At the meeting, three directors will each be elected to serve a three-year term that will expire at the close of our annual meeting to be held during 2010. The shares represented by the enclosed proxy will be voted to elect as directors the nominees named below, unless a vote is withheld for an individual nominee. If a nominee cannot or will not serve as a director (which events are not anticipated), the shares represented by the enclosed proxy may be voted for another person as determined by the holder of the proxies.

 

Board Structure 

 

     Our Board of Directors currently has nine members. The directors are divided into three classes. Directors in each class serve a term of three years. At each annual meeting, the term of one class expires. Our Class III Directors, whose terms expire at the conclusion of this annual meeting, are Norman J. Barta, Lawrence J. Centella and Dr. Eric A. Rose.

 

Board Nominees 

 

     The Board of Directors has nominated Norman J. Barta, Lawrence J. Centella and Dr. Eric A. Rose for re-election as directors. Each director nominee would serve a three-year term expiring at the close of our annual meeting to be held during 2010. Biographical information on each of the nominees is furnished below under “Directors, Director Nominees and Executive Officers.”

 

Vote Required 

 

     The three nominees receiving the highest number of votes cast for them at the meeting will be elected to serve for a term of three years, or until their successors are duly elected and qualified. Abstentions and broker non-votes will not affect the outcome of the election.

 

Board Recommendation 

 

THE BOARD UNANIMOUSLY RECOMMENDS A VOTE “FOR” THE ELECTION (ITEM 1 OF THE ENCLOSED PROXY CARD) OF MR. BARTA, MR. CENTELLA AND DR. ROSE AS DIRECTORS.

 

 

Committees and Meetings 

 

    The Board of Directors has an Audit Committee, a Compensation Committee and a Nominating and Corporate Governance Committee. The Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee are each governed by a specific charter, each of which is available on our website at www.nephros.com, and all members of these committees are independent directors. We comply with the rules promulgated by the AMEX for determining the independence of directors, as well as the SEC requirements for independence of directors on the Audit Committee. Compliance with these requirements is reviewed annually by the Nominating and Corporate Governance Committee.

 

The Board has at least one regularly scheduled meeting per year. In addition, the Board holds special meetings whenever requested by either the Chairman of the Board, the President, the Secretary or by two or more directors. The Audit Committee has no less than one meeting per quarter. The Compensation Committee meets at least twice a year and the Nominating and Corporate Governance Committee meets at least once a year. In addition, special meetings of the Board or any Committee may be called from time to time as determined by the needs of the business.

 

     The Board of Directors held six meetings during fiscal 2006. During 2006, all directors attended at least 75% of the combined total of (i) all Board meetings and (ii) all meetings of committees of the Board of which the director was a member. The Board of Directors allocates time at each Board meeting to meet without management present.

 

Audit Committee 

 

The purpose of the Audit Committee of the Board of Directors is to represent and assist the Board in monitoring (i) accounting, auditing, and financial reporting processes; (ii) the integrity of our financial statements; (iii) our internal controls and procedures designed to promote compliance with accounting standards and applicable laws and regulations; and (iv) the appointment of and evaluating the qualifications and independence of our independent registered public accounting firm. The Audit Committee’s specific responsibilities are set forth in its charter, a copy of which is attached as Exhibit A to this proxy statement.

 

 

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The Audit Committee currently consists of Ms. Slotkin (Chairman) and Mr. Centella each of whom have been determined by the Board of Directors to be independent under the AMEX listing standards. Dr. Rose served on the Audit Committee from February 2, 2006 until February 28, 2007. Mr. Fox, who had served as Chairman of the Audit Committee since September 24, 2004, resigned from the Audit Committee upon becoming an employee of the Company in June 2006. The Audit Committee met eight times in fiscal 2006.

 

     The Board of Directors has determined that all Audit Committee members are financially literate under the current listing standards of the AMEX. The Board also determined that Ms. Slotkin qualifies as an “audit committee financial expert” as defined by the SEC rules adopted pursuant to the Sarbanes-Oxley Act of 2002. The Audit Committee also serves as our Qualified Legal Compliance Committee (“QLCC”). The QLCC is responsible for investigating reports, made by attorneys appearing and practicing before the SEC in the representation of us, of perceived material violations of law, breaches of fiduciary duty or similar violations by us or any of our agents.

 

Compensation Committee 

 

     The purpose of the Compensation Committee of the Board of Directors is to (i) assist the Board in discharging its responsibilities with respect to compensation of our executive officers and directors, (ii) evaluate the performance of our executive officers, (iii) assist the Board in developing succession plans for executive officers and (iv) administer our stock and incentive compensation plans and recommend changes in such plans to the Board as needed. The Compensation Committee establishes the compensation of senior executives on an annual basis. The Compensation Committee currently consists of Mr. Ziebold (Chairman), Mr. Centella and Dr. Salick, all of whom have been determined by the Board of Directors to be independent under the AMEX listing standards. The Compensation Committee met three times in fiscal 2006.

 

Nominating and Corporate Governance Committee 

 

     The purpose of the Nominating and Corporate Governance Committee of the Board of Directors is to assist the Board in identifying qualified individuals to become Board members, in determining the composition of the Board and its committees, in monitoring a process to assess Board effectiveness and in developing and implementing corporate procedures and policies. The Nominating and Corporate Governance Committee currently consists of Mr. Centella (Chairman) and Mr. Ziebold, both of whom have been determined by the Board of Directors to be independent under the AMEX listing standards. The Nominating and Corporate Governance Committee met two times in fiscal 2006.

 

     The entire Board is responsible for nominating members for election to the Board and for filling vacancies on the Board that may occur between annual meetings of the stockholders. The Nominating and Corporate Governance Committee is responsible for identifying, screening, and recommending candidates to the entire Board for prospective Board membership. When formulating its Board membership recommendations, the Nominating and Corporate Governance Committee also considers any qualified candidate for an open board position timely submitted by our stockholders in accordance with our established procedures.

 

     The Nominating and Corporate Governance Committee will consider stockholder recommendations of candidates when the recommendations are properly submitted. Stockholder recommendations should be submitted to us under the procedures discussed in “Procedures For Security Holder Submission of Nominating Recommendations” which is available on our website at www.nephros.com, by clicking on the Investor Relations link, then the Corporate Governance link. Written notice of any nomination must be timely delivered to Nephros, Inc., 3960 Broadway, New York, New York 10032, Attention: Nominating and Corporate Governance Committee, c/o Chief Financial Officer. 

 

The Nominating and Corporate Governance Committee will evaluate and recommend candidates for membership on the Board of Directors consistent with criteria established by the Committee. When considering a potential non-incumbent candidate, the Nominating and Corporate Governance Committee will factor into its determination the following qualities of a candidate: professional experience, including

 

 

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PROPOSAL 3: APPROVAL OF THE POTENTIAL ISSUANCE OF THE COMPANY’S

COMMON STOCK UPON CONVERSION OF CERTAIN NOTES AND EXERCISE OF CERTAIN

WARRANTS

Introduction

 

In June 2006, we entered into subscription agreements with certain investors who purchased an aggregate of $5,200,000 principal amount of our Secured Convertible Notes due 2012 (the “Notes”) for the face value thereof. We closed on the sale of the first tranche of Notes, in an aggregate principal amount of $5,000,000, on June 1, 2006 (the “First Tranche”) and closed on the sale of the second tranche of Notes, in an aggregate principal amount of $200,000, on June 30, 2006 (the “Second Tranche”). The Notes also provided that, upon any prepayment of the Notes occurring on or before June 1, 2008, we must issue the holder of such Notes warrants (“Prepayment Warrants”) to purchase shares of our common stock.

 

The Notes are convertible into shares of common stock at an initial conversion price of $2.10 per share (subject to anti-dilution adjustments upon the occurrence of certain events) (the “Conversion Price”). Upon issuance, the Prepayment Warrants would permit the holder thereof to purchase a quantity of our common stock equal to three shares for every $20 principal amount of Notes prepaid at an exercise price of $0.01 per share (subject to adjustment) (the “Exercise Price”). The terms of the Notes and Prepayment Warrants are described in greater detail below in the section entitled “Terms of the Transaction.”

As of April 1, 2007, principal and interest on the Notes was convertible into 2,599,525 shares of common stock, and, if still outstanding on June 1, 2012, the principal and accrued interest on the Notes will be convertible into 3,421,998 shares of common stock; provided that no event occurs that causes adjustment to the conversion price in accordance with the terms of the Notes. If we were to repay the Notes in full prior to June 1, 2008, then we would be obligated to issue Prepayment Warrants exercisable for an aggregate of 780,000 shares of common stock for $0.01 per share.

Unless and until our stockholders approve the issuance of shares of common stock in excess of such amount, the number of shares of common stock issuable upon conversion of the First Tranche of Notes and exercise of the Prepayment Warrants related thereto, in the aggregate, is limited to 2,451,280 shares, which equals approximately 19.9% of the number of shares of common stock outstanding immediately prior to the issuance of the First Tranche of Notes. We will not issue any shares of common stock upon conversion of the Second Tranche of Notes or exercise of any Prepayment Warrants that may be issued pursuant to such Notes until our stockholders approve the issuance of shares of common stock upon conversion of the Second Tranche of Notes and exercise of the Prepayment Warrants as required by the applicable rules and regulations of the AMEX, as further described below.

   

Why We Need Stockholder Approval

 

We are seeking stockholder approval in order to comply with the AMEX rules. Section 713 of the AMEX Company Guide requires stockholder approval for the issuance of securities other than in a public offering at a price per share less than the greater of the book or market value of a company’s stock, where the amount of securities being issued represents 20% or more of an issuer’s outstanding common stock. The issuance of our common stock pursuant to the conversion of the Notes and the issuance of common stock pursuant to any Prepayment Warrants that may be issued in accordance with the terms of the Notes may constitute such issuances.

Terms of the Transaction

In June 2006, we entered into subscription agreements with certain investors who purchased an aggregate of $5,200,000 principal amount of the Notes for the face value thereof. The Notes are secured by substantially all of our assets.

 

The Notes accrue interest at a rate of 6% per annum, compounded annually and payable in arrears at maturity. Subject to certain restrictions, principal and accrued interest on the Notes are convertible at any time at the holder’s option into shares of our common stock, at an initial conversion price of $2.10 per

 

 

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share (subject to anti-dilution adjustments upon the occurrence of certain events, as further described below). There is no cap on any increases to the conversion price. The conversion price may not be adjusted to an amount less than $0.001 per share, the current par value of our common stock. We may cause the Notes to be converted at their then effective conversion price, if the common stock achieves average last sales prices of at least 240% of the then effective conversion price and average daily volume of at least 35,000 shares (subject to adjustment) over a prescribed time period. In the case of an optional conversion by the holder or a compelled conversion by us, we have 15 days from the date of conversion to deliver certificates for the shares of common stock issuable upon such conversion. As described above, conversion of the Notes is restricted, pending stockholder approval.

If we issue or sell any shares of common stock (excluding certain issuances or sales described below) for a consideration per share less than the Conversion Price in effect on the date of such sale or issuance (a “Dilutive Issuance”), then, and thereafter upon each further Dilutive Issuance, the Conversion Price then in effect prior to such Dilutive Issuance shall be changed to a price equal to the consideration per share received by us in respect of the shares issued in such Dilutive Issuance (rounded to the nearest cent). Such adjustment shall be made successively whenever such an issuance is made. The anti-dilution provision does not apply to certain “excluded securities,” including, among other things, securities issued in connection with employee benefit plans, upon conversion of the Notes or the exercise of the Prepayment Warrants and pursuant to certain underwritten public offerings and pursuant to certain acquisitions by us.

We may prepay outstanding principal and interest on the Notes at any time. Any prepayment requires us to pay each holder a premium equal to 15% of the principal amount of the Notes held by such holder receiving the prepayment if such prepayment is made on or before June 1, 2008, and 5% of the principal amount of the Notes held by such holder receiving prepayment in connection with prepayments made thereafter. In addition to the applicable prepayment premium, upon any prepayment of the Notes occurring on or before June 1, 2008, we must issue the holder of such Notes warrants (“Prepayment Warrants”) to purchase a quantity of common stock equal to three shares for every $20 principal amount of Notes prepaid at an exercise price of $0.01 per share (subject to adjustment). Upon issuance, the Prepayment Warrants would expire on June 1, 2012.

 

In connection with the sale of the Notes, we have entered into a registration rights agreement with the investors pursuant to which we granted the investors two demand registration rights and unlimited piggy-back and short-form registration rights with respect to the shares of common stock issuable upon conversion of the Notes or exercise of Prepayment Warrants, if any.

   

Subject to terms and conditions set forth in the Notes, the outstanding principal of and accrued interest on the Notes may become immediately due and payable upon the occurrence of any of the following events of default: our failure to pay principal or interest on the Notes when due; certain bankruptcy-related events with respect to us; material breach of any representation, warranty or certification made by us in or pursuant to the Notes, or under the registration rights agreement or the subscription agreements; our incurrence of Senior Debt (as defined in the Notes); the acceleration of certain of our other debt; or the rendering of certain judgments against us.

The terms of the transaction and the Notes, Prepayment Warrants and other transaction documents are complex and only briefly summarized above. For further information on the transaction and the rights of the holders of the Notes, please refer to the descriptions contained in the Current Reports on Form 8-K filed with the SEC on June 2, 2006 and July 7, 2006, and the transaction documents filed as exhibits to such reports.

Increased Dilution

The number of shares of our outstanding common stock would be significantly increased upon the conversion of the Notes, particularly if this Proposal Three is approved, and exercise of any Prepayment Warrants. If such conversion and/or exercise occurs, there will be a substantial pro rata dilution to our current stockholders.

 

 

 

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Increased Number of Shares Available for Public Sale

Similarly, upon the conversion of the Notes and exercise of any Prepayment Warrants, there will be a greater number of shares of common stock becoming eligible for sale in the public market, subject to certain volume limitations, after expiration of the one year holding period required under Rule 144 of the Securities Act of 1933, and all of the shares could be eligible for sale in the public markets after two years pursuant to Rule 144(k), without any volume limitations. These shares could become eligible for resale in the public markets earlier if, in connection with the sale of such shares, we file a registration statement with the Securities and Exchange Commission covering the resale of the shares. Any such sales, or the anticipation of the possibility of such sales, represents an overhang on the market and could depress the market price of our common stock.

Vote Required

The proposal to approve the potential issuance of our common stock pursuant to conversion of the Notes and exercise of any Prepayment Warrants that may be issued pursuant to the Notes requires the affirmative vote of a majority of the shares of common stock represented and voted at the Annual Meeting. Abstentions will have the same effect as votes against Proposal Three. However, because broker non-votes will not be treated as shares that are present and entitled to vote with respect to a specific proposal, broker non-votes will have no effect on the outcome of Proposal Three.

In the event that this Proposal Three is not approved by the stockholders, the Company may be limited in its ability to obtain future financing in that it could not issue or sell securities of the Company at a per share price which would cause the Conversion Price of the Notes to be adjusted to the price that is less than the greater of the book or market value of our common stock.

THE BOARD UNANIMOUSLY RECOMMENDS A VOTE “FOR” APPROVAL (ITEM 3 OF THE

ENCLOSED PROXY CARD) OF THE POTENTIAL ISSUANCE OF THE COMPANY’S

COMMON STOCK UPON CONVERSION OF THE NOTES AND EXERCISE OF ANY

PREPAYMENT WARRANTS THAT MAY BE ISSUED PURSUANT TO THE NOTES.

 

PROPOSAL 4: APPROVAL OF AMENDMENT TO FOURTH AMENDED AND RESTATED

CERTIFICATE OF INCORPORATION TO INCREASE NUMBER OF AUTHORIZED SHARES

OF COMMON STOCK

 

Our Board of Directors has approved and adopted, subject to stockholder approval, an amendment to our Fourth Amended and Restated Certificate of Incorporation (the “Capital Amendment”), and has directed that it be considered by our stockholders at this annual meeting. The Capital Amendment increases the number of authorized shares of common stock, par value $.001 per share, from 25,000,000 to 40,000,000.

The Capital Amendment, as it is proposed to be adopted, is attached to this proxy statement as Exhibit B. Other than the increase in authorized capital discussed above, the Capital Amendment does not modify our Fourth Amended and Restated Certificate of Incorporation.

On the record date, there were issued and outstanding 12,317,992 shares of common stock and no shares of preferred stock. On such date, we had reserved an additional 2,703,474 shares of common stock for issuance upon the exercise of currently outstanding options and warrants, 2,610,515 shares of common stock for issuance upon conversion of outstanding convertible notes and 71,725 shares of common stock for issuance pursuant to awards under our stock option plans.

 

The Board believes that, by increasing the authorized number of shares of our common stock, we will make available a reasonable number of shares for future financing transactions, stock issuances pursuant to employee benefit plans and other appropriate corporate opportunities and purposes. We are currently actively pursuing potential financing and/or other strategic transactions pursuant to which we may

 

 

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need to issue shares of our capital stock. However, we have not yet reached agreement with respect to any such transaction. Having a sufficient number of shares authorized will facilitate our consummating such a transaction without the additional delay of seeking stockholder approval. Once authorized, the Board would establish the terms on which any authorized shares may be issued.

For the reasons stated above, the Board believes it is in our best interests and in the best interests of our stockholders to approve the Capital Amendment.

 

Vote Required 

 

The proposal to approve the amendment to our Fourth Amended and Restated Certificate of Incorporation to increase number of authorized shares of common stock requires the affirmative vote of a majority of the outstanding shares of common stock. Abstentions and broker non-votes will have the same effect as votes against Proposal Four.

 

Board Recommendation 

 

THE BOARD UNANIMOUSLY RECOMMENDS A VOTE “FOR” THE APPROVAL

(ITEM 4 OF THE ENCLOSED PROXY CARD) OF THE AMENDMENT TO OUR

FOURTH AMENDED AND RESTATED CERTIFICATE OF INCORPORATION TO

INCREASE NUMBER OF AUTHORIZED SHARES OF COMMON STOCK.

 

 

PROPOSAL 5: AMENDMENT TO THE NEPHROS, INC. 2004 STOCK INCENTIVE PLAN

 

In June 2004, our Board of Directors retired our Amended and Restated Nephros 2000 Equity Incentive Plan (the “2000 Plan”). In July, 2004, our Board of Directors adopted and our stockholders approved the Nephros, Inc. 2004 Stock Incentive Plan (the “2004 Plan” and together with the 2000 Plan, the “Stock Option Plans”), pursuant to which awards are made to certain officers, other employees, consultants and directors of us or our subsidiary from time to time. The maximum number of shares of common stock reserved for the grant of awards under the 2004 Plan was initially 486,237. In June 2005, with stockholder approval, the 2004 Plan was amended to increase the maximum number of shares of common stock reserved for the grant of awards thereunder to 800,000. As of December 31, 2006, there were 71,725 shares of common stock available for future grants under the 2004 Plan.

 

The Board of Directors, upon recommendation of the Compensation Committee, has approved and has determined to ask the stockholders to approve the amendment to the 2004 Plan that would increase the total number of shares of common stock reserved for issuance under the 2004 Plan from 800,000 shares to 1,300,000 shares.

 

Our business depends upon recruiting and retaining employees that can perform at the highest levels. It is critical that we continue to motivate our key employees by providing them with compensation that gives them a stake in our future growth. The Board of Directors believes that providing directors, officers and employees with equity incentives such as stock options will contribute substantially to our future success by further aligning the interests of such key employees with those of our stockholders. Additionally, our overall compensation philosophy places significant emphasis on equity compensation to reward, incentivize and retain management and key employees while conserving cash.

 

For the reasons stated above, the Board believes it is in our best interests to approve the amendment to the 2004 Plan.

A description of the 2004 Plan is set forth below. This description is qualified in its entirety by reference to the full text of the 2004 Plan. Any stockholder who wishes to obtain a copy of the 2004 Plan can call us to receive a copy free of charge.

 

 

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Administration and Duration

 

The 2004 Plan is administered by our Compensation Committee. Each member of the Compensation Committee must be a “non-employee Director” within the meaning of Rule 16b-3 under the Exchange Act, and an “outside director” within the meaning of Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”). The Compensation Committee currently consists of Mr. Ziebold (Chairman), Mr. Centella and Dr. Salick, each of whom has been determined by the Board of Directors to be independent under the AMEX listing standards. Nevertheless, if the Compensation Committee is not so composed it will not invalidate any award. The Board of Directors also may act in place of the Compensation Committee. The Compensation Committee has the authority to interpret the 2004 Plan, to establish and revise rules and regulations relating to the 2004 Plan, and to make any other determinations that it believes necessary or advisable for the administration of the 2004 Plan.

 

Limit On Awards Under the 2004 Plan

 

Awards may be granted under the 2004 Plan with respect to a maximum of 800,000 shares of our common stock. No individual may be granted awards with respect to more than 485,000 shares in any calendar year. The shares to be delivered under the 2004 Plan will be made available from authorized but unissued shares, from treasury shares, or from shares purchased in the open market or otherwise. Shares that are subject to awards under the 2004 Plan but are not actually issued (for example because the award lapsed or was cancelled), shares acquired on option exercise that are returned to us as payment of the exercise price of an option and shares of unvested restricted stock that are forfeited, will be available for further awards and options.

 

Eligibility for Awards

 

Any employees of, and consultant to, us and any of our non-employee directors that are designated by the Compensation Committee as a “key person” will be eligible to participate in the 2004 Plan. As of April 15, 2007, we had approximately 33 such employees, consultants or non-employee directors that our Compensation Committee could determine are eligible to participate in the 2004 Plan. Designation as a key person reflects a determination that the individual can contribute to our growth and profitability or otherwise is entitled to an award in connection with the individual’s extraordinary performance, promotion, retention, or recruitment. From time to time, the Compensation Committee will determine who will be granted awards and the number of shares subject to such awards. The Compensation Committee may delegate to one or more officers the authority to designate the employees eligible to receive awards (other than the key officers) and the size of each such award. An individual who receives an award under the 2004 Plan is referred to as a “Participant.”

 

Change in Control

 

The 2004 Plan provides that if there is a change in control, unless the agreement granting an award provides otherwise, all awards under the 2004 Plan will become vested and exercisable as of the effective date of the change in control. As defined in the 2004 Plan, a change in control means the occurrence of any of the following events: (i) any “person,” including a “group,” as such terms are defined in sections 13(d) and 14(d) of the Exchange Act and the rules promulgated thereunder, becomes the beneficial owner, directly or indirectly, whether by purchase or acquisition or agreement to act in concert or otherwise, of more than 50% of the outstanding shares of our common stock; (ii) our complete liquidation; (iii) the sale of all or substantially all of our assets; or (iv) a majority of the members of our Board of Directors are elected to the Board without having previously been nominated and approved by a majority of the members of the Board incumbent on the day immediately preceding such election.

 

Stock Options

 

Options granted under the 2004 Plan may be either non-qualified stock options or incentive stock options qualifying under Section 422 of the Code. The exercise price of an incentive stock option may not be less than the fair market value of the stock on the date the option is granted. The option price is payable in cash or, with the consent of the Compensation Committee, in shares of our common stock or by means of a brokered cashless exercise.

 

 

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The Compensation Committee determines the terms of each stock option grant at the time of grant. Unless the option agreement granting an option specifies otherwise, options to employees will be exercisable as to one-quarter of the shares on each of the first four anniversaries of the option grant and will remain exercisable until the tenth anniversary of the date of the grant. In no event can an incentive stock option be exercised after the tenth anniversary of the date of grant.

 

Stock Appreciation Rights

 

A stock appreciation right (“SAR”) entitles the Participant to receive - in cash or shares of stock, at the Compensation Committee’s discretion - the excess of the fair market value of a share of stock on the date of exercise over the fair market value on the date of grant. A SAR may, but need not, relate to an option. The Compensation Committee determines the terms of each SAR at the time of the grant.

 

Restricted Stock

 

The Compensation Committee, in its discretion, may grant awards of restricted stock. A share of restricted stock is a share of our common stock that may not be transferred before it is vested and may be subject to such other conditions as the Compensation Committee sets forth in the agreement evidencing the award. In addition, if the Participant terminates employment, he or she will forfeit any unvested shares. The grant or vesting of a restricted stock award may be made contingent on achievement of performance goals established by the Compensation Committee.

 

Amendment or Termination

 

The Board of Directors may amend, alter or terminate the 2004 Plan without stockholder approval, except that stockholder approval is required for amendments to the 2004 Plan to the extent necessary under applicable stock exchange rules, or to ensure that options can continue to qualify as incentive stock options or that awards will be exempt from the Code section 162(m) deduction limitation. Consequently, the Board of Directors may not, without stockholder approval, increase the total number of shares reserved for issuance under the 2004 Plan or make any other material changes to the 2004 Plan. In addition, no amendment, alteration or termination by the Board of Directors may adversely affect the rights of a holder of a stock incentive award without the holder’s consent. Unless terminated earlier, no new awards may be granted under the 2004 Plan after the tenth anniversary of the date it was adopted by the Board. However, outstanding awards made before the tenth anniversary will continue in accordance with their terms.

 

Federal Income Tax Consequences

 

The following discussion outlines generally the current federal income tax consequences of the 2004 Plan. Applicable tax laws and their interpretations are subject to change at any time and application of such laws may vary in individual circumstances.

 

Incentive Stock Options

 

A Participant who is granted an incentive stock option does not recognize taxable income upon the grant or exercise of the option. However, the difference between the fair market value of our common stock on the date of exercise and the option exercise price is a tax preference item that may subject the Participant to alternative minimum tax. A Participant generally will receive long-term capital gain or loss treatment on the disposition of shares acquired upon exercise of the option, provided that the disposition occurs more than two years from the date the option is granted, and the Participant holds the stock acquired for more than one year. A Participant who disposes of shares acquired by exercise prior to the expiration of the forgoing holding periods realizes ordinary income upon the disposition equal to the difference between the option price and the lesser of the fair market value of the shares on the date of exercise and the disposition price. Any appreciation between the fair market value of the shares on the date of exercise and the disposition price is taxed to the Participant as long or short-term capital gain, depending on the length of the holding period. To the extent the Participant recognizes ordinary income, we receive a corresponding tax compensation deduction.

 

Nonqualified Stock Options

 

A Participant will not recognize income upon the grant of a nonqualified option. Upon exercise, the Participant will recognize ordinary income equal to the excess of the fair market value of the stock on

 

 

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the date of exercise over the price paid for the stock. We are entitled to a tax compensation deduction equal to the ordinary income recognized by the Participant. Any taxable income recognized by a Participant in connection with an option exercise is subject to income and employment tax withholding. When the Participant disposes of shares acquired by the exercise of a nonqualified option, any amount received in excess of the fair market value of the shares on the date of exercise will be treated as capital gain. Dispositions made after one year from the exercise date will be treated as long-term capital gain. Dispositions made less than one year from the exercise date will be treated as short-term capital gain.

 

Stock Appreciation Rights

 

A Participant will not recognize income upon the grant of a SAR. Upon exercise, the Participant will recognize ordinary income equal to the cash or fair market value of the shares of common stock received from the exercise, which will be subject to income and employment tax withholding. We will receive a tax compensation deduction equal to the ordinary income recognized by the Participant.

 

Restricted Stock

 

Generally, a Participant will not recognize income upon the grant of restricted stock. When the shares of restricted stock vest, the Participant will recognize ordinary income equal to the fair market value of the stock and also will be subject to income and employment tax withholding. We will receive a tax compensation deduction equal to the amount of ordinary income recognized by the Participant. A Participant who receives a restricted stock award may elect to accelerate his or her tax obligation by submitting a Code Section 83(b) election within 30 days after the grant date, pursuant to which the Participant will be taxed on the fair market value of the restricted stock as of the grant date, and we will receive a tax compensation deduction as of the grant date equal to the ordinary income recognized by the Participant. Any gain or loss upon a subsequent disposition of the shares will be long-term capital gain or loss if the shares are held for more than one year and otherwise will be short-term capital gain or loss. If, after making the Section 83(b) election, the shares are forfeited, the Participant will not be entitled to a loss deduction.

 

Code Section 162(m)

 

Code Section 162(m) denies a federal income tax deduction for certain compensation in excess of $1 million per year paid to the chief executive officer and the four other most highly paid executive officers of a publicly traded corporation. Under a special transition rule, awards made within the first three years after our initial public offering will not be subject to the Section 162(m) limitation. In addition, to the extent that payment or exercise of an award would not be deductible to us as a result of Section 162(m), the 2004 Plan permits the Compensation Committee to defer that payment or exercise until the Participant no longer is subject to Section 162(m).

 

Vote Required 

 

The proposal to approve the adoption of the amendment to the 2004 Plan requires an affirmative vote of a majority of the common stock present at the meeting in person or represented by proxy. Abstentions will have the same effect as votes against Proposal Five. However, because broker non-votes will not be treated as shares that are present and entitled to vote with respect to a specific proposal, broker non-votes will have no effect on the outcome of this matter.

 

Board Recommendation 

 

THE BOARD UNANIMOUSLY RECOMMENDS A VOTE “FOR” APPROVAL (ITEM 5 OF THE

ENCLOSED PROXY CARD) OF THE AMENDMENT TO THE 2004 PLAN.

 

 

PROPOSAL 6: APPROVAL OF AMENDMENT TO FOURTH AMENDED AND RESTATED

CERTIFICATE OF INCORPORATION TO REPEAL A RESTRICTION ON STOCKHOLDER

ACTION WITHOUT A MEETING

 

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Our Board of Directors has approved and adopted, subject to stockholder approval, an amendment to our Fourth Amended and Restated Certificate of Incorporation (the “Stockholder Consent Amendment”), and has directed that it be considered by our stockholders at this annual meeting. The Stockholder Consent Amendment repeals Section 5 of Article VII of our Fourth Amended and Restated Certificate of Incorporation, which reads as follows:

Section 5. Notwithstanding any other provisions of this Certificate of Incorporation or the By-laws of the Corporation, any action by the Corporation’s stockholders may only be effected at an annual or special meeting of the Corporation’s stockholders called in compliance with Section 6 below, or pursuant to an unanimous written consent of the Corporation’s stockholders in compliance with §228 of the DGCL (or any successor section of the DGCL).

 

Among other things, such section requires that any stockholder action taken outside of an actual meeting be unanimous. Delaware corporation law provides that, unless otherwise provided in the certificate of incorporation, any action that may be taken at a stockholders meeting, may instead be taken by written consents signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to take such action at a meeting at which all shares entitled to vote were present and voted. The Stockholder Consent Amendment, by eliminating the specific requirement in our Fourth Amended and Restated Certificate of Incorporation of unanimity for stockholder action taken without a meeting, will have the effect of restoring the default rule provided by Delaware corporation law and set forth above.

We are currently actively pursuing potential financing and/or other strategic transactions, the consummation of which is critical to our ability to continue our planned operations. However, we have not yet reached agreement with respect to any such transaction. It is likely that one or more of these potential transactions will be dependent upon the approval of our stockholders, either due to applicable law or the rules of the AMEX. For example, Section 713 of the AMEX Company Guide requires stockholder approval for the issuance of securities other than in a public offering at a price per share less than the greater of the book or market value of a company’s stock, where the amount of securities being issued represents 20% or more of an issuer’s outstanding common stock. Eliminating the prohibition on non-unanimous stockholder action by written consent will facilitate our consummating such a transaction without the additional delay and expense of calling a meeting.

The Board believes that, by repealing the requirement that stockholder action without a meeting be unanimous, we will enable our stockholders to act more quickly with respect to any matters on which stockholder approval may be necessary or appropriate, particularly in connection with future financing activities or other strategic transactions and corporate opportunities.

For the reasons stated above, the Board believes it is in our best interests and in the best interests of our stockholders to approve the Stockholder Consent Amendment.

 

Vote Required 

 

The proposal to approve the amendment to our Fourth Amended and Restated Certificate of Incorporation to repeal a restriction on stockholder action without a meeting requires the affirmative vote of eighty percent (80%) of the outstanding shares of common stock. Abstentions and broker non-votes will have the same effect as votes against Proposal Four.

 

Board Recommendation

 

THE BOARD UNANIMOUSLY RECOMMENDS A VOTE “FOR” THE APPROVAL

(ITEM 6 OF THE ENCLOSED PROXY CARD) OF THE AMENDMENT TO OUR

FOURTH AMENDED AND RESTATED CERTIFICATE OF INCORPORATION TO

REPEAL SECTION 5 OF ARTICLE VII THEREOF.

 

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AUDIT COMMITTEE REPORT

 

 

     The Audit Committee is responsible for the oversight of the Company’s financial reporting process on behalf of the Board of Directors and such other matters as specified in the Committee’s charter or as directed by the Board. The Committee also has the sole authority and responsibility to select, evaluate and, where appropriate, replace the independent registered public accounting firm (or to nominate the independent registered public accounting firm for stockholder approval) and to pre-approve all auditing services and any permitted non-audit services performed by the Company’s independent registered public accounting firm, including fees and other terms.

 

Management has the primary responsibility for the financial statements and the reporting process including maintaining the system of internal controls, and for the preparation of the Company’s financial statements in accordance with generally accepted accounting principals, as well as the objectivity and integrity of such statements. The Company’s independent registered public accounting firm is responsible for expressing an opinion based on its audit of those financial statements as to the statements’ conformity with generally accepted accounting principles, its judgments as to the quality, not just the acceptability, of the Company’s accounting principles and such other matters as are required to be discussed with the Committee under generally accepted auditing standards. The Committee actively monitors and reviews these processes and financial statements. In carrying out its duties, the Committee relies in part on the information provided to it, and on the representations made to it, by management and the independent registered public accounting firm.

 

In this context, the Committee met with the independent registered public accounting firm, with and without management present, to discuss the results of its examinations, its evaluations of the Company’s internal controls, and the overall quality of the Company’s financial reporting. The Committee reviewed with the independent registered public accounting firm its judgments as to the quality, not just the acceptability, of the Company’s accounting principles and such other matters as are required to be discussed with the Committee under generally accepted auditing standards. In addition, the Committee has discussed with the independent registered public accounting firm the firm’s independence from management and the Company, including the matters in the written disclosures and the letter required by the Independence Standards Board Standard No. 1, as amended (Independence Discussions with Audit Committee), and considered the compatibility of non-audit services with the independent registered public accounting firm’s independence. The Committee discussed with the independent registered public accounting firm the overall scope and plans for its audits, including the matters required to be discussed with audit committees under Statement on Auditing Standards No. 61, as amended (Communication with Audit Committees).

 

The Committee reviewed the audited financial statements for the fiscal year ended December 31, 2006 with management, including a discussion of the quality and acceptability of the financial reporting, the reasonableness of significant accounting judgments and estimates, and the clarity of disclosures in the financial statements.

 

     In reliance on the reviews, discussions and assurances referred to above, and subject to the limitations on the Committee’s role and responsibilities referred to above and in the Committee’s charter, the Committee recommended to the Board of Directors (and the Board has approved) that the Company’s audited financial statements be included in the Annual Report on Form 10-KSB for the year ended December 31, 2006 for filing with the SEC.

 

April __, 2007		Audit Committee
		Judy Slotkin, Chairman
		Lawrence J. Centella

 

 

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[EXECUTIVE COMPENSATION -- to be included in Definitive Proxy Statement]