 

In our evaluation of these financing transactions, we concluded that the conversion features were not afforded the exemption as conventional convertible instruments due to the variable conversion rate; and they did not otherwise meet the conditions set forth in current accounting standards for equity classification. Because equity classification was not available for the conversion features, we elected to bifurcate the compound derivatives, and carry them as derivative liabilities, at fair value. Each compound derivative consists of (i) the embedded conversion feature, (ii) down-round anti-dilution protection features, and (iii) default, non-delivery and buy-in puts which were combined into one compound instrument that is carried as a component of derivative liabilities.

Fair Value Considerations - In accordance with FASB ASC 815, Derivatives and Hedging, we determined that the conversion features of the Series C and Series D Convertible Preferred Stock, and the August 2006, December 2006, July 2008, October 2008, April 2009, May 2009, June 2009, July 2009, August 2009, May 2010, August 2010 and September 2010 Debentures met the criteria of embedded derivatives and that the conversion features of these instruments required bifurcation and accounting as derivative instrument liabilities. Changes in the fair value of the derivative liability for the embedded conversion option are charged or credited to income each period. As permitted by FASB ASC 815-15-25, Recognition of Embedded Derivatives, we elected not to bifurcate the embedded derivatives in the March 2007, August 2007, April 2008 or May 2008 Debentures and accordingly, these convertible instruments are being carried in their entirety at their fair values, with the changes in the fair value of the Debentures charged or credited to income each period.

Derivative financial instruments arising from the issuance of convertible financial instruments are initially recorded, and continuously carried, at fair value. Upon conversion of any of the convertible financial instruments, the carrying amount of the debt, including any unamortized premium or discount, and the related derivative instrument liability are credited to the capital accounts upon conversion to reflect the stock issued and no gain or loss is recognized.

Embedded Derivative Instruments – Series C and Series D Preferred Stock and August 2006, December 2006, July 2008, October 2008, April 2009, May 2009, June 2009, July 2009, August 2009, May 2010, August 2010 and September 2010 Convertible Debentures - Embedded derivative financial instruments arising from the convertible instruments consist of multiple individual features that were embedded in each instrument. For each convertible instrument, we evaluated all significant features and, as required under current accounting standards, aggregated the components into one compound derivative financial instrument for financial reporting purposes. For financings recorded in accordance with FASB ASC 815, the compound embedded derivative instruments are valued using the Monte Carlo Simulation methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives.

The conversion price in each of the convertible debentures is subject to adjustment for down-round, anti-dilution protection.  Accordingly, if we sell common stock or common share indexed financial instruments below the stated or variable conversion price in the agreement, the conversion price adjusts to that lower amount.

As discussed above, on January 5, 2010, we entered into amendments to the convertible debentures, which extended the maturity dates to July 29, 2012, and modified the terms of the conversion prices.

 

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The assumptions included in the calculations are highly subjective and subject to interpretation.  Assumptions used as of September 30, 2010 included exercise estimates/behaviors and the following other significant estimates:

						Remaining								Equivalent				Equivalent
		Conversion				Term				Equivalent				Interest-Risk				Credit-Risk
		Prices				(years)				Volatility				Adjusted Rate				Adjusted Rate
Series C Convertible Preferred Stock		$	0.15				1.83				166	%			7.60	%			7.79	%
Series D Convertible Preferred Stock		$	0.15				1.83				166	%			7.60	%			7.79	%
August 24, 2006		$	0.14				1.83				166	%			9.50	%			7.79	%
December 29, 2006		$	0.14				1.83				166	%			9.50	%			7.79	%
July 10, 2008		$	0.12				1.83				166	%			13.03	%			7.79	%
July 29, 2008		$	0.14				1.83				166	%			13.03	%			7.79	%
October 28, 2008		$	0.14				1.83				166	%			13.03	%			7.79	%
May 1, 2009		$	0.14				1.83				166	%			13.03	%			7.79	%
June 5, 2009		$	0.14				1.83				166	%			13.03	%			7.79	%
July 15, 2009		$	0.14				1.83				166	%			13.03	%			7.79	%
August 14, 2009		$	0.14				1.83				166	%			13.03	%			7.79	%
May 27, 2010		$	0.15				1.83				166	%			13.03	%			7.79	%
August 13, 2010		$	0.15				1.83				166	%			13.03	%			7.79	%
September 29, 2010		$	0.15				1.83				166	%			13.03	%			7.79	%

Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions.

Due to the variable component of the conversion price, rapid fluctuations in the trading market price may result in significant variations to the calculated conversion price. For each debenture, we analyze the ratio of the conversion price (as calculated based on the percentage of VWAP for the appropriate look back period) to the trading market price for a period of time equal to the term of the debenture to determine the average ratio for the term of the note. Each quarter, the ratio in effect on the date of the valuation is compared with the average ratio over the term of the debenture to determine if the calculated conversion price is representative of past trends or if it is considered unrepresentative due to a large fluctuation in the stock price over a short period of time. If the calculated conversion price results in a ratio that deviates significantly from the average ratio over the term of the agreement, the average ratio of the conversion price to the trading market price is then multiplied by the current trading market price to determine the variable portion of the conversion price for use in the fair value calculations. This variable conversion price is then compared with the fixed conversion price and, as required by the terms of the debentures, the lower of the two amounts is used as the conversion price in the Monte Carlo Simulation model used for valuation purposes. On September 30, 2010, the fixed conversion price for each of the debentures was equal to or higher than the calculated variable conversion price. Accordingly, the variable conversion price was used in the Monte Carlo Simulation model. This analysis is performed each quarter to determine if the calculated conversion price is reasonable for purposes of determining the fair value of the embedded conversion features (for instruments recorded under FASB ASC 815) or the fair value of the hybrid instrument (for instruments recorded under FASB ASC 815-15-25).

Hybrid Financial Instruments Carried at Fair Value – 2007 and 2008 Convertible Debentures - The March 2007, August 2007, April 2008 and May 2008 convertible debentures are recorded in accordance with FASB ASC 815-15-25 and the entire hybrid instrument was initially recorded at fair value, with subsequent changes in fair value charged or credited to income each period. These financial instruments are valued using the common stock equivalent approach. The common stock equivalent is calculated using the shares indexed to the debentures valued at the market price of our stock and the present value of the coupon.

 

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Subsequent to the January 5, 2010 amendment, the shares indexed to the debentures issued prior to that date were calculated using the variable conversion price based on the 125 day look-back period and the present value of the coupon from inception of the debentures to the revised maturity date of July 29, 2012.

Current Period Valuations - For the Series C Preferred Stock and the August 2006 and December 2006 debentures, due to our previous default position with respect to these instruments, the carrying value of each instrument in effect as of December 31, 2006 was written up to its full face value during the fourth quarter of 2006. For these instruments and the Series D Convertible Preferred Stock and the July 2008, October 2008, April 2009, May 2009, June 2009, July 2009, August 2009, May 2010, August 2010 and September 2010 debentures, the embedded derivative instrument, primarily the conversion feature, has been separated and accounted for as a derivative instrument liability, as discussed above. This derivative instrument liability is marked-to-market each reporting period.

The March 2007, August 2007, April 2008 and May 2008 debentures were each initially recorded at their full fair value pursuant to FASB ASC 815-15-25. That fair value is marked-to-market each reporting period, with any changes in the fair value charged or credited to income.

On January 5, 2010, the terms of all of the debentures issued prior to that date were modified to increase the look-back period used to calculate the variable conversion price per share for all debentures to a period of 125 days and to extend the stated maturity date to July 29, 2012, which increased our future anticipated cash flows related to those instruments.  Because that increase exceeded the threshold prescribed by FASB ASC 470-50, Debt Modifications and Extinguishments, the modification of the amounts due under these instruments was accounted for as an extinguishment. Accordingly, the original convertible debentures were considered extinguished and the revised convertible debentures were recorded at their fair value, resulting in an extinguishment loss of approximately ($5.6) million.

For instruments which were recorded under FASB ASC 815-15, the instruments were first adjusted to fair value as of January 5, 2010 using the conversion rate and maturity date prior to the amendment. The fair value of the instrument was then calculated using the modified conversion rate and maturity date to determine the fair value of the instrument subsequent to the amendment. The difference in the fair value before and after the amendment was recorded as an extinguishment loss.

For instruments recorded under FASB ASC 815-10, the embedded conversion feature was first adjusted to fair value as of the date of the amendment using the conversion rate and maturity date prior to the amendment. The carrying value of the host instrument and the embedded conversion feature, less any deferred financing costs, was then compared with the fair value of the hybrid instrument subsequent to the amendment and the difference was recorded as an extinguishment loss.

 

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For our Series C and Series D Convertible Preferred Stock and convertible debentures, the following table reflects the face value of the instruments and, as appropriate, either their amortized cost carrying value and the fair value of the separately-recognized compound embedded derivative or, for those debentures recorded in their entirety at fair value, their fair value, as well as for each of the instruments and the number of common shares (in thousands) into which the instruments are convertible as of September 30, 2010 and December 31, 2009:

  

										Embedded								Common
September 30, 2010		Face				Carrying				Conversion								Stock
		Value				Value				Feature				Fair Value				Shares
		(in thousands)
Series C Convertible Preferred Stock		$	8,369			$	8,369			$	5,435			$	-				57,517
Series D Convertible Preferred Stock		$	2,500			$	2,500				1,624				-				17,182
August 24, 2006		$	5,000			$	5,000				4,449				-				50,025
December 29, 2006			2,500				2,500				2,287				-				25,011
March 27, 2007			7,459				-				-				17,749				55,249
August 24, 2007			1,775				-				-				4,612				14,792
April 11, 2008			390				-				-				1,037				3,250
May 16 ,2008			500				-				-				1,322				4,167
May 29, 2008			790				-				-				2,085				6,583
July 10, 2008			138				138				174				-				1,537
July 29, 2008			2,325				2,325				2,084				-				21,298
October 23, 2008			2,325				2,325				2,096				-				20,721
May 1, 2009			294				294				236				-				2,628
June 5, 2009			715				660				684				-				5,952
July 15, 2009			535				535				494				-				4,401
August 14, 2009			475				475				439				-				3,869
May 27, 2010			2,006				223				2,233				-				13,836
August 13, 2010			550				8				581				-				3,685
September 29, 2010			475				5				493				-				3,126
Total		$	28,252			$	14,488			$	23,309			$	26,805				314,829

										Embedded								Common
December 31, 2009		Face				Carrying				Conversion								Stock
		Value				Value				Feature				Fair Value				Shares
		(in thousands)
Series C Convertible Preferred Stock		$	8,642			$	8,642			$	16,397			$	-				22,158
August 24, 2006		$	5,000			$	5,000				14,131				-				13,889
December 29, 2006			2,500				2,500				6,926				-				9,260
March 27, 2007			7,459				-				-				25,046				20,718
August 24, 2007			1,775				-				-				6,573				5,547
April 11, 2008			390				-				-				1,412				1,219
May 16 ,2008			500				-				-				1,803				1,563
May 29, 2008			790				-				-				2,844				2,469
July 10, 2008			137				127				337				-				430
July 29, 2008			2,325				2,109				4,618				-				6,118
October 28, 2008			2,325				2,130				4,594				-				6,118
May 1, 2009			294				120				580				-				774
June 5, 2009			715				71				1,410				-				1,882
July 15, 2009			535				253				1,056				-				1,408
August 14, 2009			475				213				936				-				1,250
Total		$	25,220			$	12,523			$	50,985			$	37,678				94,803

 

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The terms of the embedded conversion features in the convertible instruments presented above provide for variable conversion rates that are indexed to our trading common stock price. As a result, the number of indexed shares is subject to continuous fluctuation. For presentation purposes, the number of shares of common stock into which the embedded conversion feature of the Series C and Series D Preferred Stock was convertible as of September 30, 2010 was calculated as face value plus assumed dividends (if declared), divided by the lesser of the fixed rate or the calculated variable conversion price using the 125 day look-back period. The number of shares of common stock into which the embedded conversion feature in the convertible debentures was convertible as of September 30, 2010 was calculated as the face value of each instrument divided by the variable conversion price using a 125 day look-back period.

The March 2007, August 2007, April 2008 and May 2008 debentures are carried in their entirety at fair value in accordance with FASB ASC 815-15-25 and the value of the embedded conversion feature is effectively embodied in those fair values.

Changes in the fair value of convertible instruments that are carried in their entirety at fair value (the March 2007, August 2007, April 2008 and May 2008 debentures) are reported as “Gain (loss) from change in fair value of hybrid financial instruments” in the accompanying consolidated statements of operations.

The changes in fair value of these hybrid financial instruments were as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2010				2009				2010				2009
		(in thousands)								(in thousands)
March 27, 2007		$	(4,587	)		$	(5,272	)		$	8,218			$	(5,382	)
August 24, 2007			(1,223	)			(1,388	)			2,216				(1,232	)
April 11, 2008			(263	)			(264	)			505				(215	)
May 16, 2008			(336	)			(341	)			648				(257	)
May 29, 2008			(532	)			(537	)			1,024				(404	)
Gain (loss) from changes in fair value of hybrid instruments		$	(6,941	)		$	(7,802	)		$	12,611			$	(7,490	)

The carrying value of our liability for convertible instruments carried at fair value decreased $10.9 million during the nine month period from December 31, 2009 to September 30, 2010. However, the fair values of these liabilities decreased $12.6 million. The difference between the change in carrying value and change in fair value is an extinguishment loss of $1.7 million resulting from the January 5, 2010 amendment.

Changes in the fair value of derivative instrument liabilities related to the bifurcated embedded derivative features of convertible instruments not carried at fair value are reported as “Gain (loss) from change in fair value of derivative liability – Series C and Series D preferred stock and debentures” in the accompanying consolidated statement of operations.

 

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The changes in fair value of these derivative financial instruments were as follows:

		Three Months Ended Sept 30								Nine Months Ended Sept 30
		2010				2009				2010				2009
		(in thousands)								(in thousands)
Series C Convertible Preferred Stock		$	(4,827	)		$	(1,837	)		$	10,709			$	(13,226	)
Series D Convertible Preferred Stock			(1,375	)			-				2,927				-
August 24, 2006			(2,922	)			(3,001	)			10,158				(2,382	)
December 29, 2006			(1,525	)			(1,323	)			4,878				(1,034	)
July 10, 2008			(92	)			(59	)			236				(42	)
July 29, 2008			(1,285	)			(726	)			3,087				(365	)
October 28, 2008			(1,282	)			(699	)			2,810				(410	)
April 6, 2009			-				(167	)			-				(88	)
May 1, 2009			(149	)			(167	)			423				(200	)
June 5, 2009			(357	)			(218	)			831				(126	)
July 15, 2009			(295	)			(235	)			695				(235	)
August 14, 2009			(261	)			(219	)			604				(219	)
May 27, 2010			(696	)			-				(271	)			-
August 13, 2010			122				-				122				-
September 29, 2010			-				-				-				-
			(14,944	)			(8,651	)			37,209			$	(18,327	)
Less:  Day-one loss from Series D Convertible Preferred financing			-				-				(4,582	)			-
Less:  Day-one loss from May 27, 2010 financing			-				-				(747	)			-
Less: Day-one loss from August 13, 2010 financing			(407	)			-				(407	)			-
Less: Day-one loss from September 29, 2010 financing			(210	)			-				(210	)			-
Gain (loss) from change in fair value of derivative liability		$	(15,561	)		$	(8,651	)		$	31,263			$	(18,327	)

The carrying value of the derivative liabilities-Series C and Series D preferred stock and debentures increased $15.8 million during the three months ended September 30, 2010 resulting from (i) $14.9 million increase in the fair value of the derivative liability, as shown in the table above, (ii) conversion of a portion of the Series C Preferred Stock resulting in a reduction of $253,000 and (iii) an increase of $703,000 and $493,000 due to the inception date fair value of the derivative liabilities resulting from the August 13, 2010 and September 29, 2010 financings, respectively. 

The carrying value of the derivative liabilities-Series C and Series D preferred stock and debentures decreased $27.7 million for the nine months ended September 30, 2010 due to (i) $ 37.2 million reduction in the derivative liability fair value, as provided above, (ii) conversion of a portion of the Series C Preferred Stock resulting in a reduction of $253,000 (iii) increases of $4.5 million, $2.0 million, $703,000 and $493,000 due to the inception date fair value of the derivative liabilities resulting from the Series D Preferred Stock and the May 27, 2010, August 13, 2010 and September 29, 2010 financings, respectively and iv) an increase of $2.1 resulting from a loss on extinguishment due to the January 5, 2010 modification mentioned above. 

Warrants - YA Global holds warrants to purchase shares of our common stock that were issued in connection with the convertible debentures and the Series C and Series D Preferred Stock. The warrants are exercisable at the lower of a fixed exercise price or a specified percentage of the current market price. From time to time, the fixed exercise prices of the warrants held by YA Global have been reduced as an inducement for YA Global to enter into subsequent financing arrangements. In addition to the warrants issued to YA Global, certain other warrants have been issued to consultants and other service providers.

The warrants issued to YA Global and others do not meet all of the established criteria for equity classification in FASB ASC 815-40, Derivatives and Hedging – Contracts in Entity’s Own Equity, and accordingly, are recorded as derivative liabilities at fair value. Changes in the fair value of the warrants are charged or credited to income each period.

The January 5, 2010 investment agreement with YA Global amended the exercise price of warrants indexed to 350,000 shares of common stock, which were issued in July 2008. Due to down-round anti-dilution provisions, the exercise price of the warrants prior to the amendment was based on the lowest conversion price of convertible debentures issued subsequent to July 2008; however, the amendment fixed the exercise price at $1.00, subject to subsequent adjustment for anti-dilution, resulting in an approximate decrease in fair value of $3,500.

 

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In connection with the January 5, 2010 investment agreement, we also issued to YA Global warrants to purchase 225,000 shares of our common stock at an exercise price of $1.00, expiring after seven years. These warrants were accounted for as a derivative liability and their fair value at inception was approximately $2.4 million.

The following table summarizes the warrants outstanding (in thousands) and their fair value:

		September 30,				December 31,					September 30,								December 31,
		2010				2009					2010								2009
		Exercise				Exercise			Expiration						Fair								Fair
		Price				Price			Date		Warrants				Value				Warrants				Value
											(in thousands)								(in thousands)
Series C Convertible Preferred Stock		$	0.12			$	0.32		2/17/2011			450			$	96				750			$	712
Series D Convertible Preferred Stock			0.43				—		1/5/2017			2,250				499				—				—
August 24, 2006			0.12				0.32		8/24/2011			1,750				285				1,750				1,697
December 29, 2006			0.12				0.32		12/29/2011			420				76				420				412
March 27, 2007			0.12				0.32		3/27/2012			1,250				226				1,250				1,238
August 24, 2007			0.12				0.32		8/24/2012			750				155				750				750
May 16, 2008			0.12				0.32		5/16/2015			75				17				75				77
May 29, 2008			0.12				0.32		5/29/2015			500				112				500				515
July 29, 2008			0.14				0.95		7/29/2015			1,000				223				1,000				1,000
July 29, 2008			0.43				0.95		7/29/2015			3,500				735				3,500				3,500
May 27, 2010			0.28				—		5/27/2015			5,000				1,091				—				—
August 13, 2010			0.20				—		8/13/2015			1,000				222				—				—
September 29, 2010			0.20				—		9/29/2015			750				167				—				—
Other warrants			1.10			$	1.10- $3.50		1/16/2011			1				—				67				11
									Total			18,696			$	3,904				10,062			$	9,912

The warrants are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions used in this model as of September 30, 2010 included an expected life equal to the remaining term of the warrants, an expected dividend yield of zero, estimated volatility ranging from 102% to 185%, and risk-free rates of return of 0.16% to 1.91%. For the risk-free rates of return, we use the published yields on zero-coupon Treasury Securities with maturities consistent with the remaining term of the warrants and volatility is based upon our expected stock price volatility over the remaining term of the warrants.

Changes in the fair value of the warrants are reported as "(Gain) loss from change in fair value of derivative liability - warrants" in the accompanying consolidated statement of operations.

 

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The changes in the fair value of the warrants were as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2010				2009				2010				2009
		(in thousands)								(in thousands)
Series C Convertible Preferred Stock		$	(29	)		$	389			$	616			$	(517	)
Series D Convertible Preferred Stock			(157	)			-				1,931				-
August 24, 2006			(96	)			980				1,412				(1,120	)
December 29, 2006			(21	)			231				336				(273	)
March 27, 2007			(62	)			688				1,012				(813	)
August 24, 2007			(49	)			420				595				(487	)
May 16, 2008			(6	)			46				60				(50	)
May 28, 2008			(38	)			305				403				(330	)
July 29, 2008			(294	)			2,700				3,542				(2,998	)
May 27, 2010			(364	)			-				(178	)			-
August 13, 2010			11				-				11				-
September 29, 2010			-				-				-				-
Other warrants			-				41				11				(14	)
Total		$	(1,105	)		$	5,800			$	9,751			$	(6,602	)

The carrying value of warrants increased $1.5 million during the three month period from June 30, 2010 to September 30, 2010 due to the issuance of warrants on August 13, 2010 and September 29, 2010 with a fair value of $233,000 and $167,000, respectively, in addition to warrant fair value adjustments of $1.1 million as shown in the table above.

The carrying value of warrants decreased approximately $6.0 million during the nine month period from December 31, 2009 to September 30, 2010 as described in the table above. This decrease was due to (i) a reduction in the warrant fair value of $9.7 million as described in the table below and (ii) the issuance of warrants on January 5, 2010, May 27, 2010, August 13, 2010 and September 29, 2010 with a fair value of $2.4 million, $912,000, $233,000 and $167,000, respectively, totaling $3.7 million. Accordingly, the difference between the change in the carrying value of the warrants and the gain from the change in fair value of the warrant derivative liability is $3.7 million.

Fair Value Considerations – As required by FASB ASC 820, assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement. Our derivative financial instruments that are measured at fair value on a recurring basis under FASB ASC 815-15-25 or FASB ASC 815 are all measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

 

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The following represents a reconciliation of the changes in fair value of financial instruments measured at fair value using Level 3 inputs during the three and nine months ended September 30, 2010:

		Compound
		Embedded				Warrant
		Derivatives				Derivatives				Total
Beginning balance, December 31, 2009:		$	50,985			$	9,912			$	60,897
Issuances:
January 5, 2010			4,551				2,431				6,982
Extinguished:			2,076				-				2,076
Fair value adjustments:
Compound embedded derivatives			(44,761	)			-				(44,761	)
Warrant derivatives			-				(6,551	)			(6,551	)
Ending balance, March 31, 2010		$	12,851			$	5,792			$	18,643
Issuances:
May 27, 2010			1,964				912				2,876
Fair value adjustments:
Compound embedded derivatives			(7,393	)			-				(7,393	)
Warrant derivatives			-				(4,305	)			(4,305	)
Ending balance, June 30, 2010		$	7,422			$	2,399			$	9,821
Issuances:
August 13, 2010			704				233				937
September 29, 2010			493				167				660
Conversions:
Series C Convertible Preferred Stock			(255	)			-				(255	)
Fair value adjustments:
Compound embedded derivatives			14,945				-				14,945
Warrant derivatives			-				1,105				1,105
Ending balance, September 30, 2010		$	23,309			$	3,904			$	27,213

Estimating fair values of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, valuation techniques are sensitive to changes in the trading market price of our common stock, which has a high estimated historical volatility. Because derivative financial instruments are initially and subsequently carried at fair values, our income will reflect the volatility in these estimate and assumption changes.

 

 

ITEM 1.  Legal Proceedings

 

There have been no material developments relating to certain pending legal proceedings.  For a description of certain non-material pending legal proceedings, see Note 7 – Contingencies, to the Consolidated Financial Statements set forth in this Form 10-Q.