Net Income. For the year ended December 31, 2005, we recognized net income of $48.4 million, representing 7.9% of total revenues, compared to a net income of $20.5 million for the year ended December 31, 2004, representing 4.9% of total revenues due to the reasons stated above.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
Revenues. Revenues for the year ended December 31, 2004 increased by $286.5 million, or 220.2%, to $416.6 million from $130.1 million for the year ended December 31, 2003. Revenues derived from the USB flash drive market increased by $217.9 million, or 274.5%, to $297.2 million, revenues derived from the mobile handset and portable devices market increased by $52.4 million, or 302.0%, to $69.8 million, and revenues derived from the embedded systems market increased by $16.0 million, or 52.0%, to $46.7 million. Sales to the USB flash drive market in 2004 include sales made by the Venture to Toshiba.
Cost of Goods Sold. OOur cost of goods sold for the year ended December 31, 2004 increased by $210.2 million to $303.5 million, an increase of 225.1% from cost of goods sold of $93.4 million for the year ended December 31, 2003. Our cost of goods sold as a percentage of total revenues increased from 71.8% for the year ended December 31, 2003 to 72.9% for the year ended December 31, 2004, primarily due to competitive pricing pressures.
Research and Development Expenses, Net. Our gross research and development expenses for the year ended December 31, 2004 increased by $9.6 million to $26.1 million, an increase of 58.1% from gross research and development expenses of $16.5 million for the year ended December 31, 2003. Our net research and development expenses for the year ended December 31, 2004 increased by $10.0 million to $25.9 million, an increase of 63.3% from net research and development expenses of $15.9 million for the year ended December 31, 2003. The increase in our gross research and development expenses is attributable to our increase in investments in the development of new products and the enhancement of existing products. As a percentage of revenues, our net research and development expenses decreased to 6.2% for the year ended December 31, 2004 from 12.2% for the year ended December 31, 2003. During the year ended December 31, 2004, we recognized $111,000 and $128,000 of research and development grants from IST and OCS, respectively, compared to $84,000, $414,000 and $177,000 of research and development grants we recognized from SIIRD, IST and OCS, respectively, during the year ended December 31, 2003.
Selling and Marketing Expenses. Selling and marketing expenses for the year ended December 31, 2004 increased by $11.6 million, or 54.6%, to $32.7 million from $21.1 million for the year ended December 31, 2003, due to increased expenditures on broadening our sales channels to target additional geographic and end markets, increased sales and marketing personnel and increased marketing activity for existing and new opportunities, including our mSIM MegaSIM product. As a percentage of revenues, our selling and marketing expenses decreased to 7.9% for the year ended December 31, 2004 from 16.3% for the year ended December 31, 2003.
General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2004 increased by $2.1 million, or 36.8%, to $7.6 million from $5.6 million for the year ended December 31, 2003. This increase was attributable to our expanding operations to accommodate our substantial growth in 2004, principally an increase in salaries, legal and accounting expenses, rent expense and insurance premiums to accommodate our growing operations and larger employee base. As a percentage of revenues, our general and administrative expenses decreased to 1.8% for the year ended December 31, 2004 from 4.3% for the year ended December 31, 2003.
Financial Income, Net. Financial income, net for the year ended December 31, 2004 increased by $1.2 million to $3.9 million from $2.7 million for the year ended December 31, 2003, due primarily to our increased cash balance in 2004 resulting from our secondary equity offering in February 2004.
Minority interest. Minority interest in earnings of a consolidated subsidiary was $30.4 million in 2004 compared to minority interest in losses of a consolidated subsidiary of $0.1 million in 2003. Minority interest in the earnings of a consolidated subsidiary in 2004 represents the proportional share of earnings of the Venture attributable to Toshiba.Minority interest in losses of a consolidated subsidiary in 2003 represents 20.5% of the proportional losses of SmartCaps Ltd., a subsidiary that we established together with the State of Israel, through the OCS.
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Taxes on Income. Due to our carry forward of net operating losses as well as various programs established by the Israeli government to encourage investment in Israel, under which we enjoy tax holidays and reduced tax rates in Israel, we did not incur any income tax expenses in 2003 and 2004 on a consolidated basis. We expect that we will incur little to no income taxes on a consolidated basis during 2005.
Net Income (Loss). For the year ended December 31, 2004, we recognized net income of $ 20.5 million compared to net loss of $2.9 million for the year ended December 31, 2003.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, investments, income taxes, warranty obligations, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our significant judgments and estimates used in the preparation of our consolidated financial statements:
Revenue Recognition
We generate most of our revenues from selling our flash data storage products to end customers, distributors, retailers and OEMs.
We recognize revenues from product sales in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition” when the earning process is complete, delivery has occurred, persuasive evidence of an arrangement exists, the vendor’s fee is fixed or determinable, no further obligation exists, and collectibility is probable. Because of frequent sales price reductions and rapid technological obsolescence in the industry, sales made to distributors and retailers under agreements allowing price protection and/or a right of return are deferred until the earlier of sale by distributors or retailers of our products to the end customers or their return right expires. In addition, when introducing a new product, we defer revenues generated by sales of such products until such time as we estimate the acceptance of the product by the end customer to be reasonably certain, since at the time of sale we do not have sufficient experience to estimate the amount of returns for such products.
We exercise judgment and use estimates in connection with the determination of the amount of product revenues to be recognized in each accounting period.
Allowances For Doubtful Accounts
We perform ongoing credit evaluations of our customers’ financial condition and we require collateral as we deem necessary. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments. In judging the adequacy of the allowance for doubtful accounts, we consider multiple factors including the aging of our receivables, historical bad debt experience and the general economic environment. Management applies considerable judgment in assessing the realization of receivables, including assessing the probability of collection and the current credit worthiness of each customer. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Inventory Valuation
Inventories are stated at the lower of cost or market. Our policy for valuation of inventory and commitments to purchase inventory, including the determination of obsolete or excess inventory, requires us to perform a detailed assessment of inventory at each balance sheet date which includes a review of, among other factors, an estimate of future demand for products within specific time horizons, valuation of existing inventory, as well as product life-cycle and product development plans. The estimates of future demand that we use in the valuation of inventory are the basis for the revenue forecast, which is also consistent with our short-term manufacturing plan. Inventory write-downs are also provided to cover risks arising from slow moving items. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the market value based upon assumptions about future demand, market conditions, and, specifically, prices of flash components. Our inventory impairment charges permanently establish a new cost basis and are not subsequently reversed to income even if circumstances later suggest that increased carrying amounts are recoverable. Rather these amounts reverse into income only if, as and when the inventory is sold. If our estimates regarding consumer demand are inaccurate or changes in technology affect demand for certain products in an unforeseen manner, we may be exposed to losses or gains in excess of our established inventory write-down that could be material.
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Warranties
We provide for the estimated cost of product warranties at the time revenue is recognized. The products we sell are covered by a warranty for periods ranging from one year to five years. We accrue a warranty reserve for estimated costs to provide warranty services. Our estimate of costs to service the warranty obligations is based on historical experience and expectation of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, our warranty accrual will increase, resulting in decreased gross profits.
Accounting For Investments
We evaluate whether entities in which we have invested are variable interest entities within the meaning of FIN 46R. If an entity is a variable interest entity, then we determine whether we are the primary beneficiary of that entity by reference to our contractual and business arrangements. Assessment of whether an entity is a variable interest entity for purposes of FIN 46R and the determination of the primary beneficiary of such entity requires judgment and careful analysis of all relevant facts and circumstances, including determining whether other parties are related parties solely for the purposes of FIN 46R.
With respect to equity investments, we review the degree of control that our investment and other arrangements give us over the entity in which we have invested in order to confirm that these conclusions are correct. Generally, after considering all factors, if we hold equity interests representing less than 20% of the outstanding voting interests of an entity in which we have invested, we use the cost method of accounting. If we hold at least 20% but less than 50% of the outstanding voting interests of an entity in which we have invested, we generally use the equity method of accounting.
Management evaluates investments in other companies for evidence of declines in value, other than temporary declines. When relevant factors indicate a decline in value that is other than temporary, we record a provision for the decline which results in a capital loss. Depending on the amount of any such decline, a capital loss may have a material adverse impact on our financial condition or results of operations. A judgmental aspect of accounting for investments involves determining whether an other-than-temporary decline in value of the investment has been sustained. Such evaluation is dependent on the specific facts and circumstances. Factors indicative of other-than-temporary decline include recurring operating losses, credit defaults and subsequent rounds of financings at an amount below the cost basis of the investment. This list is not all inclusive and management weighs all quantitative and qualitative factors in determining if other-than-temporary decline in value of an investment has occurred. As of December 31, 2005, no such decline in value has been indicated.
Deferred Tax Asset
We provide a valuation allowance against deferred tax assets if it is more likely than not that such an amount will not be realized. In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent fiscal years and our forecast of future taxable income on a jurisdiction by jurisdiction basis. In determining future taxable income, we are responsible for assumptions utilized, including the amount of Israeli and international pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we use to manage the underlying businesses. At December 31, 2005, we carried a valuation allowance on our deferred tax assets of $6.5 million based on our expectation that it is not likely that our subsidiaries will be able to utilize these losses prior to their expiration.
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Acquired Intangibles And Goodwill
Under SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized but is subject to an annual impairment test based upon its estimated fair value in accordance with SFAS No. 142. We conduct an annual test for impairment of goodwill as of September 30 of each year. The goodwill impairment test compares the carrying value of our reporting units with the fair value at that date. We determine fair value using a discounted cash flow analysis. This type of analysis requires us to make assumptions and estimates regarding industry economic factors and the profitability of future business strategies. It is our policy to conduct impairment testing based upon our current business strategy in light of present industry and economic conditions, as well as future expectations. In assessing the recoverability of our goodwill, we may be required to make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. This process is subjective and requires judgment at many points throughout the analysis. If our estimates or their related assumptions change in subsequent periods, or if actual cash flows are below our estimates, we may be required to record impairment charges for these assets.
In addition, we test for impairment periodically whenever events or circumstances occur subsequent to our annual impairment tests that indicate that the asset may be impaired. Indicators we consider important which could trigger an impairment include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends, or a significant decline in our stock price for a sustained period.
Intangible assets arising on acquisition are capitalized and amortized to the income statement over the period during which benefits are expected to accrue. Where events and circumstances are present which indicate that the carrying value may not be recoverable, we recognize an impairment loss. Such impairment loss is measured by comparing the recoverable amount of the asset with its carrying value. The determination of the value of such intangible assets requires management to make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or the related assumptions change in the future, we could be required to record impairment charges.
Contingencies
We are involved in legal proceedings and other claims from time to time. We are required to assess the likelihood of any adverse judgments or outcomes to these proceedings, as well as potential ranges of probable losses. A determination of the amount of reserves required, if any, for any contingencies is made after careful analysis of each individual claim. The required reserves may change due to future developments in each matter or changes in approach, such as a change in the settlement strategy in dealing with any contingencies, which may result in higher net loss. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material.
Royalty Commitments
Under our research and development agreements with Britech, we are required to pay royalties at the rate of 2%-5% of sales of products developed with funds provided by Britech, up to an amount equal to 150% of the research and development grants related to such projects. The obligation to pay these royalties is contingent on actual sales of the products and in the absence of such sales, no payment is required.
During 2005, we reached a settlement agreement with the OCS under which we paid a total of $544,000 in respect of grants received from this institution. The SIIRD project which started during 2004 failed, accordingly, the contingent obligation in respect of these institutions ceased to exist.
Taxation
The general Israeli corporate tax rate was reduced in July 2004 from 36% to 35% for the 2004 tax year, 34% for the 2005 tax year, and starting January 1, 2006, the corporate tax rate was reduced to 31% for the 2006 tax year, 29% for the 2007 tax year, 27% for the 2008 tax year, 26% for the 2009 tax year and 25% for the 2010 tax year and thereafter. However, the effective rate of tax of a company that derives income from an approved enterprise may be considerably lower than those rates. All of our production facilities have been granted approved enterprise status under six separate programs pursuant to Israel’s Law for the Encouragement of Capital Investments, 1959, or the Capital Investments Law. The primary tax benefits resulting from such status are described below.
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During 2000, we purchased the assets of Fortress U&T Ltd., which had a facility that had been granted approved enterprise status. In 2000, we initiated a research and development facility in Omer, Israel, a region defined as a “Priority A Development Region” under the Capital Investment Law, at the site of Fortress’ facilities. Income derived from our Omer facility is tax exempt for a 10-year period commencing in the year in which we first recognize Israeli taxable income from that facility. We have an approval from the Investment Center as to the percentage of our revenues which are deemed attributable to the facility in Omer.
In addition, income which is not attributable to our Omer facility and which is derived from our approved enterprises that commenced operations prior to or during 1996 is tax exempt for the first four years of the 10-year tax benefit period (provided that we meet the requirements of a qualified foreign investment company, by being at least 25% owned by non-residents of Israel), and is subject to a reduced tax rate of between 10% and 25% during the rest of the period, based on the percentage of foreign ownership in our Ordinary Shares. Income which is not attributable to the Omer facility and which is derived from our approved enterprises that commenced operations after 1996 is tax exempt for the first two years of the 10-year tax benefit period (in case of qualified foreign investment company, which is at least 25% owned by non-Israeli residents), and is subject to a reduced tax rate during the rest of the period. The reduced tax rate is imposed at a rate of between 10% and 25%, based on the percentage of foreign ownership of our Ordinary Shares, in that remaining period (the more of our Ordinary Shares held by non-Israelis, the lower the tax rate). The tax benefit periods for each respective approved enterprise will commence in the year in which we first recognize Israeli taxable income from such approved enterprise. The reduced tax rate period in each approved enterprise will end no later than the earlier of 12 years from the commencement of production, or 14 years from receipt of the approval for such approved enterprise. Accordingly, the reduced tax periods relating to these approved enterprises will expire between 2007 and 2012. We expect that the tax benefit periods for these approved enterprises will commence in 2006.
On April 1, 2005, an amendment to the Capital Investments Law came into effect (the “Amendment”) and has significantly changed the provisions of the Capital Investments Law. The Amendment limits the scope of enterprises which may be approved by the Investment Center by setting criteria for the approval of a facility as a Privileged Enterprise, such as provisions generally requiring that at least 25% of the Privileged Enterprise’s income will be derived from export. Additionally, the Amendment enacted major changes in the manner in which tax benefits are awarded under the Capital Investments Law so that companies no longer require Investment Center approval in order to qualify for tax benefits. However, the Capital Investments Law provides that terms and benefits included in any certificate of approval already granted will remain subject to the provisions of the law as they were on the date of such approval. Therefore, our existing Approved Enterprise will generally not be subject to the provisions of the Amendment. As a result of the Amendment, tax-exempt income generated under the provisions of the new law, will subject us to taxes upon distribution or liquidation and we may be required to record deferred tax liability with respect to such tax-exempt income. As of December 31, 2005, we did not generate income under the provision of the new law.
We cannot be sure that approved enterprise programs will continue to be available, or that we will continue to qualify for benefits under these programs. In addition, the benefits available to an approved enterprise are conditional upon the fulfillment of certain conditions stipulated in the relevant laws and regulations and the criteria set forth in the certificate of approval issued to us. We and our Israeli subsidiary have accumulated losses for Israeli income tax purposes as of December 31, 2005, in the amount of $7.0 million. We expect that our income taxes in 2006 as a percentage of our income will increase as compared to 2005 for various reasons, including the contribution of a full year of income generated by Microelectronica Espanola, which is subject to a 35% tax rate, recent changes in the Israeli tax law which apply a 31% tax rate to financial income, and the sale of available-for-sale equity securities. As of December 31, 2005, our U.S. subsidiary had net operating loss carryforwards for federal income tax purposes of $14.3 million which expire beginning in the year 2012. It also has net operating loss carryforwards for state tax purposes of $5.3 million which expire beginning in the year 2010. Utilization of U.S. net operating losses may be subject to substantial annual limitations due to the “change in ownership” provisions of the Internal Revenue Code of 1986 and similar state law provisions. The annual limitations may result in the expiration of net operating losses before utilization.
As of December 31, 2005, M-Systems China and M-Systems Japan had net operating loss carry forward of $213,000 and $906,000, respectively, which can be carried forward and offset against taxable income during the years 2006 to 2008.
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Inflation
Most of our sales are made in dollars, and most of our expenses are incurred in dollars or New Israeli Shekels. We have not been materially affected by changes in the rate of inflation in Israel. Inflation in the United States and our other markets has not had a material effect on our results of operations.
B. LIQUIDITY AND CAPITAL RESOURCES
Through December 31, 2005, we have funded our operations primarily through the sales of our ordinary shares, the issuance of convertible senior notes by our subsidiary in March 2005, cash from operations and, to a lesser extent, government grants to support our research and development efforts. Since our initial public offering, we have raised $329.0 million in the aggregate through public offerings and private placements of our ordinary shares and convertible senior notes, including a secondary offering of our ordinary shares in February 2004, which raised net proceeds of $95.4 million, and a $75 million offering in March 2005 of 1% convertible senior notes due in 2035 which provided net proceeds of $72.8 million. Our growth in revenues in 2005 created greater working capital needs. We funded these working capital needs from cash generated from operations due to the growth in profits and positive cash flow that we experienced in 2005. We believe that our cash, cash equivalents, bank deposits, marketable securities and cash generated from operations will be sufficient to fund our anticipated working capital needs for the next twelve months.
As of December 31, 2005, our cash, cash equivalents, bank deposits and marketable securities were $186.3 million ($87.4 million of this amount being comprised of long-term marketable securities) compared to $181.0 million as of December 31, 2004. This slight increase is mainly a result of our operating cash flows, and our offering of convertible senior notes, which provided net proceeds to us of $72.8 million, less the recent purchase of equipment placed at Hynix and the acquisition of Microelectronica Espanola.
We had indebtedness of $71.4 million as of December 31, 2005, arising exclusively from the indebtedness we incurred through our offering of convertible senior notes in March 2005.
Our trade receivables increased to $131.9 million at December 31, 2005 from $61.4 million at December 31, 2004, which increase reflects our increased sales in the fourth quarter of 2005. We expect trade receivables to continue to increase as our sales grow.
Our inventories increased from $59.4 million at December 31, 2004 to $76.3 million at December 31, 2005. The portion of our inventory that represents our product sales for which revenues were not recognized during the period in accordance with our revenue recognition policy, as well as inventory on consignment to our customers, increased from $21.2 million to $21.9 million over this period. In 2005, we managed our inventory to allow us to hold lower levels of inventory than in prior periods, in part due to our decision in the first half of 2005 to reduce our inventory levels in order to reduce our exposure to potential devaluations of on-hand inventory. As a result, notwithstanding the significant increase in our revenues in 2005, we have maintained lower levels of inventory as a percentage of revenues during 2005, in comparison to prior periods. We do not believe that this reduction in inventory levels on a relative basis has had a material effect on our liquidity needs.
As of December 31, 2005, we had an outstanding obligation of $36.2 million due for the purchase of equipment to be placed at Hynix’s premises under our agreement with Hynix, which was satisfied in the first quarter of 2006.
Operating Activities
Net cash provided by operating activities for the year ended December 31, 2005 was $63.6 million as compared to $27.8 million net cash provided by operating activities for the year ended December 31, 2004. The increase in cash provided by operating activities was primarily attributable to our increase in net income to $48.4 million in 2005 from $20.5 million in 2004 and an increase in accounts payable offset in part by an increase in accounts receivable.
Investing Activities
Net cash used in investing for the year ended December 31, 2005 was $94.2 million as compared to $75.9 million for the year ended December 31, 2004. The increase was primarily attributable to our investments in marketable securities, the acquisition of Microelectronica and the investment in equipment related to our agreement with Hynix.
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Financing Activities
Net cash provided by financing activities for the year ended December 31, 2005 was $45.8 million as compared to $78.7 million for the year ended December 31, 2004. The decrease was primarily attributable to our issuance in 2005 of convertible senior notes, which provided net proceeds of $72.8 million as compared to the public offering that we completed in 2004, which provided proceeds of $96.9 million, and a cash distribution to the minority shareholder of the Venture in the amount of $36.0 million in 2005 compared to $23.1 million in 2004.
We expect that our uses of cash in the near future will be to fund working capital and increases in selling and marketing expenditures and research and development expenditures as well as for potential strategic acquisitions of, or investments in, related businesses, product lines and technologies. Further, in order to support our expected continued growth, we intend to continue to make investments and expenditures to secure additional supply of flash memory components. These investments or expenditures may include, among other things, direct investments in fabrication facilities, investments in suppliers of flash memory components, purchase of semiconductor manufacturing equipment or advance payments to secure future flash memory component manufacturing capacity. We will need to raise capital in the future to fund those and additional investments and expenditures to secure supply of flash memory components. However, we currently have no commitments for any specific acquisitions, expenditures or investments. We cannot assure you that the uses will not be different.
For the year ended December 31, 2005, the aggregate amount of our capital expenditures was $10.2 million. These expenditures were principally for the construction of our second facility in Kfar-Saba and for the purchases of computer hardware and software. In addition, during 2005 we purchased $63.8 million of equipment which we placed in Hynix’s facilities under the terms of our agreement with Hynix.
C. RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC.
Government of Israel Support Programs
Research and Development Overview and Internal Program
We have devoted significant resources to research and development activities with respect to our core flash data storage technology. We have emphasized the development of our technology, the enhancement of existing products and the development of new products, generally in response to the rapidly evolving markets for High-End Mobile Devices, Embedded Devices, military systems and network infrastructure equipment and other embedded systems. In addition, we emphasize the development and addition of new features to our products, such as security and access control.
Our gross research and development expenses during 2003, 2004 and 2005 were $16.5 million, $26.1 million and $38.9 million, respectively. A small portion of our revenues during those years was funded through grants from OCS, SIIRD and IST, as discussed below.
Research and Development Grants
In the past, we participates in programs offered by the OCS, and we currently participate in programs offered by SIIRD, Britech and IST that support research and development activities. We received or accrued participation from OCS, SIIRD, Britech and IST of $ 0, $0, $ 331,000 and $ 188,000, respectively, in 2005, $ 128,000, $ 0, $ 0 and $ 111,000, respectively, in 2004 and $ 177,000, $ 84,000, $ 0 and $ 414,000, respectively, in 2003. Our OCS grants related to the development of a compact IDE interface flash disk, our SIIRD grants related to the development of LPC flash disk and our IST grants related to the development of secure mobile payment on chip (SM-PAYSOC).
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D. TREND INFORMATION
Please see the discussion of significant recent trends in our business, including trends in our revenues, cost of goods sold, research and development expenses, net, selling and marketing expenses and net income (loss), in “Item 5A: Operating Results – Overview.”
E. OFF-BALANCE SHEET ARRANGEMENTS
We are not party to any material off-balance sheet arrangements.
F. TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS
| | | | | | | | | | | | | | | | |
| | Payments due by Period (US$ in thousands) | |
Contractual Obligations as of
December 31, 2005 | | Total | | Less than
1 year | | 1-3 years | | 3-5 years | | More than
5 years | |
| |
| |
| |
| |
| |
| |
Long term debt obligations(1) | | $ | 96,938 | | $ | 750 | | $ | 2,250 | | $ | 2,250 | | $ | 91,688 | |
Operating lease obligations(2) | | | 9,752 | | | 4,569 | | | 5,183 | | | --- | | | --- | |
Purchase obligations(3) | | | 237,418 | | | 237,418 | | | --- | | | --- | | | --- | |
Other long term liabilities(4) | | | 1,312 | | | --- | | | --- | | | --- | | | 1,312 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | 345,420 | | $ | 242,737 | | $ | 7,433 | | $ | 2,250 | | $ | 93,000 | |
| | |
| (1) | Senior convertible notes including interest accrued thereon. |
| | |
| (2) | Includes leases for facilities and vehicle leases for Israeli employees. |
| | |
| (3) | Covers material goods and services under issued purchase orders and further includes material purchase commitments under applicable binding forecasts. Additionally, this amount includes purchase obligations under the Product Supply Agreement with Hynix in an amount of $36.2 million. |
| | |
| (4) | Accrued severance pay, net. |
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| |
ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES |
A. DIRECTORS AND SENIOR MANAGEMENT
The following table sets forth certain information regarding our directors and executive officers as of June 15, 2006:
| | | | |
Name | | Age | | Position |
| |
| |
|
Dov Moran | | 50 | | President, CEO and Chairman of the Board of Directors |
Aryeh Mergi | | 44 | | Executive Vice President of Business Development; Director |
Ronit Maor | | 35 | | CFO and Corporate Secretary |
Dana Gross | | 39 | | Chief Marketing Officer; Director |
Itsik Onfus | | 44 | | Director |
Yair Shoham | | 53 | | Director |
Dr. Hans Wagner | | 76 | | Director |
Yossi Ben Shalom | | 50 | | Director |
Zehava Simon | | 47 | | Director |
Yuval Neeman | | 48 | | Director |
The background of each of our directors, executive officers and key employees is as follows:
Dov Moran. Mr. Moran is a founder of msystems and has been a director and President, Chief Executive Officer and Chairman of the Board of Directors of msystems since 1989. Mr. Moran also serves on the board of directors of some of our subsidiaries. From 1984 to 1989, Mr. Moran was an independent consultant in the computer industry. Prior thereto, Mr. Moran served in the Israeli Navy for seven years and was director of its microprocessors department. Mr. Moran received a B.Sc. in Computers and Electronic Engineering (with honors) from the Technion, Israel Institute of Technology, in Haifa, Israel in 1977.
Aryeh Mergi. Mr. Mergi is a founder of msystems and has been a director of msystems since 1989 and also serves on the board of directors of some of our subsidiaries. Mr. Mergi has been our Executive Vice President of Business Development of the Company since 2000. From 1995 to 2000, he served as Executive Vice President of Sales and Marketing. From 1989 to 1995, he served as Vice President of Research and Development. Mr. Mergi also serves of the board of directors of WideMed Ltd., of which he is a founder, since May, 2000, and of Kidin, a company founded by his wife, since 1999. Mr. Mergi received a B.Sc. in Electronic Engineering (with honors) from the Technion, Israel Institute of Technology, in Haifa, Israel in 1988.
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Ronit Maor. Ms. Maor has been Chief Financial Officer since May 1997. Ms. Maor joined us as Planning and Control Manager in March 1996 and was promoted to Vice President of Planning and Control in February 1997. Prior thereto, Ms. Maor was a project manager at Tefen, an industrial engineering consulting company. She received her B.Sc. in Industrial Management Engineering (with honors) from Tel-Aviv University in 1995.
Dana Gross. Ms. Gross, a director of the Company since September 2000, joined the Company in July, 1992 as Vice President of Operations and has served in various management positions, including, among others, as Chief Financial Officer and President of our US subsidiary, M-Systems, Inc. Mr. Gross also serves on the board of directors of some of our subsidiaries. Currently, she serves as the company’s Chief Marketing Officer since July, 2002. Ms. Gross also serves on the board of directors of AudioCodes Ltd. (Nasdaq: AUDC), since June, 2000, and of PowerDsine Ltd. (Nasdaq: PDSN), since September, 2004. Ms. Gross received a B.Sc. in Industrial Management Engineering (with honors) from Tel-Aviv University in 1992 and an M.B.A. degree from San Jose State University in 1997.
Itsik Onfus. - Mr. Onfus has served as a director of msystems since August, 2003. Since the consolidation of all SAP entities in Israel in the beginning of 2005, Mr. Onfus serves as the Vice President Finance of the consolidated corporation - SAP Labs Israel. From July, 2002 to 2005, Mr. Onfus served as the Director of Finance at Sap Portals Israel Ltd. From 1995 to 2002, Mr. Onfus served as the Chief Financial Officer of a number of start-up companies in their incubation stage, including, among others, VDOnet Corporation Ltd., TI ISRAEL (formerly Butterfly V.L.S.I Ltd.), CallManage Inc., Voquette, RFWaves Ltd., Envara Ltd. and IXI Mobile. From 1990 to 1995, Mr. Onfus filled the positions of Controller, Corporate Controller and, prior to its purchase by Elbit, Chief Financial Officer of Fibronics Ltd., prior to which, from 1986 to 1990, Mr. Onfus worked as a CPA for the accounting firm of Goren, Ben Yaakov. During his studies, Mr. Onfus worked both as an assistant professor in the Economics department of the Hebrew University, Jerusalem, and as a research assistant, in the Research Department of the Bank of Israel. Mr. Onfus received his B.A. degree in Economics and Accounting from the Hebrew University, Jerusalem in 1986. Mr. Onfus qualifies as an independent director under applicable Nasdaq rules and was elected to the Board of Directors as an External Director under the applicable provisions of the Companies Law.
Yair Shoham. Mr. Shoham has served as a director of msystems since 1996. Since June 1999, Mr. Shoham has been general partner with Genesis Partners, a large Israel-based venture capital fund. From 1997 to 1999, Mr. Shoham was the Vice President for Business Development of Butterfly VLSI Ltd., and from January 1996 to December 1996 he was the Vice President for Business Development of VDOnet Corporation Ltd. From January 1994 to December 1995, Mr. Shoham was a partner at the law firm of Goldfarb, Levy, Eran & Co., Tel-Aviv, Israel. Mr. Shoham received his B.A. degree from Haifa University in Israel in 1982 and a J.D. degree from Loyola University of Chicago School of Law in 1985. Mr. Shoham qualifies as an independent director under applicable Nasdaq rules and was elected to the Board of Directors as an External Director under the applicable provisions of the Companies Law.
Dr. Hans Wagner. Dr. Wagner has served as a director of msystems since November, 2002. Dr. Wagner also serves as chairman of each of Bamboo Multicasting Ltd. and Kibi Ltd., two Israeli start up companies in the mobile phone sector. Until 2003, Dr. Wagner was as a Senior Partner of Omega Partners Ltd., a telecommunications consultancy firm, of which he was a founder in 1977. Dr. Wagner also founded and serves as a director of Ozone Ltd., a manufacturer of recycling devices founded in 1996, and served as chairman of Pelikon Ltd., a developer and manufacturer of electro-luminescent displays founded in 2000. From 1995 to 2000, Dr. Wagner served as a strategic advisor to the management of Ericsson Mobile LM. From 1984 to 1992, Dr. Wagner was a founder and served as chairman of Technophone, a mobile telephone manufacturer which was then the worldwide number three in sales prior to its acquisition by Nokia. From 1973 to 1977, Dr. Wagner served as the Assistant Secretary General of the UNDP. From 1969 to 1973, Dr. Wagner served as the CEO of SONAB AB, Sweden’s second largest communication equipment manufacturer. From 1963 to 1969, Dr. Wagner served as the COO of Incentive AB, Sweden’s largest technical conglomerate. Dr. Wagner holds a Masters degree in Chemical Engineering, an M.B.A. degree from the Stockholm School of Economics and a Ph.D. from the Massachusetts Institute of Technology. Dr. Wagner qualifies as an independent director under applicable Nasdaq rules.
Yossi Ben Shalom. Mr. Ben Shalom has served as a director of the Company since January, 2003. Mr. Ben Shalom is a co-founder of DBSI Investments Ltd. Before establishing DBSI Investments, Mr. Ben-Shalom had been Executive Vice President and Chief Financial Officer of Koor Industries Ltd. (NYSE: KOR) from 1998 through 2000. Before that, Mr. Ben-Shalom served as Chief Financial Officer of Tadiran Ltd. Mr. Ben Shalom also serves as active chairman of the board of directors of Pointer Telocations Ltd. (Nasdaq Capital Market: PNTR) (formerly known as Nexus Telocation Ltd.), as the chairman of the board of directors of Shagrir Vehicles Systems, as a member of the board of directors of Taldor, a company publicly traded on the Tel Aviv Stock Exchange and as a member of the board of directors of Cimatron Ltd. (Nasdaq: CIMT). Mr. Ben Shalom holds a B.A. in Economics and an MA in Business Management from Tel Aviv University.
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Zehava Simon. Ms. Simon joined our Board in May, 2005. Since 2002, Ms. Simon has served as Chief Executive Officer of BMC Software Israel, Ltd. after having served in various positions at BMC from 2000 to 2002. Prior to her joining BMC, Ms. Simon served as CFO & Operations manager for Intel’s Israeli subsidiaries. Ms. Simon received her B.A. degree from the Hebrew University, Jerusalem in 1981, an M.Sc. in Business Management degree from the joint program of Boston University/Ben Gurion University in 1991 and an LLB from the Interdisciplinary Center, Herzliya in 2003. Ms. Simon qualifies as an independent director under applicable Nasdaq rules.
Yuval Neeman. Mr. Neeman joined our Board in February, 2006.Since 1989 and until recently, Mr. Neeman has been with Microsoft Corporation, most recently, as its Corporate Vice President of Storage and Platform Solutions. Prior to this position, Mr. Neeman served in various other management positions at Microsoft including as its Vice President Engineering Enterprise Storage Division and its Vice President of Developer Division, where he led the development of Microsoft Visual Studio® .NET and Microsoft .NET Framework. Mr. Neeman received his B.Sc. in computer engineering in 1984 and an M.Sc. in Computer Science in 1989, each from the Technion, Israel Institute of Technology, in Haifa, Israel. Mr. Neeman qualifies as an independent director under applicable Nasdaq rules.
B. COMPENSATION
The aggregate compensation paid by us and our subsidiaries to all persons who served in the capacity of director and executive officer for the year ended December 31, 2005 (9 persons) was approximately $513,000 (of which approximately $505,000 have been paid), which amount includes approximately $53,800 set aside or accrued to provide pension, retirement or similar benefits, but does not include amounts expended by us for automobiles made available to our officers, expenses (including business travel, professional and business association dues and expenses) reimbursed to officers and other fringe benefits commonly reimbursed or paid by companies in Israel. Following the approval of the shareholders, beginning as of April 19, 2005 each of the directors, other than the Chairman of the Board, shall receive compensation for their service as directors in the amount of US $10,000 per year and US $400 per in-person board or committee meeting.
During 2005, no persons who served in the capacity of director and executive officer for the year ended December 31, 2005 (9 persons), were granted options to purchase shares.
C. BOARD PRACTICES
Terms of Office
Directors are elected by an ordinary resolution at the Annual General Meeting of our shareholders. All directors of the Company (other than external directors appointed under the Companies Law, who serve for a period of three years after their election (see in this Item 6.C below the paragraph titled “External Directors”)), serve until the next Annual General Meeting, unless their offices are vacated earlier under any relevant provision of our Articles of Association.
We have entered into employment agreements with all of our executive officers similar in form to the agreements entered into with all of our other employees. These agreements are subject to termination by either party, with or without cause, in most cases on either 30 or 60 days’ notice, depending on the agreement. Under these agreements with our Israeli executive officers, we and the employee each contribute a percentage of the salary of the employee to a fund known as “Managers’ Insurance.” This fund provides a combination of savings plan, insurance and severance pay benefits to the employee, giving the employee a lump sum of payment upon retirement and securing severance pay, if legally entitled, upon termination of employment. Each employee who agrees to participate contributes an amount equal to 5% of his or her salary and we contribute between 13.3% and 15.8% of his or her salary. Israeli law generally requires severance pay, which may be funded by Managers’ Insurance, upon the retirement or death of an employee or termination of employment without due cause. These agreements all contain provisions standard for a company in our industry regarding non competition, confidentiality of information and assignment of inventions. The enforceability of covenants not to compete is limited in Israel.
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Alternate Directors
Our Articles of Association provide that a director may appoint, by written notice to us, any individual to serve as an alternate director so long as such individual does not already serve as a director or an alternate director. Any alternate director will have all of the rights and obligations of the director appointing him or her, except the power to appoint an alternate (unless the instrument appointing him or her provides otherwise) and the right to remuneration. The alternate director may not act at any meeting at which the director appointing him or her is present. Unless the appointing director limits the time period or scope of any such appointment, the appointment will be effective for all purposes and for an indefinite time, but will expire upon the expiration of the appointing director’s term. Currently, no alternate directors have been appointed. Under the Israeli Companies Law, (i) a director of a company whose articles of association permit the appointment of an alternate director to the board, may appoint another director as an alternate director to a committee of the board, provided that the alternate director is not already a member of such committee and further provided that if the appointing director is an external director, the alternate director shall posses the financial and accounting expertise or the professional qualification (as described under “External Directors” below) possessed by the appointing director, and (ii) an external director may not appoint an alternate director except as set forth in clause (i).
External Directors
Under the Companies Law, companies incorporated under the laws of Israel whose shares have been offered to the public in or outside of Israel are required to appoint at least two external directors. This law provides that a person may not be appointed as an external director if the person or the person’s relative, partner, employer or any entity under the person’s control, has, as of the date of the person’s appointment to serve as external director, or had, during the two years preceding that date, any affiliation with the company or any entity controlling, controlled by or under common control with the company. The term “affiliation” includes:
| | |
| • | an employment relationship with the company; |
| | |
| • | a business or professional relationship with the company maintained on a regular basis; |
| | |
| • | control of the company; and |
| | |
| • | service as an office holder, except where the director was appointed as such for the purpose of serving as an external director of a company that was contemplating becoming a publicly held company. |
No person may serve as an external director if the person’s position or other business activities create, or may create, a conflict of interest with the person’s responsibilities as an external director or may otherwise interfere with the person’s ability to serve as an out external side director.
External directors are to be elected by a majority vote at a shareholders’ meeting, provided that either:
| | |
| 1. | at least one-third of the shares of non-controlling shareholders voted at the meeting (disregarding votes abstained), vote in favor of election of the director; or |
| | |
| 2. | the total number of shares of non-controlling shareholders voted against the election of the director does not exceed one percent of the aggregate voting rights in the company. |
The initial term of an external director will be three years and may be extended for an additional three years. Each committee of a company’s board of directors will be required to include at least one external director and the audit committee of a company’s board of directors is required to include all of the external directors. We have appointed Yair Shoham and Itsik Onfus as external directors pursuant to the Companies Law.
An external director is entitled to compensation as provided in regulations adopted under the Companies Law and is otherwise prohibited from receiving any other compensation, directly or indirectly, in connection with service provided as an external director.
Under regulations recently promulgated under the Companies Law, at least one of the external directors serving on a company’s board of directors is required to have “financial and accounting expertise” and the other external director or directors are required to have “professional qualification”.
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The recently promulgated regulations set out the conditions and criteria for a director qualifying as having a “financial and accounting expertise” or a “professional qualification”. A director with financial and accounting expertise is a director who, due to his education, experience and skills, possesses capabilities relating to and an understanding of business and accounting matters and financial statements, which enable him to understand in depth the company’s financial statements and to initiate a debate regarding the manner in which the company’s financial information is presented. A director who meets certain professional qualifications is a director who satisfies one of the following requirements: (i) the director holds an academic degree in either economics, business administration, accounting, law or public administration, (ii) the director either holds another academic degree or has obtained other high education in the company’s primary field of business or in an area that is relevant to his position, (iii) the director has at least five (5) years of experience serving in one of the following capacities or an aggregate of at least five (5) years of experience in two or more of the following capacities: (a) a senior business management position of a company with a substantial scope of business, (b) a senior position in the primary field of business of the company or (c) a senior public administration position. A proposed external director must submit to the company a declaration as to his or her compliance with the requirements for his or her election as an external director (including with respect to such person’s financial and according expertise or professional qualification).
The board of directors should determine the minimum number of directors having financial and accounting expertise in addition to the external directors. In determining such number the board of directors shall consider, among other things, the type and size of the company and the scope and complexity of its operations.
Independent Directors
Our Ordinary Shares are listed for quotation on The Nasdaq National Market and thus we are subject to the rules of The Nasdaq National Market applicable to quoted companies as well as to the applicable provisions of the Sarbanes-Oxley Act of 2002 and the rules and regulations thereunder. Under the rules, a majority of the board is required to consist of independent directors. The independence standard under the rules excludes any person who is a current employee of the Company or any subsidiary thereof and any person who has a relationship with the Company that, in the opinion of the board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The standard provides that the following persons will not be considered independent: (i) a director who is, or at any time during the three years prior to his appointment as a director was, employed by the company or by any parent or subsidiary of the company; (ii) a director who accepted or who has a family member who accepted any payments from the company or any parent or subsidiary of the company in excess of $60,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than certain exceptions, (iii) a director who is a family member of an individual who is, or at any time during the three years preceding the determination of independence was, employed by the company or by any parent or subsidiary of the company as an executive officer; (iv) a director who is, or has a family member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the preceding three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than certain exceptions, (v) a director who is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the listed company served on the compensation committee of such other entity or (vi) a director who is, or has a family member who is, a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during any of the past three years. Messrs. Onfus, Shoham and Yuval Neeman, Dr. Wagner and Ms. Simon serve as independent directors and meet the independence standard of the above rules.
Audit Committee
Under the Companies Law, the board of directors of any publicly traded company must appoint an audit committee, comprised of at least three directors including all of the external directors but excluding: (a) the chairman of the board of directors; (b) any controlling shareholder or relative of a controlling shareholder; or (c) any director employed by the company or who provides services to the company on a regular basis. Under the Nasdaq rules, we are required to have at least three independent directors on the audit committee. In addition, Nasdaq requires that the each member of the audit committee (i) be independent (as defined above under “Independent Directors”); (ii) meet the criteria for independence set forth in certain rules under the US Securities Exchange Act of 1934 (subject to certain exemptions); (iii) not have participated in the preparation of the financial statements of the company or any current subsidiary of the company at any time during the past three years; and (iv) be able to read and understand fundamental financial statements, including a company’s balance sheet, income statement and cash flow statement. Additionally, each company must certify that it has, and will continue to have, at least one member of the audit committee who has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities.
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The roles of our audit committee under the Companies Law include identifying irregularities in the management of the Company’s business and approving related party transactions as required by law. The responsibilities of the audit committee under the Nasdaq rules include, among other things, evaluating the independence of a company’s outside auditors.
In addition to such functions as the audit committee may have under the Companies Law or under the Nasdaq rules, the primary purpose of our audit committee is to assist the board of directors in fulfilling its responsibility to oversee management’s conduct of the financial reporting process, the systems of internal accounting and financial controls and the annual independent audit of the Company’s financial statements. The audit committee reviews with management and our outside auditors the audited financial statements included in our Annual Report on Form 20-F and our interim quarterly financial results included on Form 6-K.
The audit committee must observe the independence of our outside auditors and has the authority and responsibility to nominate for shareholder approval, evaluate and, where appropriate, replace our outside auditors.
In discharging its oversight role, our audit committee is empowered to investigate any matter brought to its attention with full access to all books, records, facilities and personnel of the Company and the power to retain outside counsel, auditors or other experts for this purpose.
Our audit committee currently consists of Zehava Simon, Itsik Onfus and Yair Shoham. Itsik Onfus possesses past employment experience in finance or accounting, requisite professional certification in accounting or other comparable experience or background, as required under the Nasdaq rules.
Financial Expert
Under Sarbanes-Oxley, one of the Audit Committee members must have accounting or related financial management expertise. Our Board of Directors has recognized Mr. Onfus, based on all of the requirements set forth in the applicable rules and regulations, as our “financial expert” and we believe that we are in compliance with this requirement.
Internal Auditor
Under the Companies Law, the board of directors of a public company must appoint an internal auditor, nominated by its audit committee. The role of the internal auditor is to examine, among other matters, whether the Company’s actions comply with the law and orderly business procedure. Under the Companies Law, the internal auditor may be an employee of the Company but not an office holder, an affiliate, or a relative of an office holder or affiliate, and he may not be the Company’s independent accountant or its representative. We have appointed an internal auditor in accordance with the requirements of the Companies Law.
D. EMPLOYEES
As of December 31, 2003, 2004 and 2005, we had 362, 513 and 822 employees, respectively, of which for 2005, such number includes 88 employees in administration and finance, 224 in sales and marketing, 371 in research and development and 139 in operations. Of these 822 employees, 550 were based in Israel, 140 in Spain, 57 in the United States and 75 in other countries.
We are subject to Israeli labor laws and regulations with respect to our Israeli employees. These laws principally concern matters such as paid annual vacation, paid sick days, length of the workday and work week, minimum wages, pay for overtime, insurance for work-related accidents, severance pay and other conditions of employment.
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Furthermore, by order of the Israeli Ministry of Labor and Welfare, we and our Israeli employees are subject to provision of the collective bargaining agreements between the Histadrut, the General Federation of Labor in Israel and the Coordination Bureau of Economic Organizations, including the Industrialists Associations. These provisions principally concern cost of living increases, recreation pay and other conditions of employment. We believe that the benefits and working conditions that we provide to our employees are above the required minimum. Our employees are not represented by a labor union. We have written employment contracts with virtually all of our employees and we believe that our relations with our employees are satisfactory.
E. SHARE OWNERSHIP
As of June 15, 2006, the aggregate number of our Ordinary Shares beneficially owned by our directors and executive officers as a group was 3,505,485, and includes options to purchase up to 443,065 Ordinary Shares which are exercisable or will become exercisable within 60 days of June 15, 2006. The weighted average exercise price of these options was $ 8.13 per share.
Other than those individual directors and executive officers listed in the table below, all of our directors and executive officers listed in Item 6.B above beneficially own less than one percent of our Ordinary Shares as of June 15, 2006. The percentages set forth below are based on 38,077,551 shares issued and outstanding as of June 15, 2006:
| | | | | | | | |
| | | Ordinary Shares
beneficially owned1 | |
| Name | | Number | | Percent | |
|
| |
| |
| |
| Dov Moran (1) | | | 2,319,792 | | | 6.06 | % |
| | | | | | | | |
| Hans Wagner (2) | | | 697,312 | | | 1.83 | % |
| | | | | | | | |
1. Includes options to purchase 176,250 shares, which are exercisable within 60 days of June 15, 2006.2. Includes options to purchase 90,312 shares, which are exercisable within 60 days of June 15, 2006.
Share Option Plans and Recent Changes in Israeli Law
The Company previously had two incentive share option plans in place, the Incentive and Restricted Share Option Plan (the “IRSO Plan”) and the Section 102 Share Option Plan (the “102 Plan” and, together with the IRSO Plan, the “Old Plans”). The respective term of each of the Old Plans expired on February 15th, 2003.
In replacement of the Old Plans and in lieu of recent revisions (the “Tax Reform”) to the Israeli Income Tax Ordinance (New Version) 1961 (the “Tax Ordinance”) requiring the adoption of certain adjustments concerning the issuance of share options to Israeli employees, the Company adopted, by way of a resolution of the Board of Directors on November 5th, 2002 and a resolution of the shareholders of the Company on December 17th, 2002, its new omnibus 2003 Stock Option and Restricted Stock Incentive Plan (the “New 2003 Plan”). Following is a brief review of each of the New 2003 Plan and the Tax Reform:
The New 2003 Plan
Under the New 2003 Plan, the Company has reserved eight million (8,000,000) Ordinary Shares for the grant of awards to the employees, officers, directors, service providers and consultants of the Company and of any subsidiary of the Company. Of this amount, five million (5,000,000) Ordinary Shares were reserved for issuance with the adoption of the New 2003 Plan by the shareholders of the Company on the December 17, 2003 Annual General Meeting of Shareholders and the number of Ordinary Shares reserved for issuance was increased by an additional three million (3,000,000) Ordinary Shares following approval by the shareholders of the Company on November 11, 2004. The New 2003 Plan is intended to enable the Company to issue awards under varying tax regimes, including without limitation (i) pursuant and subject to the provisions of the Tax Ordinance; (ii) incentive stock options within the meaning of Section 422 of the Code; (iii) nonqualified stock options; (iv) restricted shares; (v) capped SARs (as described below) and (vi) other share-based awards. Apart from issuance under the relevant tax regimes in the State of Israel and the United States of America, the New 2003 Plan contemplates issuances of awards in other jurisdictions, with respect to which the Board of Directors is empowered to make the requisite adjustments in the New 2003 Plan and set forth the relevant conditions in the Company’s agreement with the grantee in order to comply with the requirements of the tax regimes in any such jurisdictions.
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Awards may be granted pursuant to the New 2003 Plan from time to time within a period of ten (10) years from the date the New 2003 Plan was adopted by the Board of Directors. The exercise prices of options granted under the New 2003 Plan is to be determined, subject to applicable law, by the Board of Directors at the time of the grant, and such granted options usually expire no later than ten years from the date of grant. Any of the Ordinary Shares reserved under the New 2003 Plan, which may remain unsold and which are not subject to outstanding options at the termination of the New 2003 Plan, shall cease to be reserved for the purpose of the New 2003 Plan.
The capped SARs are similar to traditional options, except that instead of representing the right to receive shares by payment of the exercise price, each SAR represents the right to receive shares equal in value to the difference between the market price of an Ordinary Share on the exercise date less the exercise price of the SAR. Each SAR has a cap, and if the market price exceeds this cap on the date of exercise, the payment to the holder is equal to the cap less the exercise price. Like options, the SARs have a vesting schedule, and may not be exercised prior to vesting.
If any outstanding award under the New 2003 Plan should, for any reason, expire, be canceled or be forfeited without having been exercised in full, the Ordinary Shares allocable to the unexercised, canceled or terminated portion of such award shall (unless the New 2003 Plan shall have been terminated) become available for subsequent grants of awards under the New 2003 Plan.
Aggregate Amounts of Outstanding Options
As of June 15, 2006, we had outstanding options for 5,667,171 Ordinary Shares at an average exercise price of $ 19.82 per Ordinary Share, and with expiration dates ranging from August 2003 to May 2016.
Revisions to the Tax Ordinance
The Tax Reform created a new tax structure for taxing stock or stock options that the Company grants to its Israeli employees, while the existing tax structure will continue to apply to the issuance of options to external service providers and to the controlling owners of the Company, who are not considered to be ‘employees’ of the Company for the purposes of Section 102 of the Tax Ordinance. As a general rule, a company can choose to issue options or shares through a trustee or without a trustee. If such company chooses the trustee track, it must further opt for either the ‘ordinary income track’ or the ‘capital gains track’ and this decision is then binding on the company and on all similarly situated office-holders for the subsequent two years.
We have chosen to issue shares and options through a trustee, who has been authorized by the tax authorities in accordance with and for the period set by law and, as a result, neither the issuance of shares or options to those of our eligible employees, nor the exercise by such employees of their options, will be taxable. The tax will be imposed only when the shares are sold by the trustee or transferred to the employee, whichever is earlier. We have notified the tax authorities of our opting for the ‘capital gains track’ in accordance with the requirements of the Tax Ordinance.
As a result of our choosing the ‘capital gains track,’ in the event that the trustee holds the shares until the end of the required holding period, which is at least 2 years from the end of the tax year in which the shares or options were issued to the trustee and for issuance as of 2006 the required holding period was revised to 2 years from the issuance of the shares or options (as applicable), the value of the benefit to the employee will be considered to be capital gain and he or she will be taxed at a rate of 25%. In addition, we will not be able to deduct expenses for tax purposes. As our Ordinary Shares are registered on a stock exchange, a part of the profit that reflects the value of the benefit to the date of issuance will be considered as ordinary income by the employee and we will be able to deduct this as a salary expense, with the balance being deemed as capital gains and taxable at 25% which we will not be able to deduct as an expense. Had we chosen the ‘ordinary income (employment income) track’, the employee would have been considered as having received employment income in an amount equal to the benefit (consideration at date of sale, less share option exercise price and expenses from the purchase and sale). We would then have been entitled to deduct as a salary expense, the same amount as the employee would have received in income. The required holding period by the trustee under the ‘ordinary income (employment income) track’ is one year from the end of the tax year in which the options or shares were issued to the employee.
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The Employee Stock Purchase Plan – Global Non-U.S. (the “Global ESPP plan”); and the Employee Stock Purchase Plan – U.S. (the “U.S. ESPP plan”)
The purpose of the ESPP plans was to enable our employees to purchase msystems’ shares through accumulated payroll deductions. The Global ESPP plan was available to all of our non-U.S. employees. The U.S. ESPP plan was available to our U.S. employees and contains certain provisions intended to qualify the U.S. ESPP plan as an “employee stock purchase plan” under Section 423 of the Code.
The terms of our ESPP plans (both Global and U.S.) provided that any of our employees (with certain restrictions in the U.S. ESPP Plan), if he or she so chooses, was able to elect before any “Offering Period” to have any whole percentage between 1% and 10% deducted from his salary and allocated to buy msystems shares. An “Offering Period” was a six-month period, with a new Offering Period beginning on May 15 and November 15 each year (unless changed by the Board of Directors). The price of the shares purchased by the employee – i.e., the number of shares that he was to receive in return for the amounts deducted from his salary over the six-month Offering Period – was determined at the end of the Offering Period and was equal to the lower of 85% of the closing bid for of msystems’ shares on (1) the first day of the Offering Period; or (2) the last day of the Offering Period.
The ESPP plans were terminated by our Board of Directors effective November 15, 2005.
ITEM 7. MAJOR SHAREHOLDERS AND INTERESTED PARTY TRANSACTIONS
A. MAJOR SHAREHOLDERS
The following table sets forth the number of Ordinary Shares owned beneficially by all shareholders known to us to own beneficially more than 5% of the outstanding Ordinary Shares on June 15, 2006. The percentages set forth below are based on 38,077,551 shares issued and outstanding as of June 15, 2006:
| | | | | | | |
| | Ordinary Shares
beneficially owned | |
Name | | Number | | Percent | |
| |
| |
| |
Dov Moran * | | | 2,319792 | | | 6.06 | % |
Eastbourne Capital Management LLC(1) | | | 3,460,994 | | | 9.39 | % |
All directors and executive officers as a group (10 persons)(2) | | | 3,505,485 | | | 9.10 | % |
The following table lists the significant changes in the percentage ownership held by any major shareholders during the past three years:
| | | | |
Name of Significant Shareholder | | Effect of Change | | Year of Change |
| |
| |
|
Federated Investors, Inc. (Asset Management)(1) | | decreased its shareholdings beneath 5% | | 2004 |
| | | | |
RS Investment Management LP(1) | | decreased its shareholdings beneath 5% | | 2005 |
| | | | |
Eastbourne Capital Management LLC(1) | | increased its shareholdings beyond 5% | | 2005 |
| | | | |
Massachusetts Financial Services Company(1) | | increased its shareholdings beyond 5% | | 2005 |
| decreased its shareholdings beneath 5% | | 2005 |
| | | | |
Federated Investors, Inc. (Asset Management)(1) | | increased its shareholdings beyond 5% | | 2004 |
| | | | |
Fidelity Investments(1) | | increased its shareholdings beyond 5% | | 2003 |
| | decreased its shareholdings beneath 5% | | 2004 |
| | | | |
Viking Global Investors LP(1) | | increased its shareholdings beyond 5% | | 2004 |
| | decreased its shareholdings beneath 5% | | 2004 |
| | |
| * | Includes options to purchase 176,250 shares, which are exercisable within 60 days of June 15, 2006. |
| | |
| (1) | Numbers and percentages are based on information provided to the Company from outside sources. We are unable to give accurate percentages of each entity’s holdings. |
| | |
| (2) | Includes options to purchase 443,065 shares, which are exercisable within 60 days of June 15, 2006. |
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Our shareholders do not have different voting rights.
As of June 15, 2006, our Ordinary Shares were held by approximately 74 holders of record. Based on a review of the information provided to us by our transfer agent, 59 holders of record, holding approximately 82.4% of our outstanding Ordinary Shares, were residents of the United States.
B. RELATED PARTY TRANSACTIONS
Insurance. We have obtained directors and officers liability insurance for the benefit of our office holders and intend to continue and obtain such insurance and pay all premiums thereunder to the fullest extent permitted by the Companies Law. Under the Companies Law, an Israeli company may not exempt an office holder from liability for a breach of his duty of loyalty, but may exempt in advance an office holder from his liability to the company, in whole or in part, for a breach of his duty of care.
Our Articles of Association provide that, subject to the provisions of the Companies Law, we may enter into a contract for the insurance of the liability of any of our office holders for acts which he or she performed in his or her capacity as an office holder in relation to:
| | |
| • | a breach of his/her duty of care to us or to another person; |
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| • | a breach of his/her duty of loyalty to us, provided that the office holder acted in good faith and had reasonable cause to assume that his/her act would not prejudice our interests; or |
| | |
| • | a financial liability imposed upon him/her in favor of another person. |
| | |
Indemnification of Office Holders. Our Articles of Association provide that we may indemnify an office holder against: |
|
| • | a financial liability imposed on an office holder in favor of another person by any judgment, including a judgment given as a result of a settlement or an arbitrator’s award which has been confirmed by a court in respect of an act performed by the office holder; |
| | |
| • | reasonable litigation expenses, including attorneys’ fees, expended by the Office Holder as a result of an investigation or proceeding instituted against him or her by an authority authorized to conduct such investigation or proceeding, provided that (i) no indictment (as defined in the Companies Law) was filed against such Office Holder as a result of such investigation or proceeding; and (ii) no financial liability as a substitute for the criminal proceeding (as defined in the Companies Law) was imposed upon him or her as a result of such investigation or proceeding or if such financial liability was imposed, it was imposed with respect to an offence that does not require proof of criminal intent; and |
| | |
| • | reasonable litigation costs, including attorney’s fees, expended by an Office Holder or which were imposed on an Office Holder by a court in proceedings filed against the Office Holder by the Company or in its name or by any other person or in a criminal charge in respect of which the Office Holder was acquitted or in a criminal charge in respect of which the Office Holder was convicted for an offence which did not require proof of criminal intent. |
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| | |
Our Articles of Association also include: |
|
| • | authorization to undertake, in advance, to indemnify an office holder, provided that the undertaking is limited to specified events which the board of directors believes are anticipated and limited in amount determined by the board of directors to be reasonable under the circumstances; and |
| | |
| • | authorization to indemnify retroactively an office holder. |
We have agreed to indemnify our office holders under indemnification agreements with each office holder, to the maximum extent permitted under the Companies Law.
Engagement Terms with Yossi Ben Shalom. In December 2005 our audit committee and Board of Directors approved the terms of Mr. Ben Shalom’s engagement with the Company, subject to the approval of our shareholders. If approved by the shareholders, in consideration for the services provided by Mr. Ben Shalom, he will receive NIS 12,500 per month and a grant of an option to purchase 10,000 ordinary shares of our company.
C. INTEREST OF EXPERT AND COUNSEL
–Not applicable
ITEM 8. FINANCIAL INFORMATION
A. CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION
Our consolidated audited financial statements are included in this annual report in Item 18 “Financial Statements.”
Legal Proceedings
Other than the litigation set forth below, we are not involved in any legal proceedings that we believe, individually or in the aggregate, will have a material adverse effect on the Company:
Trek
msystems and a number of its distributors in Singapore are in litigation with Trek Technology (Singapore) Pte Ltd. a company registered in Singapore (“Trek”). In April 2002, Trek received a patent in Singapore for a “Portable Data Storage Device”. Trek immediately issued ‘Cease and Desist’ letters to several companies, including msystems’ distributors in Singapore alleging that msystems’ mDrive product infringed its patent. msystems asked Trek to withdraw its letters and was refused. Consequently, On May 17th, 2002 msystems filed a lawsuit against Trek for groundless threats and on May 20th, 2002 Trek filed a lawsuit against msystems’ distributors (and later msystems itself) for patent infringement. msystems is under a contractual obligation to indemnify these distributors and we represent them in the pending litigation.
On May 12, 2005, a court in Singapore ruled in favor of Trek. On November 11, 2005, the Court of Appeal of Singapore confirmed the lower court’s ruling. The matter is currently before the court to determine the amount of damages, both for legal costs and compensatory damages, which are to be awarded to Trek. We have made a provision for this litigation based on current estimates provided by our external legal counsel.
Former Employee Claim
On May 7, 2006, a former employee filed a lawsuit against us in Israel claiming that we had breached an undertaking to him to establish a jointly-held company with him, which would be the owner of certain intellectual property rights, in the development of which he claims to have participated during his employment with us. This employee had previously filed a similar lawsuit against us in labor court, which was dismissed due to lack of jurisdiction. The Company filed a statement of defense on July 16, 2006. We believe that we have meritorious defenses to the claims and we intend to contest the former employee’s claims vigorously. However, we cannot at this time determine what the outcome of this litigation will be, and if we do not prevail our results of operations may be adversely affected.
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Dividend Distribution Policy
We have never declared or paid any cash dividends on our Ordinary Shares and we do not intend to pay cash dividends on our Ordinary Shares in the foreseeable future. We currently intend to retain all future earnings to finance operations and to expand our business.
Under the provisions of our Articles of Association, the declaration of any final cash dividends in respect of any fiscal period requires shareholder approval, which may reduce but not increase such dividend from the amount proposed by our board of directors; provided that any failure by the shareholders to approve a final dividend will not affect any interim dividend which has been paid. Payments of dividends may be subject to withholding and other taxes.
If we declare cash dividends, they could be taxable to the recipient. Because we have received benefits under the Investment Law (see item 10.E below the paragraph titled “Law for the Encouragement of Capital Investments, 1959”), payment of cash dividends during the exemption period granted under the Investment Law will subject that portion of our income derived from the ‘approved enterprise’ status granted to us under the Investment Law, to Israeli taxes to which the income would not otherwise be subject. We have decided to reinvest permanently the amount of tax-exempt income derived from our approved enterprises and not to distribute such income as dividends. In the event that we decide to pay a cash dividend from income that is tax exempt, we would be liable for corporate tax on the amount distributed at the rate of 20%. Cash dividends may be paid by an Israeli company only out of retained earnings as calculated under Israeli law.
B. SIGNIFICANT CHANGES
–None other than disclosed in this report.
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ITEM 9. THE OFFER AND LISTING
A. OFFER AND LISTING DETAILS
The following table lists the high and low last reported sales prices on Nasdaq for the periods indicated
| | | | | | | |
Yearly Figures | | | | | | | |
|
| | High | | Low | |
| |
|
|
| |
| | | | | | | |
2001 | | $ | 16.56 | | $ | 3.92 | |
2002 | | $ | 12.59 | | $ | 4.95 | |
2003 | | $ | 22.49 | | $ | 5.20 | |
2004 | | $ | 23.15 | | $ | 11.50 | |
2005 | | $ | 34.89 | | $ | 18.49 | |
| | | | | | | |
Quarterly Figures | | | | | | | |
| | | | | | | |
| | High | | Low | |
| |
|
|
| |
2004: | | | | | | | |
First Quarter | | $ | 22.00 | | $ | 16.86 | |
Second Quarter | | $ | 23.15 | | $ | 13.55 | |
Third Quarter | | $ | 16.50 | | $ | 11.50 | |
Fourth Quarter | | $ | 19.99 | | $ | 13.85 | |
| | | | | | | |
2005: | | | | | | | |
First Quarter | | $ | 26.18 | | $ | 18.49 | |
Second Quarter | | $ | 23.99 | | $ | 18.64 | |
Third Quarter | | $ | 30.39 | | $ | 18.90 | |
Fourth Quarter | | $ | 34.89 | | $ | 27.40 | |
| | | | | | | |
2006: | | | | | | | |
First Quarter | | $ | 37.16 | | $ | 24.72 | |
Second Quarter | | $ | 37. 60 | | $ | 25.34 | |
| | | | | | | |
Monthly Figures | | | | | | | |
| | | | | | | |
| | High | | Low | |
| |
|
|
| |
2006: | | | | | | | |
Most Recent 6 months: | | | | | | | |
| | | | | | | |
January 2006 | | $ | 37.16 | | $ | 27.82 | |
February 2006 | | $ | 29.34 | | $ | 25.40 | |
March 2006 | | $ | 27.75 | | $ | 24.72 | |
April 2006 | | $ | 35.00 | | $ | 25.34 | |
May 2006 | | $ | 37.60 | | $ | 32.32 | |
June 2006 | | $ | 30.67 | | $ | 26.67 | |
| | | | | | | |
Closing Price on first trading
day of each of most recent six
months: | | | | | | | |
February 1, 2006 | | $ | 28.75 | | | | |
March 1, 2006 | | $ | 27.42 | | | | |
April 1, 2006 | | $ | 25.86 | | | | |
May 1, 2006 | | $ | 33.29 | | | | |
June 1, 2006 | | $ | 28.90 | | | | |
July 1, 2006 | | $ | 29.63 | | | | |
On July 14, 2006, the last reported sale price of our Ordinary Shares was $ 25.13 per share. There is currently no trading market for our Ordinary Shares outside the United States.
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B. PLAN OF DISTRIBUTION
–Not applicable
C. MARKETS
Our Ordinary Shares were quoted on The Nasdaq Capital Market (under its former name, Nasdaq Small-Cap Market) under the symbol “FLSHF” from our initial public offering in March 1993 through our secondary public offering in August 1996. Since August 8, 1996, our Ordinary Shares have been quoted on The Nasdaq National Market. On March 24, 1999, our ticker symbol was changed to “FLSH.”
D. SELLING SHAREHOLDERS
–Not applicable
E. DILUTION
– Not applicable
F. EXPENSES OF ISSUE
–Not applicable
| |
ITEM 10. ADDITIONAL INFORMATION |
A. SHARE CAPITAL
–Not applicable
B. MEMORANDUM AND ARTICLES OF ASSOCIATION
Objects and Purposes
The objects and purposes of our Company appear in our Memorandum of Association and include taking all actions permissible under applicable laws.
Approval of Specified Related Party Transactions
The Companies Law imposes a duty of care and a duty of loyalty on all of a company’s office holders as defined below, including directors and executive officers. The duty of care requires an office holder to act with the level of care that a reasonable office holder in the same position would have acted under the same circumstances. The duty of loyalty generally requires an office holder to act in good faith and for the good of the company. An “office holder” as defined in the Companies Law is a director, a general manager, a chief executive officer, a deputy general manager, a vice general manager, other managers directly subordinate to the general manager and any person who fills one of the above positions without regard to title.
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The Companies Law requires that an office holder of a company promptly disclose any personal interest that he may have and all related material information known to him, in connection with any existing or proposed transaction by the company. Once an office holder complies with these disclosure requirements, the board of directors may approve a transaction between the company and the office holder, or a third party in which an office holder has a personal interest, unless the articles of association provide otherwise. A transaction that is adverse to the company’s interest cannot be approved. If the transaction is an extraordinary transaction under the Companies Law, then, in addition to any approval stipulated by the articles of association, it also requires audit committee approval before board approval and, in specified circumstances, subsequent shareholder approval. Any transaction between a company and one of its directors relating to the conditions of the director’s service, including in relation to exculpation, insurance or indemnification, or in relation to the terms of the director’s service in any other capacity requires audit committee approval before board approval and subsequent shareholder approval.
The Companies Law also provides that a director with an interest in an extraordinary transaction brought before the board of directors or the audit committee for its approval may not vote on the approval and may not be present for the discussion of the issue. However, this rule does not apply if a majority of the directors or a majority of the members of the audit committee also possessed an interest in the transaction, in which case the transaction is subject to shareholders approval.
Under our Articles of Association, our Board of Directors may exercise all powers and take all actions that are not required under law or under our Articles of Association to be exercised or taken by our shareholders, including the power to borrow money for the purposes of our Company.
Our directors are not subject to any age limit requirement, nor are they disqualified from serving on the Board of Directors because of a failure to own certain amount of our shares.
Rights, Preferences and Restrictions on Shares
Our Articles of Association authorize one class of shares, which are our Ordinary Shares. We may declare a dividend to be paid to the holders of our Ordinary Shares and allocated among them in proportion to the sums paid up or credited as paid up on account of the nominal value of their respective shareholdings, without taking into account any premium paid for the shares. Our Board of Directors may declare dividends only out of retained earnings, or earnings derived over the two most recent fiscal years, whichever is higher. Our Articles of Association provide that our Board of Directors may propose a final dividend in respect of any fiscal period but that such dividend shall be payable only after approved by our shareholders. All unclaimed dividends may be invested or otherwise used by the Board of Directors for our benefit until those dividends are claimed. In the event an unclaimed dividend is claimed, only the principal amount of the dividend will be paid to the person entitled to the dividend.
If we liquidate, after satisfying liabilities to creditors and subject to the rights of holders of shares, if any, with any special rights upon winding up, our assets will be distributed to the holders of Ordinary Shares in proportion to their holdings.
Holders of Ordinary Shares have one vote for each paid-up Ordinary Share held of record on all matters submitted to a vote of our shareholders. These voting rights may be affected by the grant of any special voting rights to the holders of a class of shares with preferential rights that may be authorized in the future.
Our Articles of Association provide that directors are elected by an ordinary resolution of a general meeting of our shareholders. Our Ordinary Shares do not have cumulative voting rights in the election of directors. Accordingly, the holders of Ordinary Shares representing more than 50% of the voting power in our Company have the power to elect all directors.
We may, subject to the applicable provisions of the Companies Law, issue redeemable shares and subsequently redeem them. In addition, our Board of Directors may make calls for upon shareholders in respect of any sum that has not been paid up in respect of any shares held by those shareholders.
Under the Companies Law, the disclosure requirements that apply to an office holder also apply to a controlling shareholder of a public company. A controlling shareholder includes a shareholder that holds 25% or more of the voting rights in a public company if no other shareholder owns more than 50% of the voting rights in the company. Extraordinary transactions with a controlling shareholder or in which a controlling shareholder has a personal interest, and the terms of compensation of a controlling shareholder who is an office holder, require the approval of the audit committee, the board of directors and the shareholders of the company. The shareholder approval requires that: (a) the majority of shares voted at the meeting, including at least one third of the shares of disinterested shareholders voted at the meeting (disregarding votes abstained), vote in favor of the transaction; or (b) the total number of shares of disinterested shareholders voted against the transaction does not exceed one percent of the aggregate voting rights in the company.
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The Companies Law also requires a shareholder to act in good faith towards a company in which he holds shares and towards other shareholders and to refrain from abusing his power in the company, including in connection with voting at a shareholders’ meeting on:
| | |
| • | Any amendment to the Articles of Association; |
| | |
| • | An increase in the company’s authorized capital; |
| | |
| • | A merger; or |
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| • | Approval of some of the acts and transactions that require shareholder approval. |
A shareholder has the general duty to refrain from depriving other shareholders of their rights. Any controlling shareholder, any shareholder that knows that it possesses the power to determine the outcome of a shareholder vote and any shareholder that, under the provisions of the articles of association, has the power to appoint an office holder in the company, is under a duty to act in fairness towards the company. The Companies Law does not describe the substance of this duty, except to state that the remedies generally available upon a breach of contract will apply also in the event of a breach of the duty to act with fairness.
Modifications of Share Rights
Under our Articles of Association, the rights attached to any class may be varied by adoption of the necessary amendment of the Company’s Articles of Association, provided that the holders of shares of the affected class approve the change by a class meeting in which the holders of at least 75% of the shareholders present at the meeting, in person or by proxy, and voting on the issue approve the change. Our Articles of Association differ from the Companies Law in this respect, as under the law changes in the rights of shareholders require the consent of at least 50% of the voting power of the affected class represented at the meeting and voting on the change. Our Articles of Association require for quorum at a meeting of a particular class of shares the presence of two shareholders holding at least 25% of the voting power of that class. Our Articles of Association - may be amended by majority of the voting power of our Company represented at a shareholders meeting and voting thereon, except that the provisions of our Articles of Association relating to mergers and acquisitions can only be amended by a vote of 75% of the voting power of our Company represented at a meeting and voting thereon.
Shareholders Meetings and Resolutions
We are required to hold an annual general meeting of our shareholders once every calendar year, but no later than 15 months after the date of the previous annual general meeting. All meetings other than the annual general meeting of shareholders are referred to as extraordinary general meetings. Our Board of Directors may call extraordinary general meetings whenever it sees fit, at such time and place, within or without the State of Israel, as it may be determined. In addition, the Companies Law provides that the board of directors of a public company is required to convene an extraordinary meeting upon the request of (a) any two directors of the company or one quarter of the company’s board of directors or (b) one or more shareholders holding, in the aggregate, (i) five percent of the outstanding shares of the company and one percent of the voting power in the company or (ii) five percent of the voting power in the company.
The quorum required by our Articles of Association for a meeting of shareholders consists of at least two shareholders present in person or by proxy who hold or represent between them at least 25% of the voting power in our Company. This percentage requirement complies with the Companies Law; however, it differs from the Nasdaq requirement of 33%. Nasdaq rules enable foreign private issuers, such as ourselves, to comply with the law of our jurisdiction of incorporation in place of certain Nasdaq listing requirement. A meeting adjourned for lack of quorum is adjourned to the same day in the following week at the same time and place or any time and place as the chairman of the meeting decides. At such reconvened meeting, the required quorum consists of any two shareholders present in person or by proxy.
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Our Articles of Association enable our Board of Directors to fix a record date to allow us to determine the shareholders entitled to notice of, or to vote at, any general meeting of our shareholders. The record date may not be more than 40 days, or any longer period permitted under the Companies Law, nor less than 4 days before the date of the meeting. Each shareholder of record as of the record date determined by the Board of Directors may vote the shares then held by that shareholder unless all calls and other sums then payable by the shareholder in respect of its shares have not been paid.
Limitation on Ownership of Securities
The ownership and voting of our Ordinary Shares by non-residents of Israel are not restricted in any way by our Articles of Association or by the laws of the State of Israel, except for shareholders who are subjects of countries which are enemies of the State of Israel.
Mergers and Acquisitions; Anti-takeover Provisions
The Companies Law includes provisions allowing corporate mergers. These provisions require that the board of directors of each company that is party to the merger approve the transaction. In addition, the shareholders of each company must approve the merger. Our Articles of Association require approval of a merger or acquisition by a vote of the 75% of our Company’s voting power, present and voting on the proposed merger at a shareholders’ meeting. In determining whether the requisite majority has approved the merger, shares held by the other party to the merger or by any person holding at least 25% of such other party are excluded from the vote. The Companies Law does not require court approval of a merger other than in specified situations. However, upon the request of a creditor of either party to the proposed merger, a court may delay or prevent the merger if it concludes that there exists a reasonable concern that as a result of the merger, the surviving company will be unable to satisfy the obligations of any of the parties of the merger to their creditors.
A merger may not be completed until at least 50 days have passed from the time that a merger proposal was filed with the Israeli Registrar of Companies and 30 days have passed from the shareholders’ approval of the merger in each of the merging companies.
The Companies Law also provides that the acquisition of shares in a public company on the open market (i.e., from other shareholders of the company) must be made by means of a tender offer if, as a result of the acquisition, the purchaser would become a 25% shareholder of the company. The rule does not apply if there already is another 25% shareholder of the company. Similarly, the law provides that an acquisition of shares in a public company must be made by means of a tender offer if, as a result of the acquisition, the purchaser would become a 45% shareholder of the company, unless there already is another 45% shareholder of the company.
If, following any acquisition of shares, the purchaser would hold 90% or more of the shares of the company that acquisition must be made by means of a tender offer for all of the target company’s shares. An acquirer who wishes to eliminate all minority shareholders must do so by means of a tender offer and acquire 95% of all shares not held by or for the benefit of the acquirer prior to the acquisition. However, in the event that the tender offer to acquire that 95% is not successful, the acquirer may not acquire tendered shares if by doing so the acquirer would own more than 90% of the shares of the target company.
Changes in Capital
Our Articles of Association enable us to increase or reduce our share capital. Any such changes are subject to the provisions of the Companies Law and must be approved by a resolution passed by a majority of the voting power of our Company present, in person or by proxy, at a general meeting and voting on such change in the capital. In addition, certain transactions, which have the effect of reducing capital, such as the declaration and payment of dividends under certain conditions and the issuance of shares for less than their nominal value, require a resolution of the Board of Directors and court approval.
C. MATERIAL CONTRACTS
On March 23, 2005, we completed an offering of our Convertible Notes which provided net proceeds for us of approximately $ 72.75 million. The interest rate, conversion rate and offering price were pursuant to the Purchase Agreement between M-Systems Finance, msystems and the initial purchasers of the Convertible Notes and the Senior Indenture between M-Systems Finance, msystems and The Bank of New York Trust Company, N.A., as trustee. The Purchase Agreement provides that obligations of M-Systems Finance under the Purchase Agreement are unconditionally guaranteed by msystems. M-Systems Finance issued the notes under the Senior Indenture. The terms for registering the Convertible Notes and the ordinary shares issuable upon conversion of the Convertible Notes with the SEC are covered by the Registration Rights Agreement.
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In August 2005, we entered into cooperation agreements with Hynix in order to secure guaranteed capacity and favorable purchasing terms for flash memory components from Hynix. Under these agreements, we agreed to purchase and place at Hynix’s manufacturing facility $100 million worth of semiconductor manufacturing equipment in return for guaranteed capacity, favorable purchasing terms for flash memory components and the receipt of an aggregate of up to $100 million in credits (the price for the purchased equipment) on wafers that we purchase from Hynix over the six year term of the agreement, subject to certain conditions. As of March 31, 2006, we had completed the purchase and placement in Hynix’s facilities of the equipment, and we began to receive credits on wafers we purchased from Hynix in the first quarter of 2006.
In November 2005, we acquired Microelectronica Espanola, a European SIM card manufacturer, for approximately $75.0 million in cash, including acquisition related costs (or approximately $40.5 million net of working capital acquired in the transaction). Microelectronica Espanola designs, manufactures and markets SIM cards to mobile network operators, primarily in Spain and Latin America. The acquisition expands our technology, security, know-how, manufacturing capabilities and geographical reach for the mobile market. Further, the acquisition provides us with sales channels and a customer base to assist in accelerating sales of mSIM MegaSIM and flash memory cards for mobile handsets.
Other than the agreements referred to above, in the past two years we have not entered into any material contracts other than contracts entered into in the ordinary course of our business.
D. EXCHANGE CONTROLS
Holders of Ordinary Shares are able to convert dividends and liquidation distributions into freely repatriable non-Israeli currencies at the rate of exchange prevailing at the time of repatriation, pursuant to a general permit issued by the Controller of Foreign Exchange at the Bank of Israel under the Currency Control Law, 1978, provided that Israeli income tax has been withheld by us with respect to such amounts.
Our Ordinary Shares may be freely held and traded pursuant to the General Permit and the Currency Control Law. The ownership or voting of Ordinary Shares by non-residents of Israel, except with respect to citizens of countries that are in a state of war with Israel, are not restricted in any way by our Memorandum of Association or Articles of Association or by the laws of the State of Israel.
E. TAXATION
The following is a summary of the current tax structure applicable to companies in Israel, with special reference to its effect on us. The following also contains a discussion of certain Israeli Government programs benefiting us. To the extent that the discussion is based on new tax legislation that has not been subject to judicial or administrative interpretation, there can be no assurance that the views expressed in the discussion will be accepted by the tax authorities in question. The discussion is not intended, and should not be construed, as legal or professional tax advice and is not exhaustive of all possible tax considerations.
General Corporate Tax Structure
Israeli companies are subject to corporate tax. The corporate tax rate was reduced, in July 2004 and August 2005 from 36% to 35% for the 2004 tax year, 34% for the 2005 tax year, 31% for the 2006 tax year, 29% for the 2007 tax year, 27% for the 2008 tax year, 26% for the 2009 tax year and 25% for the 2010 tax year and thereafter. However, the effective rate of tax of a company that derives income from an ‘approved enterprise’ (as referred to below) may be considerably lower (see in this Item 10.E below the paragraph titled “Law for the Encouragement of Capital Investments, 1959”).
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Tax Reform
The Law for the Amendment of the Income Tax Ordinance (Amendments Nos. 132 and 147), together known as the ‘Tax Reform’, came into effect in 2003 and 2006 respectively.
The Tax Reform, aimed at broadening the categories of taxable income and reducing the tax rates imposed on employment income, introduced the following, among other things:
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| • | Reduction of the tax rate levied on capital gains (other than gains deriving from the sale of listed securities) derived after January 1, 2003, to a general rate of up to 25% for individuals (as described below) and 25% for corporations. Regarding assets acquired prior to January 1, 2003, the reduced tax rate will apply to a proportionate part of the gain, in accordance with the holding periods of the asset, before or after January 1, 2003, on a linear basis. Taxes on capital gains, applicable to individuals, reduced from 2006 to 20% and to 25% for individuals who hold 10% or more of the means of control during the 12 months preceding the sale of the shares or receipt of the dividend; |
| | |
| • | Imposition of Israeli tax on all income of Israeli residents, individuals and corporations, regardless of the territorial source of income, including income derived from passive sources such as interest, dividends and royalties; |
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| • | Introduction of controlled foreign corporation (CFC) rules into the Israeli tax structure. Generally, under such rules, an Israeli resident who holds, directly or indirectly, 10% or more of the rights in a foreign corporation whose shares are not publicly traded (or which has offered less than 30% of its shares or any rights to its shares to the public), in which more than 50% of the rights are held directly or indirectly by Israeli residents, and a majority of whose income in a tax year is considered passive income, will be liable for tax on the portion of such income attributed to his holdings in such corporation, as if such income were distributed to him as a dividend; |
| | |
| • | Imposition of capital gains tax on capital gains realized by Israeli individuals as of January 1, 2003, from the sale of shares of publicly traded companies on the Tel Aviv Stock Exchange and from the sale of shares of publicly traded Israeli companies on certain other stock exchanges (such gain was previously exempt from capital gains tax in Israel in certain cases). For information with respect to the applicability of Israeli capital gains taxes on the sale of our Ordinary Shares, see “Capital Gains Taxes on Sales of our Ordinary Shares” below; |
| | |
| • | Introduction of a new regime for the taxation of shares and options issued to employees and officers (including directors); and |
| | |
| • | Introduction of tax at a rate of 25% on dividends paid by one Israeli company to another (which are generally not subject to tax), if the source of such dividend is income that was derived outside of Israel. |
Law for the Encouragement of Industry (Taxes), 1969
We currently qualify as an “industrial company” under the Law for the Encouragement of Industry (Taxes), 1969 (the “Industry Encouragement Law”). A company qualifies as an “industrial company” if it is resident in Israel and at least 90% of its income in a given tax year, determined in NIS (other than income from certain types of loans, capital gains, interest and dividends), is derived from industrial enterprises owned by that company. An “industrial enterprise” is defined as an enterprise whose major activity in a particular tax year is industrial manufacturing activity. See Note 12 to our Consolidated Financial Statements.
Under the Industry Encouragement Law, an industrial company is entitled to deduct the purchase price of patents and certain other intangible property rights (other than goodwill) over a period of eight years, beginning with the year in which such rights were first used.
An industrial company may be eligible for special depreciation rates for machinery, equipment and buildings. These rates differ based on various factors, including the date of commencement of operation and the number of work shifts. An industrial company owning an ‘approved enterprise’ may choose between such special depreciation rates and the depreciation rates available to ‘approved enterprises’.
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Qualification as an industrial company under the Industry Encouragement Law is not conditioned upon the receipt of prior approval from any Israel government authority. No assurance can be given that we will continue to qualify as an industrial company or that we will, in the future, be able to take advantage of any tax benefits available to industrial companies.
Law for the Encouragement of Capital Investments, 1959
The Investment Law provides that a capital investment in eligible facilities may, upon application to the Investment Center, be designated as an ‘approved enterprise’. Each certificate of approval for an ‘approved enterprise’ relates to a specific investment program delineated both by its financial scope, including its capital resources, and by its physical characteristics, e.g., the equipment to be purchased and utilized pursuant to the program. The tax benefits derived from any such certificate of approval relate only to taxable income attributable to the specific ‘approved enterprise’. If a company has more than one approval, its effective tax rate is the result of a weighted combination of the applicable rates. Income derived from activity that is not integral to the activity of the enterprise should not be divided between the different enterprises and should not enjoy tax benefits.
Most of our current production facilities have been granted the status of an ‘approved enterprise’ under the Investment Law, in six separate investment programs. Under the Investment Law, we have chosen the “alternative benefits” option and have waived Government grants in return for a tax exemption. These programs provide us with the tax benefits described below. Under the terms of our ‘approved enterprise’ programs, our income from ‘approved enterprises’ will be tax exempt for periods of 2-4 years (except with respect to income from our Omer facility, which will be tax-exempt for 10 years), commencing with the year in which we first earn taxable income from the relevant ‘approved enterprise’, and is subject to a reduced tax rate for an additional period of up to a total of ten years from when the tax exemption began. The reduced tax rate is imposed at a rate of between 10% and 25%, depending on the percentage of msystems’ shares held by non-Israelis during that remaining period (the more shares held by non-Israelis, the lower the tax rate). The tax benefits periods described above, except from the 2-4 years tax exemption which is not limited in time, will end upon the earlier of (a) 12 years from the year of commencement of production, or (b) 14 years from the year of approval of ‘approved enterprise’ status).
A company that has elected the alternative package of benefits, like we have, and that subsequently pays dividend out of income derived from the ‘approved enterprise’ during the tax exemption period, will be subject to tax in respect of the amount distributed (including the tax thereon) at the rate that would have been applicable had it not elected the alternative package of benefits (generally 10%-25%, depending on the extent of foreign shareholders holding our Ordinary Shares). The dividend recipient is taxed at the reduced rate applicable to dividends from ‘approved enterprises’ (15%), if the dividend is distributed during the tax exemption period or within 12 years thereafter.
The Company’s Board of Directors has determined that such tax-exempt income will not be distributed as dividends. Accordingly, no deferred taxes have been provided on income attributable to the Company’s “Approved Enterprise”.
The benefits available to an ‘approved enterprise’ are conditional upon our fulfilling certain conditions stipulated in the Investment Law and its regulations and the criteria set forth in the specific certificate of approval, as described below. If we were to violate those conditions, in whole or in part, we would be required to refund the amount of tax benefits, with the addition of the CPI linkage adjustment and interest. We believe that our ‘approved enterprises’ operate in substantial compliance with all of these conditions and criteria.
The Investment Law also provides that an ‘approved enterprise’ is entitled to accelerated tax depreciation on property and equipment included in an approved investment program.
On April 1, 2005, an amendment to the Capital Investments Law came into effect (the “Amendment”) and has significantly changed the provisions of the Capital Investments Law. The Amendment limits the scope of enterprises which may be approved by the Investment Center by setting criteria for the approval of a facility as a Privileged Enterprise, such as provisions generally requiring that at least 25% of the Privileged Enterprise’s income will be derived from export. Additionally, the Amendment enacted major changes in the manner in which tax benefits are awarded under the Capital Investments Law so that companies no longer require Investment Center approval in order to qualify for tax benefits. However, the Capital Investments Law provides that terms and benefits included in any certificate of approval already granted will remain subject to the provisions of the law as they were on the date of such approval. Therefore, our existing Approved Enterprise will generally not be subject to the provisions of the Amendment. As a result of the Amendment, tax-exempt income generated under the provisions of the new law, will subject us to taxes upon distribution or liquidation and we may be required to record deferred tax liability with respect to such tax-exempt income. As of December 31, 2005, we did not generate income under the provision of the new law.
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No assurance can be given that we will, in the future, be eligible to receive additional tax benefits under this law.
As of December 31, 2005, we generated a total of approximately $ 7 million of net operating loss carry forwards in Israel. These Israeli net operating loss carryforwards have no expiration date. The tax benefits granted to an ‘approved enterprise’ are not available to us with respect to the income of our subsidiaries.
Taxation under Inflationary Conditions
The Income Tax (Inflationary Adjustments) Law, 1985 (the “Inflationary Adjustments Law”), was designed to neutralize the erosion of capital investments in business and to prevent tax benefits resulting from deduction of inflationary expenses. This law applies a supplementary set of inflationary adjustments to the normal taxable profits computed under regular historical cost principles.
The Inflationary Adjustments Law introduced a special tax adjustment for the preservation of equity based on changes in the Israeli CPI, whereby certain corporate assets are classified broadly into fixed (inflation-resistant) assets and non-fixed assets. Where a corporation’s equity exceeds the depreciated cost of fixed assets, a tax deduction that takes into account the effect of the annual rate of inflation on such excess is allowed (up to a ceiling of 70% of taxable income for companies in any single year, with the unused portion carried forward on a linked basis, without limit). If the depreciated cost of fixed assets exceeds shareholders’ equity, then such excess, multiplied by the annual inflation rate, is added to taxable income.
Under the Inflationary Adjustments Law, results for tax purposes are measured in real terms, in accordance with changes in the Israeli CPI. We are taxed under this law. The discrepancy between the change in (1) the Israeli CPI and (2) the exchange rate of Israeli currency in relation to the dollar, may in future periods cause significant differences between taxable income and the income measured in dollars as reflected by our financial statements (which are measured in dollars). In addition, subject to certain limitations, depreciation of fixed assets and losses carried forward are adjusted for inflation on the basis of changes in the Israeli CPI.
Withholding and Capital Gains Taxes Applicable to Non-Israeli Shareholders
The State of Israel imposes income tax on nonresidents of Israel on income accrued or derived from sources in Israel. These sources of income include passive income such as dividends, royalties and interest, as well as non-passive income from services rendered in Israel. We are required to withhold income tax at the rate of 20% for dividends paid to a non-Israeli individual or corporation that is not a substantial shareholder (generally defined as a shareholder who holds directly or indirectly 10% or more of the outstanding shares of a company), 25% for dividends paid to a substantial shareholder or 15% for dividends of income generated by an approved enterprise, on all distributions of dividends other than bonus shares (stock dividends), unless a different rate is provided in a treaty between Israel and the shareholder’s country of residence. Under the income tax treaty between the U.S. and Israel, the maximum tax on dividends paid to a holder of ordinary shares who is a U.S. resident (as defined in the treaty) is 25%.
A nonresident of Israel who receive interest, dividend or royalty income derived from or accrued in Israel, from which tax was withheld at the source, is generally exempted from the duty to file tax returns in Israel with respect to such income, provided such income was not derived from a business conducted in Israel by the taxpayer and the taxpayer has no other taxable sources of income in Israel.
Capital Gains Taxes on Sales of our Ordinary Shares
Israeli law generally imposes a capital gains tax on the sale of capital assets located in Israel, including shares in Israeli companies, unless a specific exemption is available or unless a treaty between Israel and the country of the non-resident provides otherwise.
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Israeli law generally exempts non-residents of Israel from Israeli capital gains tax on the sale of our shares. This exemption does not apply to non-residents of Israel in which a resident of Israel has a beneficial of interest of 25% or more. In addition, the US-Israel tax treaty generally exempts US residents, as defined in the treaty, from Israeli capital gains taxes on the sale of our shares, provided that the US resident did not hold an interest in our company of 10% or more during the 12 months preceding the sale and provided that the US resident does not maintain a permanent establishment in Israel.
A nonresident of Israel who receives interest, dividend or royalty income derived from or accrued in Israel, from which tax was withheld at the source, is generally exempted from the duty to file tax returns in Israel with respect to such income, provided such income was not derived from a business conducted in Israel by the taxpayer and the taxpayer has no other taxable sources of income in Israel.
United States Federal Income Tax Considerations
Subject to the limitations described below, the following discussion describes material U.S. federal income tax consequences of the ownership and disposition of our Ordinary Shares to a “U.S. Holder.” For purposes of this discussion, a “U.S. Holder” is:
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| • | An individual who is a citizen or resident of the U.S.; |
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| • | A corporation (or other entity taxed as a corporation for U.S. federal income tax purposes) created or organized in or under the laws of the U.S. or of any political subdivision thereof; |
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| • | An estate, the income of which is includible in gross income for U.S. federal income tax purposes regardless of its source; or |
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| • | A trust (i) if a court within the U.S. is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have the authority to control all substantial decisions of the trust or (ii) that has a valid election under applicable U.S. Treasury Regulations to be treated as a U.S. person. |
This discussion is a summary for general information only and does not purport to be a comprehensive description of all of the tax considerations that may be relevant to each person’s decision to purchase Ordinary Shares. This summary considers only holders that are beneficial owners of our Ordinary Shares that will own Ordinary Shares as capital assets (generally, for investment).
This discussion is based on current provisions of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), applicable U.S. Treasury Regulations promulgated thereunder, and administrative and judicial decisions as of the date hereof, all of which are subject to change, possibly on a retroactive basis. Any such change could affect the continuing validity of this discussion. This discussion does not address all aspects of U.S. federal income taxation that may be relevant to any particular holder based on such holder’s individual circumstances. In particular, this discussion does not address the potential application of the alternative minimum tax or U.S. federal income tax consequences to holders that are subject to special treatment, including:
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| • | broker-dealers or insurance companies; |
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| • | holders who have elected mark-to-market accounting; |
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| • | tax-exempt organizations; |
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| • | real estate investment trusts or regulated investment companies; |
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| • | grantor trusts; |
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| • | individual retirement and other tax deferred accounts; |
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| • | financial institutions or “financial services entities”; |
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| • | holders who hold Ordinary Shares as part of a “straddle,” “hedge,” “constructive sale” or “conversion transaction” or other integrated transaction; |
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• | holders who own or owned, directly, indirectly or by attribution, at least 10% of our voting power; |
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• | holders whose functional currency is not the dollar; |
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• | holders who received Ordinary Shares as compensation; and |
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• | certain former citizens or long-term residents of the U.S. |
This discussion does not consider the tax treatment of holders that are partnerships or other pass-through entities or persons who hold our Ordinary Shares through a partnership or other pass-through entity. In addition, this discussion does not address any aspect of state, local or non-U.S. tax laws, or the possible application of U.S. federal gift or estate tax.
Each investor is advised to consult such person’s own tax advisor with respect to the specific tax consequences to such person of purchasing, holding or disposing of our Ordinary Shares.
Dividends
Subject to the discussion below under “–Tax Consequences of Passive Foreign Investment Company Status,” a U.S. Holder will be required to include in gross income as ordinary income the amount of any distribution paid on our Ordinary Shares, including the amount of non-U.S. taxes, if any, withheld from the amount paid, on the date the distribution is received to the extent the distribution is paid out of our current or accumulated earnings and profits as determined for U.S. federal income tax purposes. Distributions in excess of these earnings and profits will be applied against and will reduce the U.S. Holder’s tax basis in the Ordinary Shares and, to the extent in excess of such basis will be treated as gain from the sale or exchange of such Ordinary Shares.
For taxable years beginning on or before 2010, dividends to non-corporate U.S. Holders who meet certain eligibility requirements (including certain holding period requirements and the absence of certain risk reduction transactions with respect to the Ordinary Shares) qualify for a reduced rate of taxation of 15% or lower if (a) our Ordinary Shares are readily tradable on an established securities market in the U.S., or (b) we qualify for benefits under an income tax treaty with the United States which includes an information exchange program and such treaty is determined by the United States Internal Revenue Service (“IRS”) to be satisfactory. Because our Ordinary Shares are listed and traded on NASDAQ and the IRS has determined that the U.S.-Israel Tax Treaty is satisfactory for this purpose, dividends paid with respect to our Ordinary Shares should qualify for the reduced rate.
Dividends paid with respect to our Ordinary Shares will not qualify for the reduced rate if, for the tax year the dividend is paid or the preceding tax year, we are classified as a passive foreign investment company (“PFIC”), as defined for U.S. federal income tax purposes. Although we do not believe we were a PFIC for 2005 or will be a PFIC for 2006, see the discussion below under “–Tax Consequences of Passive Foreign Investment Company Status,” for more information. U.S. Holders should consult their own tax advisors on their eligibility for reduced rates of taxation with respect to any dividends paid by us.
Distributions of our current or accumulated earnings and profits generally will be foreign source income for U.S. foreign tax credit purposes and will not qualify for the dividends received deduction available to corporations.
U.S. Holders will have the option of claiming the amount of any non-U.S. taxes withheld at source or paid with respect to dividends either as a deduction from gross income or as a dollar-for-dollar credit against their U.S. federal income tax liability. Individuals who do not claim itemized deductions, but instead utilize the standard deduction, may not claim a deduction for the amount of the non-U.S. taxes withheld, but those individuals may still claim the amount of such taxes as a credit against their U.S. federal income tax liability subject to limitations and restrictions discussed below.
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The amount of non-U.S. income taxes that may be claimed as a credit in any year is subject to complex limitations and restrictions, which must be determined on an individual basis by each holder. These limitations include, among others, rules that limit foreign tax credits allowable with respect to specific classes of income to the U.S. federal income taxes otherwise payable with respect to each such class of income. For this purpose, any dividend that the Company distributes generally will constitute “passive income” or, in the case of certain U.S. Holders, “financial services income” for taxable years beginning on or before December 31, 2006. U.S. Holders should note that “the financial services income” category has been eliminated with respect to taxable years beginning after December 31, 2006. At such time, the foreign tax credit limitation categories will be limited to “passive income” and “general category income.” Additionally, special rules will apply if we are a “United States-owned foreign corporation,” which we may be. In that case, distributions of current or accumulated earnings and profits will be treated as U.S. source and non-U.S. source income in proportion to our earnings and profits in the year of the distribution allocable to U.S. and non-U.S. sources. We will be treated as a “United States-owned foreign corporation” as long as stock representing 50% or more of the voting power or value of our shares is owned, directly or indirectly, by United States persons. Non-U.S. taxes allocable to the portion of our distributions treated as from U.S. sources under these rules may not be creditable against a U.S. Holder’s U.S. federal income tax liability on such portion.
The total amount of allowable foreign tax credits in any year cannot exceed the regular U.S. tax liability for the year attributable to foreign source taxable income. A U.S. Holder will be denied a foreign tax credit with respect to non-U.S. tax withheld from dividends received on the Ordinary Shares to the extent such U.S. Holder has not held the Ordinary Shares for at least 16 days of the 31-day period beginning on the date which is 15 days before the ex-dividend date or to the extent such U.S. Holder is under an obligation to make related payments with respect to substantially similar or related property. Any days during which a U.S. Holder has substantially diminished its risk of loss on the Ordinary Shares are not counted toward meeting the 16-day holding period required by the statute.
Disposition of Ordinary Shares
Subject to the discussion below under “–Tax Consequences of Passive Foreign Investment Company Status,” upon the sale or exchange of our Ordinary Shares, a U.S. Holder generally will recognize capital gain or loss in an amount equal to the difference between such U.S. Holder’s tax basis in the Ordinary Shares, which is usually the dollar cost of such shares, and the amount realized on the sale or exchange. Capital gain from the sale, exchange or other disposition of Ordinary Shares held more than one year is long-term capital gain and is eligible for a maximum 15% rate of taxation for non-corporate holders for taxable years beginning on or before December 31, 2010. Gain or loss recognized by a U.S. Holder on a sale or exchange of Ordinary Shares generally will be treated as U.S. source income or loss for U.S. foreign tax credit purposes. The deductibility of a capital loss recognized on the sale or exchange of Ordinary Shares is subject to limitations. Gain or loss recognized by a U.S. Holder on a sale or exchange of Ordinary Shares generally will be treated as U.S. source income or loss for U.S. foreign tax credit purposes. Under the income tax treaty between the United States and Israel (the “Tax Treaty”), gain derived from the sale, exchange or other disposition of Ordinary Shares by a holder who qualifies as a resident of the United States and is entitled to claim the benefits under the Tax Treaty, and who sells the Ordinary Shares within Israel, may be treated as non-U.S. source income for U.S. foreign tax credit purposes.
Tax Consequences of Passive Foreign Investment Company Status
We will be a passive foreign investment company, or “PFIC,” if 75% or more of our gross income in a taxable year, including our pro rata share of the gross income of any company, U.S. or non-U.S., treated as a corporation for U.S. federal income tax purposes, in which we are considered to own 25% or more (directly or indirectly) of the shares by value, is passive income. Alternatively, we will be a PFIC if 50% or more of our gross assets in a taxable year, averaged quarterly over the year and generally determined based on fair market value and including our pro rata share of the assets of any company, U.S. or non-U.S., treated as a corporation for U.S. federal income tax purposes, in which we are considered to own 25% (directly or indirectly) or more of the shares by value, are held for the production of, or produce, passive income. Passive income includes interest, dividends, royalties, rents and amounts derived from the investment of funds. If we were a PFIC, and a U.S. Holder did not make an election to treat us as a “qualified electing fund” (as described below):
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• | Excess distributions by us to a U.S. Holder would be taxed in a special way. “Excess distributions” are amounts received by a U.S. Holder with respect to our Ordinary Shares in any taxable year that exceed 125% of the average distributions received by such U.S. Holder from us with respect to our Ordinary Shares in the shorter of either the three previous taxable years or such U.S. Holder’s holding period for Ordinary Shares before the present taxable year. Excess distributions must be allocated ratably to each day that a U.S. Holder has held our stock. A U.S. Holder must include amounts allocated to the current taxable year and to years prior to our being a PFIC in its gross income as ordinary income for that taxable year. A U.S. Holder must pay tax on amounts allocated to each other taxable year at the highest rate in effect for that year on ordinary income and the tax is subject to an interest charge at the rate applicable to deficiencies for income tax for that taxable year. |
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• | The entire amount of gain realized by a U.S. Holder upon the sale or other disposition of Ordinary Shares will also be treated as an excess distribution and will be subject to taxation and an interest charge as described above. |
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• | The tax basis in our Ordinary Shares that were acquired from a decedent would not receive a step-up to fair market value as of the date of the decedent’s death but would instead be equal to the decedent’s basis in such shares, if lower than fair market value. |
If we become a PFIC for any taxable year, the special PFIC rules described above will not apply to a U.S. Holder if the U.S. Holder makes an election to treat us as a “qualified electing fund” (QEF) in such year or, if later, the first taxable year in which the U.S. Holder owns our Ordinary Shares and if we comply with certain reporting requirements. Instead, a U.S. Holder who has made a QEF election would be required for each taxable year in which we were a PFIC to include in income its pro rata share of our ordinary earnings as ordinary income and its pro rata share of our net capital gain as long-term capital gain, subject to a separate election to defer payment of taxes, which deferral is subject to an interest charge.
The QEF election is made on a shareholder-by-shareholder basis. Once such an election is made, it applies to all subsequent taxable years unless revoked with the consent of the IRS. A shareholder makes a QEF election by attaching a completed IRS Form 8621, using the information provided in the PFIC annual information statement, to such shareholder’s timely filed U.S. federal income tax return. Even if a QEF election is not made, a shareholder in a PFIC who is a U.S. person must file a completed IRS Form 8621 with such shareholder’s U.S. federal income tax return every year.
A U.S. Holder of PFIC stock which is “marketable stock” (e.g. regularly traded on NASDAQ) could, instead of making a QEF election, elect to mark the shares to market annually, recognizing as ordinary income or loss each year an amount equal to the difference as of the close of the taxable year between the fair market value of the U.S. Holder’s PFIC shares and the U.S. Holder’s adjusted tax basis in the PFIC shares. Losses would be allowed only to the extent of net mark-to-market gain previously included by the U.S. Holder under the election for prior taxable years. If the mark-to-market election were made, then the rules set forth above would not apply for periods covered by the election. If a U.S. Holder makes a mark-to-market election after the beginning of its holding period of our Ordinary Shares, the U.S. Holder would be subject to interest charges with respect to the inclusion of ordinary income attributable to the period before the effective date of such election.
We do not believe that we were a PFIC in 2005 and do not anticipate being a PFIC in the future. Our belief is based, in part, on our audited financial statements, our spending plans for the proceeds of future offerings, our market capitalization and our current expectations of the value and nature of our assets, the sources and nature of our income and relevant market data. However, because the tests for determining PFIC status are applied annually and are dependent upon a number of factors, some of which are beyond our control, including the value of our assets, our market capitalization and the amount and type of our gross income, we cannot determine our PFIC status until the end of each business year. We cannot assure U.S. Holders that the IRS will agree with our conclusion regarding our PFIC status for any particular taxable year and there can be no assurance that we will not become a PFIC.
U.S. Holders who hold our Ordinary Shares during a period when we are a PFIC will be subject to the foregoing rules, even if we cease to be a PFIC, subject to certain exceptions for U.S. Holders who made a QEF election or a mark-to-market election. U.S. Holders are urged to consult their tax advisors about the PFIC rules, including as to the advisability of choosing to make a QEF election, a “protective” QEF election, or an election to mark the shares to market annually.
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Information Reporting and Backup Withholding
A U.S. Holder (other than exempt recipients such as corporations) is generally subject to information reporting requirements with respect to dividends paid in the U.S. or by a U.S. payor or U.S. middleman on our Ordinary Shares and proceeds paid from the sale, exchange, redemption or other disposition of our Ordinary Shares. In addition, a U.S. Holder is subject to backup withholding (currently at a rate of 28% for taxable years through 2010) on dividends paid in the U.S. or by a U.S. payor or U.S. middleman on Ordinary Shares and proceeds paid from the sale, exchange, redemption or other disposition of our Ordinary Shares, unless the U.S. Holder provides a properly completed IRS Form W-9 or otherwise establishes a basis for exemption.
Backup withholding is not an additional tax. Amounts withheld under the backup withholding rules may be credited against a Holder’s U.S. federal income tax liability, and a Holder may obtain a refund of any excess amount withheld under the backup withholding rules, provided that certain information is timely furnished to the IRS.
F. DIVIDENDS AND PAYING AGENTS
–Not applicable
G. STATEMENT BY EXPERTS
–Not applicable
H. DOCUMENTS ON DISPLAY
All documents referenced herein concerning us are archived at our principal offices located at:
7 Atir Yeda St.,
Kfar Saba, Israel 44425.
I. SUBSIDIARY INFORMATION
–Not applicable
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ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to a variety of risks, mainly changes in foreign currency (i.e. non US Dollars) exchange rates and the credit worthiness of our customers. We use derivative financial instruments in our investment portfolio to hedge only part of foreign currency market risks.
Foreign Currency Exchange and Inflation Risk
Most of our revenues generated and costs incurred outside of the United States are generally denominated in dollar currencies. Costs not effectively denominated in United States dollars are translated to United States dollars, when recorded, at the prevailing exchange rates for the purposes of our financial statements and in Microelectronica are translated on a quarterly average exchange rate between the Euro and the United States dollars.. Consequently, fluctuations in the rates of exchange between the dollar and non-dollar currencies will affect our results of operations. An increase in the value of a particular currency relative to the dollar will increase the dollar reporting value for transactions in that particular currency, and a decrease in the value of that currency relative to the dollar will decrease the dollar reporting value for those transactions. This effect on the dollar reporting value for transactions is generally only partially offset by the impact that currency fluctuations may have on costs. We engage in currency hedging transactions to offset the risks associated with variations in currency exchange rates only partially. Consequently, significant foreign currency fluctuations and other foreign exchange risks may have a material adverse effect on our business, financial condition and results of operations. Since our revenues are generated in United States Dollars and currencies other than NIS, and a substantial portion of our expenses is incurred and will continue to be incurred in NIS, we are exposed to changes in NIS / US Dollars exchange rates. Revenues of Microelectronica are usually denominated in Euro and are mostly covered with Euro denominated expenses however certain exposure to the Euro/ United States Dollars fluctuations.
Trade Receivables credit risk
Our trade receivables balances are derived from sales to customers located primarily in the United States, the Far East and Europe. We generally do not require collateral; however, in certain circumstances, we may require letters of credit, other collateral, additional guarantees or advanced payments. we perform ongoing credit evaluations of our customers and insure certain trade receivables under foreign trade risks insurance. To date, we have not experienced material losses. An allowance for doubtful accounts is determined with respect to specific receivables the collection of which may be doubtful.
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
–Not applicable
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PART II
ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
–Not applicable
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ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS |
– Not applicable
ITEM 15. CONTROLS AND PROCEDURES
Restatement
See Item 5 “Operating and Financial Review and Prospects – Internal Review of Stock OptionGrants and Restatement of Consolidated Financial Information” for a discussion of the Special Committee’s internal review of prior stock option grants and the restatement of certain of our consolidated financial information. As discussed in Item 5 “Operating and Financial Review and Prospects – Internal Review of Stock Option Grants and Restatement of Consolidated Financial Statements – A. Review of Stock Option Grants – 2. Findings of the Special Committee” and “– C. Restatement of Consolidated Financial Statements”, based on the Special Committee’s findings, the Company concluded that, for accounting purposes, the effective measurement dates of certain past stock option grants differed from the previously determined measurement dates for such grants, and accordingly that the Company has failed to record the proper compensation expense relating to certain past stock option grants. The Company determined that this failure constitutes a material weakness in its internal control over financial reporting because it did not maintain adequate internal controls over financial reporting to ensure that option grants were accounted for using correct measurement dates in accordance with United States generally accepted accounting principles. Because the closing market prices of our ordinary shares as of the corrected measurement dates were generally higher than the relevant option exercise prices, the Company determined that it should have recognized non-cash stock-based compensation expense and related tax adjustments which were not accounted for in our previously issued financial statements.
A “material weakness” is defined by the Public Company Accounting Oversight Board in Auditing Standard No. 2 as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
The Company has concluded that a control deficiency existed with respect to its use of incorrect measurement dates for certain past stock option grants, and for the reasons set forth above, such deficiency is a material weakness in our internal control over financial reporting. Our management has reviewed this material weakness in our internal control over financial reporting with our audit committee and has discussed it with our independent registered public accounting firm. Pursuant to the recommendation of the audit committee, the Company determined to restate our previously issued consolidated financial statements as of December 31, 2004 and 2005 and for each of the years in the three-year period ended December 31, 2005 and certain previously issued consolidated financial information as of December 31, 2003 and as of and for the years ended December 31, 1999, 2000, 2001 and 2002 and, in light of the restatement, such previously issued financial statements and financial information should no longer be relied upon.
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See Item 5 “Operating and Financial Review and Prospects – Internal Review of Stock Option Grants and Restatement of Consolidated Financial Statements – A. Review of Stock Option Grants – 3. Remedial Measures Recommended by the Special Committee” and “– 4. Adoption and Implementation of Special Committee Recommendations by the Board of Directors” for a discussion of the remedial measures recommended by the Special Committee and adopted by the Board of Directors.
Conclusions Regarding the Effectiveness of Disclosure Controls and Procedures
The effectiveness of any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events, and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By its nature, any system of disclosure controls and procedures can provide only reasonable assurance regarding management’s control objectives.
Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2005 taking into account the restatement of our consolidated financial statements and certain consolidated financial information referred to above. The Company has identified a material weakness in our internal control over financial reporting with respect to accounting for stock option grants as a result of our failure to determine the proper measurement dates for measuring compensation expense relating to certain past stock option grants. Solely as a result of this material weakness, and based on the findings of the Special Committee, our Chief Executive Officer and our Chief Financial Officer have concluded that as of December 31, 2005 our disclosure controls and procedures were not effective at a reasonable assurance level.
Changes in Internal Control over Financial Reporting
During the year ended December 31, 2005 there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. However, as discussed in Item 5 “Operating and Financial Review and Prospects – Internal Review of Stock Option Grants and Restatement of Consolidated Financial Statements – A. Review of Stock Option Grants – 3. Remedial Measures Recommended by the Special Committee” and “– 4. Adoption and Implementation of Special Committee Recommendations by the Board of Directors”, in July 2006 our Board of Directors resolved to adopt various remedial measures to address the material weakness in our internal control over financial reporting discussed above.
ITEM 16. [Reserved]
ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT
Our Board of Directors has determined that we have at least one audit committee financial expert, Mr. Onfus (See in Item 6.A “Directors and Senior Management” synopsis of Mr. Onfus’ biography).
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ITEM 16B. CODE OF ETHICS
We have adopted a written code of ethics that applies to all of our employees, including our principal executive officer, principal financial officer and principal accounting officer.
You may request a copy of our code of ethics, at no cost, by writing to or telephoning us as follows:
msystems Ltd.
7 Atir Yeda St., Kfar Saba
Israel 44425
Attn. Legal Department
Telephone: (972)-9-764-5000
ITEM 16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES
During each of the last two fiscal years, Kost, Forer, Gabbay & Kasierer, a member of Ernst and Young Global, has acted as the Company’s independent auditors.
Audit fees
Ernst & Young billed the Company $230,143 for audit services for fiscal 2005. Ernst & Young billed the Company $ 376,502 for audit services for fiscal 2004.
Tax fees
Ernst & Young billed the Company $134,626 for tax services, including fees associated with tax compliance services, tax planning services and other tax consulting services for fiscal 2005. Ernst & Young billed the Company $ 94,478 for tax services, including fees associated with tax compliance services, tax planning services and other tax consulting services for fiscal 2004.
All other fees
We did not pay Ernst & Young for any fees other than the Audit Fees and Tax Fees described above for fiscal 2005 and 2004.
Pre-Approval Policies for Non-Audit Services
Prior to the engagement of Ernst & Young each year, the engagement is approved by the Audit Committee of the Board of Directors and by vote of the Company’s shareholders at the Company’s Annual General Meeting of Shareholders. The Company’s Audit Committee has also adopted its own rules of procedure. The Audit Committee’s rules of procedure provide for a process with respect to the prior approval of all services, including non-audit services, to be performed by the independent auditors for the Company. In fiscal 2004 and 2005, the Company’s Audit Committee approved all of the services provided by Ernst & Young.
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ITEM 16D. EXEMPTION FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES |
– None
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ITEM 16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS |
– None
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PART III
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ITEM 17. FINANCIAL STATEMENTS |
– Not applicable
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ITEM 18. FINANCIAL STATEMENTS |
See Consolidated Financial Statements, attached to this annual report as Exhibit 15(a).4.
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1.1 | | + | | msystems’ Memorandum of Association, as amended |
| | | | |
1.2 | | | | msystems’ Articles of Association, as amended |
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4(a).1 | | ++ | | Purchase Agreement made as of September 17, 2000 between Fortress U&T Ltd. and msystems |
| | | | |
4(a).2 | | *
!! | | Development and License Agreement dated June 25, 2002 by and between Toshiba Corporation and msystems Ltd. |
| | | | |
4(a).3 | | **
!! | | Patent License Agreement dated July 15, 2003 by and between Toshiba Corporation and msystems Ltd. |
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4(a).4 | | **
!! | | Ordinary Shares Purchase Agreement dated July 15, 2003 by and between Toshiba Corporation and msystems Ltd. |
| | | | |
4(a).5 | | **
!! | | New Master Purchase Agreement dated July 15, 2003 by and between Toshiba Corporation and msystems Ltd. |
| | | | |
4(a).6 | | **
!! | | XDOC Development and License Agreement dated July 15, 2003 by and between Toshiba Corporation and msystems Ltd. |
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4(a).7 | | !! | | Standard Nand Supply Agreement dated as of October 1, 2003 by and among Toshiba Corporation, msystems Ltd. and a third party |
| | | | |
4(a).8 | | !! | | Product Supply Agreement dated as of October 1, 2003 by and between Toshiba Corporation, msystems Ltd. and a third party |
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4(a).9 | | *** | | Purchase Agreement dated March 17, 2005 by and between M-Systems Finance Inc., msystems Ltd. and the initial purchasers of the notes, as defined therein, represented by Citigroup Global Markets Inc. |
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4(a).10 | | *** | | Registration Rights Agreement dated March 23, 2005 by and between M-Systems Finance Inc., msystems Ltd. and the initial purchasers of the notes, as defined therein, represented by Citigroup Global Markets Inc. |
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4(a).11 | | *** | | Senior Indenture dated March 23, 2005 by and between M-Systems Finance Inc., msystems Ltd. and The Bank of New York Trust Company, N.A. |
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4(a).12 | | !! | | Product Supply Agreement dated August 22, 2005, by and between msystems Ltd. and Hynix Semiconductor Inc. |
| | | | |
4(a).13 | | | | Sale And Purchase Agreement dated November 14th 2005 of the Shares of Microelectrónica Española, S.A.U. between Javier Pérez Aznar, Microelectrónica Española, S.A.U. and M-Systems Flash Disk Pioneers España, S.L.U. (formerly, GLOBAL SIGNIFERO, S.L.U.). |
| | | | |
4(c).1 | | !!! | | Form of Amended and Restated Indemnification Agreement entered into by msystems Ltd. and (i) each director and (ii) the Chief Executive Officer |
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ITEM 19. EXHIBITS (CONT.)
| | | | |
8 | | | | List of msystems’ subsidiaries and where they are incorporated |
| | | | |
12.1 | | | | Certificate of Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) |
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12.2 | | | | Certificate of Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) |
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13(a).1 | | | | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 |
| | | | |
13(a).2 | | | | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 |
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15(a).1 | | | | Consent of Kost Forer Gabbay & Kasierer (formerly Kost Forer & Gabbay) |
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15(a).3 | | | | Consolidated Financial Statements |
| | | | |
| | + | | Previously filed as an exhibit to our Registration Statement on Form F-1, File No. 33-55838, and incorporated by reference herein. |
| | | | |
| | ++ | | Previously filed as an exhibit to our Annual Report on Form 20-F for the fiscal year ended December 31, 2000, and incorporated by reference herein. |
| | | | |
| | * | | Previously filed as an exhibit to our Annual Report on Form 20-F/A Amendment No. 3 for the fiscal year ended December 31, 2002, File No. 001-11712 and incorporated by reference herein. |
| | | | |
| | ** | | Previously filed as an exhibit to our Annual Report on Form 20-F for the fiscal year ended December 31, 2003, and incorporated by reference herein. |
| | | | |
| | *** | | Previously filed as an exhibit to our Annual Report on Form 20-F for the fiscal year ended December 31, 2004, and incorporated by reference herein. |
| | | | |
| | !! | | Portions of the agreement and/or exhibits have been omitted pursuant to a request for confidential treatment provided to the SEC. |
| | | | |
| | !!! | | Previously filed as an exhibit to our Report on Form 6-K, furnished to the Securities and Exchange Commission on December 6, 2005 and incorporated by reference herein. |
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SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, msystems hereby certifies that it meets all of the requirements for filing on Form 20-F, and that it has duly caused and authorized the undersigned to sign this Annual Report on its behalf on the 17th day of July, 2006.
| | | |
| msystems Ltd. | |
| | |
| By: | /s/ Dov Moran | |
| |
| |
| | Dov Moran, | |
| | President and Chief Executive Officer |
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