March 13, 2006
VIA EDGAR and OVERNIGHT MAIL
Stephen Krikorian, Accounting Branch Chief
Securities and Exchange Commission
100 F Street
Washington, D.C. 20549
Re: Thinkpath, Inc.
Form 10-KSB for the year ended December 31, 2004 Filed April
15, 2005 Form 10-QSB for the quarter ended March 31, 2005
Filed April 15, 2005
Form 10-QSB for the quarter ended June 30, 2005
Filed August 22, 2005
File No. 001-14813
Dear Mr. Krikorian:
Below, please find our responses to your September 28, 2005 comment
letter. We have numbered the responses to correspond with your comment letter.
1. BASED ON YOUR RESPONSES TO PRIOR COMMENTS 3 AND 7 IN YOUR LETTER DATED JULY
12, 2005 AND THE RESPONSES TO PRIOR COMMENTS 1, 2 AND 3 IN YOUR LETTER DATED
SEPTEMBER 15, 2005, IT APPEARS THAT YOU HAVE CONCLUDED THAT YOUR PREVIOUSLY
ISSUED FINANCIAL STATEMENTS SHOULD NO LONGER BE RELIED UPON BECAUSE OF AN ERROR
IN SUCH FINANCIAL STATEMENTS. AS SUCH, A FORM 8-K SHOULD BE FILED PURSUANT TO
ITEM 4.02 OF THE FORM.
RESPONSE
On October 7, 2005, the Company filed a Form 8-K pursuant to Item 4.02
disclosing that its previously issued financial statements which are included in
its Annual Report on Form 10-KSB for the fiscal year ended December 31, 2004 and
Quarterly Reports on Form 10-QSB for the quarters ended March 31, 2005 and June
30, 2005 should no longer be relied upon because of an error in such financial
statements. The Company also disclosed its intent to file Forms 10-QSB/A and a
Form 10-KSB/A amending the Forms 10-QSB and 10-KSB, respectively, to include the
respective restated financial statements as soon as possible after the
completion of its discussions with the SEC staff.
2. YOU INDICATED IN RESPONSE TO PRIOR COMMENT NUMBER 3 IN YOUR LETTER DATED
SEPTEMBER 15, 2005 THAT YOU PLAN TO FILE A REVISION TO YOUR FORM 10-KSB TO
REFLECT THE RESTATEMENTS. THE AMENDED FINANCIAL STATEMENT SHOULD BE FILED AS
SOON AS PRACTICAL. TELL US WHEN YOU PLAN TO FILE THE AMENDED FORM 10-KSB. ALSO
TELL US WHETHER YOU ALSO PLAN TO AMEND BOTH OF YOUR FORM 10-QSBS FOR THE
SUBSEQUENT INTERIM PERIODS ENDED MARCH 31, 2005 AND JUNE 30, 2005 TO REFLECT THE
RESTATEMENTS.
RESPONSE
The Company intends to file Forms 10-QSB/A and a Form 10-KSB/A amending the
Forms 10-QSBs and 10-KSB, respectively, to include the respective restated
financial statements as soon as possible after the completion of its discussions
with the SEC staff.
3. IN RESPONSE TO PRIOR COMMENT NUMBER 3 IN YOUR LETTER DATED SEPTEMBER 15,
2005, YOU INDICATE YOUR INTENTION TO AMEND THE FINANCIAL STATEMENTS TO LIMIT THE
AMOUNT OF BENEFICIAL CONVERSION FEATURE TO THE AMOUNT OF PROCEEDS ALLOCATED TO
THE CONVERTIBLE DEBENTURES. PLEASE PROVIDE US WITH THE CALCULATION OF YOUR
PROPOSED ADJUSTMENTS TO THE 2003 AND 2004 FINANCIAL STATEMENTS. IN THIS REGARD,
WE NOTE THAT THE ADJUSTED AMOUNT OF BENEFICIAL CONVERSION FEATURE FOR 2003
DEBENTURES IS APPROXIMATELY $2,210 THOUSAND, HOWEVER THE AMOUNT OF PROCEEDS
ALLOCATED TO THE CONVERTIBLE DEBENTURES WAS $924 THOUSAND. IN ADDITION, WE NOTE
THAT THE ADJUSTED AMOUNT OF BENEFICIAL CONVERSION FEATURE FOR 2004 DEBENTURES IS
APPROXIMATELY $1,242 THOUSAND, HOWEVER THE AMOUNT OF PROCEEDS ALLOCATED TO THE
CONVERTIBLE DEBENTURES WAS $731 THOUSAND.
RESPONSE
The Company intends to amend the financial statements to limit the amount of
beneficial conversion feature to the amount of proceeds allocated to the
convertible debentures as indicated in paragraph 6 of EITF 98-5.
As the first convertible debentures were issued on December 5, 2002, only a very
small portion of the beneficial conversion feature and amount allocated to
warrants was amortized in 2002 and the balances were carried forward to 2003 to
be amortized in this period.
The calculations for the adjusted amount of beneficial conversion feature for
the 2003 debentures and 2004 debentures are attached hereto as Exhibit A.
4. IN YOUR PROPOSED REVISED DISCLOSURE INCLUDED IN YOUR RESPONSE TO PRIOR
COMMENT NUMBER 4 IN YOUR LETTER DATED SEPTEMBER 15, 2005, YOU INDICATE THAT, AS
OF DECEMBER 31, 2004, TWO MATERIAL WEAKNESSES WERE IDENTIFIED. DISCLOSE IN
GREATER DETAIL THE NATURE OF THE MATERIAL WEAKNESSES IDENTIFIED IN YOUR
DISCLOSURE. DESCRIBE THE FACTS AND CIRCUMSTANCES LEADING TO THE IDENTIFICATION
OF THE MATERIAL WEAKNESSES.
RESPONSE
Please see the revised disclosure below which includes a description of the
nature of the material weaknesses including the Company's failure to identify
and provide the correct accounting treatment for the Company's convertible
debenture financing and its failure to retain the personnel that would be able
to identify such issue.
The disclosure also discusses the circumstances leading the identification of
the material weaknesses, which included the CEO and CFO's evaluation of the
inappropriate accounting treatment of the two convertible debentures issued by
the Company and subsequent decision that such treatment was the result of a
material weakness in the Company's control environment.
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"(a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are
designed to ensure that information required to be disclosed in the
Company's reports under the Securities Exchange Act of 1934, as amended
(the "Exchange Act") is recorded, processed, summarized and recorded
within time periods specified in the SEC's rules and forms, and that
such information is accumulated and communicated to the Company's
management, including its Chief Executive Officer and Chief Financial
Officer, as appropriate, to allow timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and
procedures, management recognized that any controls and procedures, no
matter how well designed and operated, can provide only reasonable
assurances of achieving the desired control objectives, and management
was required to apply its judgment in evaluating the cost benefit
relationship of possible controls and procedures. The Company's
certifying officers have concluded that the Company's disclosure
controls and procedures were not effective in reaching that level of
reasonable assurance in so far as the controls and procedures are not
effective to ensure that information required to be disclosed by us in
the reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified
in the Commission's rules and forms.
As of the end of the period covered by this report, an evaluation was
performed under the supervision and with the participation of our
Company's management, including the Chief Executive Officer and the
Chief Financial Officer, of the effectiveness of the design and
operation of the Company's disclosure controls and procedures. Based
upon that evaluation, the Chief Executive Officer and the Chief
Financial Officer concluded that the Company's disclosure controls and
procedures were not effective. In light of the material weakness
described below, which were first discovered by the Chief Executive
Officer and the Chief Financial Officer subsequent to the end of the
quarter ended June 30, 2005, the Company implemented additional post
closing procedures to ensure its consolidated financial statements are
prepared in accordance with generally accepted accounting principles.
Accordingly, management believes the financial statements presented in
this Form 10-KSB fairly present, in all material respects, the
Company's financial position, results of operations and cash flow for
the periods presented.
The Company's management, including the Company's Chief Executive
Officer and Chief Financial Officer, assessed the effectiveness of the
Company's internal control over financial reporting as of December 31,
2004.
A material weakness is a control deficiency, or combination of control
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. As of December 31, 2004, management
has identified the following material weaknesses:
1. As of December 31, 2004, the Company did not have an effective
control environment based on criteria established in "Internal Control
- Integrated Framework" issued by COSO. The Company failed to design
appropriate company wide policies and procedures over the accounting,
revenue, treasury and risk management functions and did not uniformly
and consistently communicate the importance of internal controls
throughout the organization. In addition, the Company's policies and
procedures with respect to review and supervision of its accounting
operations were not operating effectively in so far as the Company
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failed to implement the appropriate accounting treatment in connection
with two convertible debenture financings engaged in by the Company.
This control deficiency, together with the control deficiencies
described in point 2 below, indicate that the Company did not maintain
an effective control environment. This control deficiency could result
in a material misstatement of annual or interim financial statements
that would not be prevented or detected. Accordingly, management
determined that this control deficiency constitutes a material
weakness.
2. As of December 31, 2004, the Company did not maintain a sufficient
complement of personnel with an appropriate level of accounting
knowledge, experience and training in the application of generally
accepted accounting principles commensurate with the Company's
financial reporting requirements including personnel that had the
expertise to evaluate the accounting treatment of convertible
debentures issued by the Company. In addition, the Company also failed
to implement processes to ensure periodic monitoring of its existing
internal control activities over financial reporting. Specifically, the
Company had a shortage of finance and accounting staff with sufficient
depth and skill in the application of U.S. generally accepted
accounting principles and individuals in the finance function who did
not have the appropriate skills, training and experience to meet the
objective that should be expected of these roles.
Because of these material weaknesses, management has concluded that the
Company did not maintain effective internal control over financial
reporting as of December 31, 2004, based on the criteria in Internal
Control - Integrated Framework.
PLAN FOR REMEDIATION OF MATERIAL WEAKNESSES
At the direction of our board of directors, management has spent and
continues to spend a significant amount of time, effort and resources
to improve our control environment. Such efforts have included the
engagement of the Complex Accounting and Transaction Expertise and the
SEC Services Group of Deloitte & Touche, the appointment of David
Barnes as a director of the Company who has extensive accounting
experience and will serve on our audit committee, the subscription to
accounting journals and the attendance of accounting seminars by our
personnel. This effort has been undertaken to improve our operational
and financial reporting efficiency.
Although we have undertaken steps to prevent further material
weaknesses or significant deficiencies in our internal controls, we
cannot assure that we will not in the future identify further material
weaknesses or significant deficiencies in our internal control over
financial reporting that have not previously been identified, or that
all the material weaknesses identified in this report were remediated
by December 31, 2005.
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(b) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
Except the material weaknesses identified including the Company's
failure to appropriately apply accounting standards to two convertible
debenture financings, there were no changes in the Company's internal
control over financial reporting during the year ended December 31,
2004, other than as described above, that materially affected, or are
reasonably likely to materially affect, the Company's internal control
over financial reporting."
5. IN YOUR PROPOSED REVISED DISCLOSURE INCLUDED IN YOUR RESPONSE TO PRIOR
COMMENT NUMBER 4 IN YOUR LETTER DATED SEPTEMBER 15, 2005, YOU INDICATE THAT
MANAGEMENT HAS SPENT A CONSIDERABLE AMOUNT OF TIME, EFFORT AND RESOURCES TO
IMPROVE YOUR CONTROL ENVIRONMENT. DISCLOSE IN GREATER DETAIL THE NATURE OF THESE
IMPROVEMENTS, INCLUDING THE SPECIFIC STEPS YOU HAVE TAKEN TO ADDRESS EACH OF THE
MATERIAL WEAKNESSES IDENTIFIED IN YOUR DISCLOSURE.
RESPONSE
Please see the proposed language for the controls and procedures section set
forth in response #4 above. The specific steps taken to remedy the material
weakness include:
o the engagement of the Complex Accounting and Transaction Expertise and
the SEC Services Group of Deloitte & Touche;
o the appointment of David Barnes as a director of the Company who has
extensive accounting experience and will serve on our audit committee;
o the subscription to accounting journals; and
o the attendance of accounting seminars by our personnel.
6. IN YOUR PROPOSED REVISED DISCLOSURE INCLUDED IN YOUR RESPONSE TO PRIOR
COMMENT NUMBER 4 IN YOUR LETTER DATED SEPTEMBER 15, 2005, YOU INDICATE THAT
THERE WERE NO CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING DURING THE
YEAR ENDED DECEMBER 31, 2004, OTHER THAN DESCRIBED ABOVE. REVISE TO STATE
CLEARLY, IF TRUE, THAT THERE WERE CHANGES IN YOUR INTERNAL CONTROL OVER
FINANCIAL REPORTING THAT OCCURRED DURING THE PERIOD COVERED BY THE REPORT.
RESPONSE
We have revised to state that there have been changes in the Company's internal
controls during the year including "the Company's failure to appropriately apply
accounting standards to two convertible debenture financings."
7. IN THE CLOSING PARAGRAPH OF YOUR RESPONSE LETTER DATED SEPTEMBER 15, 2005,
YOU INDICATE THAT YOU MUST FILE A REGISTRATION STATEMENT ON AN EXPEDITIOUS BASIS
PURSUANT TO COVENANTS MADE TO LAURUS MATER FUND, LTD. FURTHER DESCRIBE THE
REGISTRATION RIGHTS ASSOCIATED WITH THE LAURUS FINANCING. IN LIGHT OF THESE
COVENANTS, EXPLAIN HOW YOU CONSIDERED THE GUIDANCE IN SFAS 133 AND EITF 00-19 IN
DETERMINING THE CLASSIFICATION AND MEASUREMENT OF THE WARRANTS AND OPTIONS. ALSO
TELL US HOW YOU CONSIDERED THE GUIDANCE IN SFAS 133 IN DETERMINING WHETHER THE
EMBEDDED CONVERSIONS FEATURE SHOULD BE ACCOUNTED FOR SEPARATELY AS A DERIVATIVE
AND THE GUIDANCE IN EITF 00-19 IN DETERMINING THE CLASSIFICATION.
RESPONSE
On June 27, 2005, the Company closed a $3,100,000 convertible financing facility
with Laurus Master Fund, Ltd. ("Laurus"). The facility consists of a secured
convertible note ("Minimum Borrowing Note") based on 90% of eligible accounts
receivable which matures on June 27, 2008 and bears interest at an annual rate
equal to The Wall Street Journal prime rate plus 3% ("contract rate") but never
less than 8%.
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At closing, the Company received $3,100,000 in proceeds from the facility based
on its eligible accounts receivable. Laurus has the option to convert into
common stock at anytime all or any portion of the principal and interest and
fees payable at a fixed conversion price as follows:
o first $1,000,000 in principal convertible at a fixed price of $0.40
(80% of the average price for 10 days prior to closing of debt);
o next $1,000,000 in principal convertible at a fixed price of $0.50
(100% of the average price for 10 days prior to closing of debt); and,
o any remaining principal convertible at a fixed price of $0.53 (105% of
the average price for 10 days prior to closing of debt).
Should the Company complete a subsequent financing at a lower price than the
original issue, the conversion prices of the three tranches above will be
adjusted to 80%, 100% and 105% of the new lower price. This feature would modify
the number of shares that the Company will issue on conversion of the notes.
The Company has the option of prepaying the note at any time by paying to the
holder a sum of money equal to 130% of the principal amount of the note.
In connection with the financing, the Company issued warrants to purchase up to
2,100,000 shares of its common stock with 1,050,000 at an exercise price of
$0.55 per share and 1,050,000 at an exercise price of $0.60 per share. The
warrants vest immediately and expire on June 27, 2011. The Company also issued
options to purchase up to 379,572 shares of its common stock, no par value per
share, at an exercise price of $.0001 per share. The options vest immediately
and expire on June 27, 2015.
The financing included a Registration Rights Agreement which prescribes that the
Company shall have caused a registration statement to be filed with the SEC, in
respect of the securities covered by the Minimum Borrowing Note, Warrants and
Options within 30 days of closing and to cause the registrations to become
effective within 90 days of closing. In the event that the Company fails to file
such registration statement, the agreement also provides that the Company shall
pay to Laurus, as partial damages, for each day that an Event has occurred and
is continuing, an amount in cash equal to one-thirtieth (1/30th) of the product
of: (A) the original principal amount of each Minimum Borrowing Note outstanding
at such time multiplied by (B) 0.02. In the event the Company fails to make any
such payments in a timely manner, Section 1 of the Registration Rights Agreement
also provides that such payments shall bear interest at the rate of 1.5% per
month (prorated for partial months) until paid in full.
Assuming a successful registration of the shares and warrants, if the market
price of the Company's common stock exceeds the then applicable fixed conversion
price by at least 25%, the contract rate for the succeeding calendar month shall
automatically be reduced by 100 basis points (1%) for each incremental 25%
increase in the market price of the common stock above the then applicable fixed
conversion price.
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The Company accounted for the Laurus financing as a conventional convertible
debt instrument under EITF 98-5 and EITF 00-27. The proceeds of $3,100,000
received by the Company were allocated between the options, warrants and the
debenture without warrants on a pro rata basis. Paid in capital was credited by
the value of the options and the warrants in the amount of $766,002. This
unamortized debt discount was to be amortized over the three year term of the
facility. The beneficial conversion feature was determined to be $953,739 which
was also credited to paid in capital and was to be amortized over the three year
term of the facility. The Company did not consider the guidance in SFAS 133 in
determining whether the embedded conversion feature should be accounted for
separately as a derivative and the guidance in EITF 00-19 in determining the
classification.
In response to the Commission's comments, the Company has reviewed its
accounting of the Laurus financing to determine whether any of its features
qualify as embedded derivatives under the guidance SFAS 133 and EITF 00-19. The
Company engaged the Complex Accounting and Transaction Expertise group and the
SEC Services Group of Deloitte & Touche to assist with the application of these
standards.
CONVERSION OPTION EMBEDDED IN THE NOTE
The Company concluded that the conversion option embedded in the note meets the
characteristics of a derivative under FAS 133 paragraph 6 by satisfying the
following criteria:
1. The conversion option has an underlying index and a notional amount
which determines the amount of the settlement or settlements, and, in
some cases, whether or not a settlement is required. The underlying
index is the price of the Company's shares and the notional amount is
the number of shares that each tranche can be converted into.
2. The conversion option requires no initial net investment or an initial
net investment that is smaller than would be required for other types
of contracts that would be expected to have a similar response to
changes in market factors. The Company did not pay an initial amount
for the conversion option other than the implicit fair/(time) value of
the option.
3. The conversion option's terms require or permit net settlement, it can
readily be settled net by a means outside the contract, and it
provides for delivery of an asset that puts the recipient in a
position not substantially different from net settlement.
With respect to the third criteria, the Company considered the impact on its
share price should the convertible instruments held by Laurus be converted at
the same time. The financing agreements provide for a mechanism whereby a
conversion can result in no more than 4.99% of the Company's stock being owned
by Laurus at any given time. The issue considered is whether this would allow
Laurus to slowly convert and liquidate in a fashion that would limit the impact
on the share price.
FAS 133, paragraph 11a. states that "Contracts issued or held by that reporting
entity that are both (1) indexed to its own stock and (2) classified in
stockholders' equity in its statement of financial position" would not be
considered derivative contracts. Therefore, in order for the conversion feature
not to be considered an embedded derivative both these criteria must be met.
First, to determine if the embedded feature was indexed to the Company's stock,
we referred to EITF 01-6 - THE MEANING OF INDEXED TO A COMPANY'S STOCK, which
concluded that:
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"5. THE TASK FORCE REACHED A CONSENSUS ON ISSUE 2 THAT INSTRUMENTS WITHIN
THE SCOPE OF THIS ISSUE ARE CONSIDERED INDEXED TO A COMPANY'S OWN STOCK
WITHIN THE MEANING OF ISSUE 00-19 AND PARAGRAPH 11(A) OF STATEMENT 133
FOR THE ISSUER PROVIDED THAT (1) THE CONTINGENCY PROVISIONS ARE NOT BASED
ON (A) AN OBSERVABLE MARKET, OTHER THAN THE MARKET FOR THE ISSUER'S STOCK
(IF APPLICABLE), OR (B) AN OBSERVABLE INDEX, OTHER THAN THOSE CALCULATED
OR MEASURED SOLELY BY REFERENCE TO THE ISSUER'S OWN OPERATIONS (FOR
EXAMPLE, SALES REVENUE OF THE ISSUER, EBITDA [EARNINGS BEFORE INTEREST,
TAXES, DEPRECIATION, AND AMORTIZATION] OF THE ISSUER, NET INCOME OF THE
ISSUER, OR TOTAL EQUITY OF THE ISSUER), AND (2) ONCE THE CONTINGENT
EVENTS HAVE OCCURRED, THE INSTRUMENT'S SETTLEMENT AMOUNT IS BASED SOLELY
ON THE ISSUER'S STOCK"
Also, paragraph 8 concludes that this EITF is still relevant to evaluate
embedded instruments rather than FAS 150
"8. STATEMENT 150 DOES NOT APPLY TO A FEATURE EMBEDDED IN A FINANCIAL
INSTRUMENT THAT IS NOT A DERIVATIVE IN ITS ENTIRETY (FOR EXAMPLE, AN
OPTION EMBEDDED IN A NONDERIVATIVE HOST CONTRACT) IN ANALYZING THE
EMBEDDED FEATURE AS THOUGH IT WERE A SEPARATE INSTRUMENT UNDER THE METHOD
REQUIRED BY PARAGRAPH 12 OF STATEMENT 133. THEREFORE, ISSUE 01-6 (AND
ISSUE 00-19) ARE STILL APPLICABLE WHEN EVALUATING EMBEDDED DERIVATIVES
FOR PURPOSES OF STATEMENT 133."
Paragraph 2.1 of the Minimum Borrowing Note details the conversion conditions,
which are not based on an observable market, other than the market price of the
Company's common shares, instead it is contingent upon registration of the
shares; thus, criterion 11a (1) is met. In order to determine if criterion 11b
(2) is met, we considered EITF 00-19: Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. The
purpose of this EITF is to provide guidance in terms of classification of these
types of instruments (either asset/liability or equity). The general premise is
that contracts that require net-cash settlement are assets or liabilities and
contracts that require settlement in shares are equity instruments.
Paragraph 4 of EITF 00-19 states that:
"4. THE TASK FORCE OBSERVED THAT, PURSUANT TO PARAGRAPHS 11(A) AND 12(C)
OF STATEMENT 133, IF AN EMBEDDED DERIVATIVE IS INDEXED TO THE REPORTING
ENTITY'S OWN STOCK AND WOULD BE CLASSIFIED IN STOCKHOLDERS' EQUITY IF IT
WAS A FREESTANDING DERIVATIVE, THAT EMBEDDED DERIVATIVE IS NOT CONSIDERED
A DERIVATIVE FOR PURPOSES OF STATEMENT 133. THE TASK FORCE REACHED A
CONSENSUS THAT FOR PURPOSES OF EVALUATING UNDER STATEMENT 133 WHETHER AN
EMBEDDED DERIVATIVE INDEXED TO A COMPANY'S OWN STOCK WOULD BE CLASSIFIED
IN STOCKHOLDERS' EQUITY IF FREESTANDING, THE REQUIREMENTS OF PARAGRAPHS
12-32 OF THIS ISSUE DO NOT APPLY IF THE HYBRID CONTRACT IS A CONVENTIONAL
CONVERTIBLE DEBT INSTRUMENT IN WHICH THE HOLDER MAY ONLY REALIZE THE
VALUE OF THE CONVERSION OPTION BY EXERCISING THE OPTION AND RECEIVING THE
ENTIRE PROCEEDS IN A FIXED NUMBER OF SHARES OR THE EQUIVALENT AMOUNT OF
CASH (AT THE DISCRETION OF THE ISSUER). HOWEVER, THE TASK FORCE OBSERVED
THAT THE REQUIREMENTS OF PARAGRAPHS 12-32 OF THIS ISSUE DO APPLY WHEN AN
ISSUER IS EVALUATING WHETHER ANY OTHER EMBEDDED DERIVATIVE INSTRUMENT IS
AN EQUITY INSTRUMENT AND THEREBY EXCLUDED FROM THE SCOPE OF STATEMENT
133."
In order to determine if the convertible note is to be considered "conventional
" such that the provisions of EITF 00-19 paragraphs 12 -32 would not need to be
considered, we looked to EITF 05-2:
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"8. ON ISSUE 2, THE TASK FORCE REACHED A CONSENSUS THAT INSTRUMENTS THAT
PROVIDE THE HOLDER WITH AN OPTION TO CONVERT INTO A FIXED NUMBER OF
SHARES (OR EQUIVALENT AMOUNT OF CASH AT THE DISCRETION OF THE ISSUER) FOR
WHICH THE ABILITY TO EXERCISE THE OPTION IS BASED ON THE PASSAGE OF TIME
OR A CONTINGENT EVENT SHOULD BE CONSIDERED "CONVENTIONAL" FOR PURPOSES OF
APPLYING ISSUE 00-19. INSTRUMENTS THAT CONTAIN "STANDARD" ANTIDILUTION
PROVISIONS WOULD NOT PRECLUDE A CONCLUSION THAT THE INSTRUMENT IS
CONVERTIBLE INTO A FIXED NUMBER OF SHARES. STANDARD ANTIDILUTION
PROVISIONS ARE THOSE THAT RESULT IN ADJUSTMENTS TO THE CONVERSION RATIO
IN THE EVENT OF AN EQUITY RESTRUCTURING TRANSACTION (AS DEFINED IN THE
GLOSSARY OF STATEMENT 123(R)2) THAT ARE DESIGNED TO MAINTAIN THE VALUE OF
THE CONVERSION OPTION."
We considered three factors in our determination of whether the convertible note
was "conventional" or not:
1. The clause that will adjust the conversion prices if a financing is
closed at lower prices than the original price. This feature calls
into question whether the note is convertible into a fixed number of
shares. Note that a subsequent financing would not likely meet the
definition of an equity restructuring as discussed in FAS 123(R).
2. Whether the 2% per month penalty clause if the shares are not
registered would be considered a net cash settlement feature. The
argument is that if the Company is not able to register the underlying
shares, the holder will demand the large penalty which will both
provide an incentive for the Company to get the shares registered and
compensate the holders for not being able to realize on the market
value of the shares. The EITF is currently discussing this issue in
EITF 05-4 THE EFFECT OF A LIQUIDATED DAMAGES CLAUSE ON A FREESTANDING
FINANCIAL INSTRUMENT SUBJECT TO EITF ISSUE NO. 00-19, "ACCOUNTING FOR
DERIVATIVE FINANCIAL INSTRUMENTS INDEXED TO, AND POTENTIALLY SETTLED
IN, A COMPANY'S OWN STOCK", but no conclusion has been reached.
3. The overall complexity of the conditions with respect to the
financing.
As a result, the note may not meet the definition of a "conventional"
convertible debt. If not, then the note would not be considered "conventional"
and therefore the criteria in paragraph 12-32 of EITF 00-19 must be considered.
The conversion option requires physical settlement, since the default settlement
method is through a physical share settlement, which would seem to indicate that
the conversion option would be classified as equity. However, the criteria in
paragraphs 12-32 would call this into question.
Since the contract does not permit the Company to settle in unregistered shares,
paragraphs 14 and 17 of EITF 00-19 clearly state the contract must be classified
as an asset or a liability because the registration of the shares is not within
the control of the Company.
"14. THE EVENTS OR ACTIONS NECESSARY TO DELIVER REGISTERED SHARES ARE
NOT CONTROLLED BY A COMPANY AND, THEREFORE, EXCEPT UNDER THE
CIRCUMSTANCES DESCRIBED IN PARAGRAPH 18, BELOW, IF THE CONTRACT
PERMITS THE COMPANY TO NET-SHARE OR PHYSICALLY SETTLE THE CONTRACT
ONLY BY DELIVERING REGISTERED SHARES, IT IS ASSUMED THAT THE COMPANY
WILL BE REQUIRED TO NET-CASH SETTLE THE CONTRACT. AS A RESULT, THE
CONTRACT MUST BE CLASSIFIED AS AN ASSET OR A LIABILITY."
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The Laurus agreements do not explicitly indicate what would happen if the
Company was unable to deliver registered shares. Upon review, the Company's
legal counsel has indicated that, the holder has the right to refuse
unregistered shares and could simply allow the penalty to accrue until either
registration or maturity of the note in June 2008, implying a penalty of up to
66% of the principal.
"17. THE TASK FORCE OBSERVED THAT IF (A) A DERIVATIVE CONTRACT REQUIRES
PHYSICAL OR NET-SHARE SETTLEMENT BY DELIVERY OF REGISTERED SHARES AND
DOES NOT SPECIFY ANY CIRCUMSTANCES UNDER WHICH NET-CASH SETTLEMENT WOULD
BE PERMITTED OR REQUIRED AND (B) THE CONTRACT DOES NOT SPECIFY HOW THE
CONTRACT WOULD BE SETTLED IN THE EVENT THAT THE COMPANY IS UNABLE TO
DELIVER REGISTERED SHARES, THEN NET-CASH SETTLEMENT IS ASSUMED IF THE
COMPANY IS UNABLE TO DELIVER REGISTERED SHARES (BECAUSE IT IS UNLIKELY
THAT NON-PERFORMANCE WOULD BE AN ACCEPTABLE ALTERNATIVE). CONSEQUENTLY,
THE DERIVATIVE MUST BE CLASSIFIED AS AN ASSET OR A LIABILITY (SUBJECT TO
THE TRANSITION GUIDANCE IN THIS ISSUE) BECAUSE SHARE SETTLEMENT IS NOT
WITHIN THE COMPANY'S CONTROL."
In addition, we examined whether the penalty could be considered a form of
net-cash settlement and if so, what impact this would have on the analysis. We
again considered the discussion above on whether the convertible note is
conventional when evaluating if the penalty may be considered net cash
settlement. Also, EITF 00-19 paragraph 25 states that:
"25. THE TASK FORCE REACHED A CONSENSUS THAT THE ABILITY TO MAKE TIMELY
SEC FILINGS IS NOT WITHIN THE CONTROL OF THE COMPANY. ACCORDINGLY, IF A
CONTRACT PERMITS SHARE SETTLEMENT BUT REQUIRES NET-CASH SETTLEMENT IN THE
EVENT THAT THE COMPANY DOES NOT MAKE TIMELY FILINGS WITH THE SEC, THAT
CONTRACT MUST BE CLASSIFIED AS AN ASSET OR A LIABILITY"
The penalty is not explicitly a settlement for net cash, but presumably, the
holder will either demand the full penalty or negotiate a cash settlement that
will be no less than the increase in market value that the holder is unable to
realize because the shares are not registered; in effect a net cash settlement.
After considering all of these factors we concluded that the embedded conversion
option does not meet the exemption in paragraph 11 of FAS 133 and therefore
should be bifurcated and accounted for separately at market value.
WARRANTS AND OPTIONS
The warrants and options attached to the Laurus financing have similar
characteristics as the conversion option embedded in the Minimum Borrowing Note
such as fixed conversion prices, requirement to settle in registered shares and
a penalty if the shares are not registered.
Paragraph 8 of EITF 00-19 sets out the general rule for freestanding instruments
indexed to the Company's stock:
Equity
o Contracts that require physical settlement or net-share settlement
o Contracts that give the company a choice of net-cash settlement or
settlement in its own shares (physical settlement or net-share
settlement), assuming that all the criteria set forth in paragraphs
12-32 have been met.
Assets or Liabilities
o Contracts that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is
outside the control of the company)
-10-
o Contracts that give the counterparty a choice of net-cash settlement
or settlement in shares (physical settlement or net-share settlement).
It would appear that the conversion option requires physical settlement,
since the default settlement is a physical share settlement, which would
seem to indicate that the conversion option would be classified as equity.
However, paragraphs 12 -32 of EITF 00-19 provide additional conditions that must
be met (footnote 8 to paragraph 39) for an instrument to be classified as equity
under the EITF. As discussed above, because of the requirement in the agreements
to settle in registered shares and the size of the penalty for not registering
the shares, the instrument does not appear to meet these additional criteria.
IMPACT OF A SUBSEQUENT REGISTRATION OF THE UNDERLYING SHARES
We also considered whether the classifications of these instruments would change
should the Company succeed in registering the shares underlying the conversion
option.
EITF 00-19, paragraph 10 states that:
"10. THE CLASSIFICATION OF A CONTRACT SHOULD BE REASSESSED AT EACH
BALANCE SHEET DATE. IF THE CLASSIFICATION REQUIRED UNDER THIS ISSUE
CHANGES AS A RESULT OF EVENTS DURING THE PERIOD (IF, FOR EXAMPLE, AS A
RESULT OF VOLUNTARY ISSUANCES OF STOCK THE NUMBER OF AUTHORIZED BUT
UNISSUED SHARES IS INSUFFICIENT TO SATISFY THE MAXIMUM NUMBER OF SHARES
THAT COULD BE REQUIRED TO NET-SHARE SETTLE THE CONTRACT -- SEE DISCUSSION
IN PARAGRAPH 19, BELOW), THE CONTRACT SHOULD BE RECLASSIFIED AS OF THE
DATE OF THE EVENT THAT CAUSED THE RECLASSIFICATION. THERE IS NO LIMIT ON
THE NUMBER OF TIMES A CONTRACT MAY BE RECLASSIFIED. IF A CONTRACT IS
RECLASSIFIED FROM PERMANENT OR TEMPORARY EQUITY TO AN ASSET OR A
LIABILITY, THE CHANGE IN FAIR VALUE OF THE CONTRACT DURING THE PERIOD THE
CONTRACT WAS CLASSIFIED AS EQUITY SHOULD BE ACCOUNTED FOR AS AN
ADJUSTMENT TO STOCKHOLDERS' EQUITY. THE CONTRACT SUBSEQUENTLY SHOULD BE
MARKED TO FAIR VALUE THROUGH EARNINGS. IF A CONTRACT IS RECLASSIFIED FROM
AN ASSET OR A LIABILITY TO EQUITY, GAINS OR LOSSES RECORDED TO ACCOUNT
FOR THE CONTRACT AT FAIR VALUE DURING THE PERIOD THAT THE CONTRACT WAS
CLASSIFIED AS AN ASSET OR A LIABILITY SHOULD NOT BE REVERSED."
Therefore, the classification of the conversion feature, the warrants and the
options as assets/liabilities (to be marked to market) would be reassessed once
the Company completes the registration of the shares. Note that the other
criteria in EITF 00-19 paragraphs 12-32 would also have to be met in order for
the instruments to be reclassified to equity. For example:
a) The Company has sufficient authorized and unissued shares available to
settle the contract after considering all other commitments that may
require the issuance of stock during the maximum period the derivative
contract could remain outstanding.
b) The contract contains an explicit limit on the number of shares to be
delivered in a share settlement
c) There are no required cash payments to the counterparty in the event
the Company fails to make timely filings with the SEC
d) There are no required cash payments to the counterparty if the shares
initially delivered upon settlement are subsequently sold by the
counterparty and the sales proceeds are insufficient to provide the
counterparty with full return of the amount due (that is, there are no
cash settled "top-off" or "make-whole" provisions)
-11-
e) The contract requires net-cash settlement only in specific
circumstances in which holders of shares underlying the contract also
would receive cash in exchange for their shares.
f) There are no provisions in the contract that indicate that the
counterparty has rights that rank higher than those of a shareholder
of the stock underlying the contract.
g) There is no requirement in the contract to post collateral at any
point or for any reason
THE 8% FLOOR ON THE INTEREST VARIABLE INTEREST RATE
This clause contained in the Laurus loan agreement would appear to be considered
clearly and closely related to the debt and would not be bifurcated, since the
criteria in paragraph 13 (a) and (b) of FAS 133 are not met. The floor would not
meet the condition in paragraph 13(a) because it could not result in the
investor not recovering substantially all of its initial investment. The floor
also would not meet the conditions in paragraph 13(b) because it could not
result in a rate of return that is more than double the initial rate of return
of nine percent (prime of about 5% at inception plus four percent). The floor,
when in the money, will only result in a rate of eight percent.
THE CLAUSE THAT CONTAINS AN ADJUSTMENT TO THE INTEREST RATE BASED ON THE MARKET
PRICE OF THE SHARES
This clause contained in the Laurus loan agreement appears to be an embedded
derivative since an adjustment based on the equity price would not be clearly
and closely related to the debt host.
-12-
PREPAYMENT CLAUSE
It would appear that the prepayment clause contained in the Laurus loan
agreement is an embedded derivative under the guidance in DIG issue B16 since
the debt was issued at a discount (after separating the warrant and options),
and an investor can get double the stated return if the debt is called within
about the first two years of the term (stated return of approximately 9% per
year versus the 30% redemption premium).
The Company has concluded that the conversion option embedded in the note and
the warrants and options attached to the note qualify as embedded derivatives
under the guidance of SFAS 133 and EITF 00-19, and as such should be accounted
for separately at inception at their fair value and subsequently marked to
market. These instruments should also be classified as liabilities rather than
as equity instruments. The remaining proceeds at inception would be allocated to
the debt instrument and accreted back to its maturity amount over the life of
the debt.
As the embedded derivatives are not standard and are not publicly quoted, a
combination of Black & Scholes methodologies and Monte Carlo simulations were
used.
Valuations were performed as of June 30, 2005 and September 30, 2005 and the
conversion option, warrants and options were each valued separately. As the
Company has no public rating or no public debt, it is very difficult to estimate
the potential change of the credit spread between the issue date and valuation
dates. Moreover, there is no evidence of any material event that could change
significantly the credit spread of the issue. A constant credit spread equal to
300 basis points as per the issue date was therefore assumed in the valuation.
For the valuation as of June 30, 2005, an assumption of 100% volatility was used
and for the valuation as of September 30, 2005 an assumption of 142% volatility
was used.
CONVERSION OPTION
As the issue is a floating rate note, it is inferred that it will substantially
be always equal to par ($3,100,000 USD(1)). The implied number of conversion
options will be derived by dividing the notional by the average conversion
price. As showed in the table below, the conversion price was calculated using
the weighted average conversion price for each tranche. This option was valued
using a standard Black & Scholes model.
TRANCHE NOTIONAL CONVERSION PRICE WEIGHTED
AVERAGE
Tranche 1 1,000,000 0.4 0.1290
Tranche 2 1,000,000 0.5 0.1613
Tranche 3 1,100,000 0.53 0.1881
================ =============
TOTAL 3,100,000 0.4784
- ---------------
(1) Notionals vary according to the outstanding eligible accounts receivable
balance which are $2,929,111 as of June 30th and $2,958,117 as of September 30th
respectively.
-13-
The interest rate adjustment clause contained in the conversion option sets that
if the stock price exceeds the prevailing conversion price by a certain level,
interest payments on the floating rate note will be reduced. This clause
diminishes the conversion options fair value as the holder will be penalized
when the conversion option will be in the money. The fair value for this clause
is dependant on the expected behaviour of the prime rate and the Company's stock
price. This clause was valued using a Monte Carlo simulation model using a mean
reversion process to simulate the prime rate and a standard Geometric Brownian
motion process for the Company's stock price.
The 8% floor on interest rate clause contained in the conversion option was
valued using a Monte Carlo simulation model with a mean reversion process to
simulate the prime rate. As the value of the floor option was determined to be
relatively insignificant ($17,000 liability as of June 30, 2005 and $10,000
liability as of September 30, 2005 representing an impact on the fair value of
..6% and .3% respectively for the valuations), it was ignored in the valuation of
the conversion option. The impact of this analysis will be performed at each
valuation date. If the model shows that the floor option would have a
significant impact on the market value, the conversion option will have to be
valued using a different model that will implicitly account for the floor option
such as the binomial model.
The 5% limitation upon issuance of shares was ignored in this valuation based on
the assumption that it is a liquidity feature that would not significantly
impact the valuation.
WARRANTS AND OPTIONS
Valuation of the warrants and options were performed separately using standard
Black & Scholes methodology. As the Company would be required to issue new
shares for these instruments it used a valuation with a dilution effect.
VALUATION RESULTS
Derivative 6/30/05 9/30/05
- ------------------------------------- ------------- --------------
Conversion Options $857,787 $574,840
Interest Adjustment Clause (83,024) ($40,687)
Warrants $677,747 $459,202
Options $175,687 $105,415
-------- --------
$1,628,198 $1,098,770
========== ==========
-14-
The entries to correct the accounting of the embedded derivatives contained
within the Laurus financing are as follows:
JUNE 30, 2005 DR CR
- ------------- --------- ---------
To reverse previous entry:
Unamortized Beneficial Conversion Feature 951,126
Unamortized Debt Discount 763,903
Paid in Capital 1,719,741
Interest Expense (3 days amortization of
BCF and Debt Discount) 4,712
--------- ---------
1,719,741 1,719,741
========= =========
To record at fair value as at June 30, 2005
and record amortization for 3 days:
Conversion Option 857,787
Interest Adjustment Clause 83,024
Warrants 677,747
Options 175,687
Deferred Financing Costs 1,628,198
Deferred Financing Costs 4,523
Financing Expense (3 days amortization) 4,523
--------- ---------
1,715,745 1,715,745
========= =========
SEPTEMBER 30, 2005 DR CR
- ------------------ --------- ---------
To reverse previous entry:
Unamortized Beneficial Conversion Feature 79,261
Unamortized Debt Discount 63,659
Interest Expense (3 months amortization of
BCF and Debt Discount) 142,920
--------- ---------
142,920 142,920
========= =========
To adjust fair value to September 30, 2005
valuation and record amortization for
3 months:
Conversion Option 282,947
Interest Adjustment Clause 42,337
Warrants 218,546
Options 70,272
Deferred Financing Costs 135,306
Financing Expense (3 months amortization) 135,306
Financing Expense (Mark-to-market of derivatives)
529,428
--------- ---------
707,071 707,071
========= =========
-15-
The following table quantifies the EPS impact of these restatements:
OPERATING
EARNINGS
AMOUNT PER SHARE
- --------------------------------------------------------------------------------
Net loss, as reported in Form 10-QSB
for the quarterly period ended
June 30, 2005 (820,529) (0.21)
To correct accounting error
for embedded derivatives 189 (0.00)
REVISED NET LOSS (820,340) (0.21)
- --------------------------------------------------------------------------------
Net loss, as reported in Form 10-QSB
for the quarterly period ended
September 30, 2005 (534,335) (0.11)
To correct accounting error
for embedded derivatives 537,042 0.11
REVISED NET INCOME 2,707 0.00
- --------------------------------------------------------------------------------
The tables attached hereto as Exhibit B quantify the balance sheet impact of
these misstatements.
The Company intends to file Forms 10-QSB/A amending the Forms 10-QSB for the
periods ending June 30, 2005 and September 30, 2005, to include the respective
restated financial statements as soon as possible after the completion of its
discussions with the SEC staff.
In its decision to amend the Forms 10-QSB, the Company gave consideration to SAB
99 which emphasizes the importance of considering both quantitative and
qualitative factors in assessing the materiality of accounting misstatements. At
both June 30, 2005 and September 30, 2005, the accounting misstatements resulted
in gains on statements of operations. Although the amount of gain at June 30,
2005 was immaterial the gain at September 30, 2005 was greater than the reported
loss and therefore resulted in positive income for the period. At both June 30,
2005 and September 30, 2005, the accounting misstatements resulted in greater
liabilities than those reported. In consideration of the balance sheet impact as
well as the complexity and nature of the derivative instruments, the Company
concluded that the misstatements were material and that the financial statements
for the quarterly periods ending June 30, 2005 and September 30, 2005 be
restated and that the respective Forms 10-QSB be amended.
8. YOUR DISCLOSURE SUGGESTS THAT YOUR DISCLOSURE CONTROLS AND PROCEDURES ARE
EFFECTIVE IN ALERTING THE OFFICERS ON A TIMELY BASIS TO MATERIAL INFORMATION
REQUIRED TO BE INCLUDED IN YOUR EXCHANGE ACT REPORTS. AS PREVIOUSLY REQUESTED IN
PRIOR COMMENT NUMBER 5 OF OUR LETTER DATED JULY 28, 2005, PLEASE CONFIRM WHETHER
YOUR OFFICERS HAVE ALSO CONCLUDED ON THE EFFECTIVENESS OF DISCLOSURE CONTROLS
AND PROCEDURES AS DEFINED IN RULE 13A-15(E) OF THE EXCHANGE ACT. IN THIS REGARD,
PROVIDE US WITH AND INCLUDE IN ANY AMENDMENT TO YOUR FILING A STATEMENT
REGARDING WHETHER YOUR OFFICERS CONCLUDED THAT YOUR DISCLOSURE CONTROLS AND
PROCEDURES ARE ALSO EFFECTIVE IN ENSURING THAT INFORMATION REQUIRED TO BE
DISCLOSED IS RECORDED, PROCESSED, SUMMARIZED AND REPORTED WITHIN THE TIME
PERIODS SPECIFIED IN THE COMMISSIONS RULES AND FORMS.
-16-
RESPONSE
Please see the revised disclosure below. The disclosure affirmatively states
that "the controls and procedures are not effective to ensure that information
required to be disclosed by us in the reports that we file or submit under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Commission's rules and forms."
"(a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are
designed to ensure that information required to be disclosed in the
Company's reports under the Securities Exchange Act of 1934, as amended
(the "Exchange Act") is recorded, processed, summarized and recorded
within time periods specified in the SEC's rules and forms, and that
such information is accumulated and communicated to the Company's
management, including its Chief Executive Officer and Chief Financial
Officer, as appropriate, to allow timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and
procedures, management recognized that any controls and procedures, no
matter how well designed and operated, can provide only reasonable
assurances of achieving the desired control objectives, and management
was required to apply its judgment in evaluating its cost benefit
relationship of possible controls and procedures. The Company's
certifying officers have concluded that the Company's disclosure
controls and procedures were not effective in reaching that level of
reasonable assurance in so far as the controls and procedures are not
effective to ensure that information required to be disclosed by us in
the reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified
in the Commission's rules and forms.
As of the end of the period covered by this report, an evaluation was
performed under the supervision and with the participation of our
Company's management, including the Chief Executive Officer and the
Chief Financial Officer, of the effectiveness of the design and
operation of the Company's disclosure controls and procedures. Based
upon that evaluation, the Chief Executive Officer and the Chief
Financial Officer concluded that the Company's disclosure controls and
procedures were not effective. In light of the material weakness
described below, which were first discovered by the Chief Executive
Officer and the Chief Financial Officer subsequent to the end of the
quarter ended June 30, 2005, the Company implemented additional
procedures to ensure its consolidated financial statements are prepared
in accordance with generally accepted accounting principles.
Accordingly, management believes the financial statements presented in
this Form 10-QSB fairly present, in all material respects, the
Company's financial position, results of operations and cash flow for
the periods presented.
The Company's management, including the Company's Chief Executive
Officer and Chief Financial Officer, assessed the effectiveness of the
Company's internal control over financial reporting as of June 30,
2005.
A material weakness is a control deficiency, or combination of control
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. As of June 30, 2005, management has
identified the following material weaknesses:
-17-
1. As of June 30, 2005, the Company did not have an effective control
environment based on criteria established in "Internal Control -
Integrated Framework" issued by COSO. The Company failed to design
appropriate company wide policies and procedures over the accounting,
revenue, treasury and risk management functions and did not uniformly
and consistently communicate the importance of internal controls
throughout the organization. In addition, the Company's policies and
procedures with respect to review and supervision of its accounting
operations were not operating effectively in so far as the Company
failed to implement the appropriate accounting treatment in connection
with two convertible debenture financings engaged in by the Company.
This control deficiency, together with the control deficiencies
described in point 2 below, indicate that the Company did not maintain
an effective control environment. This control deficiency could result
in a material misstatement of annual or interim financial statements
that would not be prevented or detected. Accordingly, management
determined that this control deficiency constitutes a material
weakness.
2. As of June 30, 2005, the Company did not maintain a sufficient
complement of personnel with an appropriate level of accounting
knowledge, experience and training in the application of generally
accepted accounting principles commensurate with the Company's
financial reporting requirements including personnel that had the
expertise to evaluate the accounting treatment of convertible
debentures issued by the Company. In addition, the Company also failed
to implement processes to ensure periodic monitoring of its existing
internal control activities over financial reporting. Specifically, the
Company had a shortage of finance and accounting staff with sufficient
depth and skill in the application of U.S. generally accepted
accounting principles and individuals in the finance function who did
not have the appropriate skills, training and experience to meet the
objective that should be expected of these roles.
Because of these material weaknesses, management has concluded that the
Company did not maintain effective internal control over financial
reporting as of June 30, 2005, based on the criteria in Internal
Control - Integrated Framework.
PLAN FOR REMEDIATION OF MATERIAL WEAKNESSES
At the direction of our board of directors, management has spent and
continues to spend a significant amount of time, effort and resources
to improve our control environment. Such efforts have included the
engagement of the Complex Accounting and Transaction Expertise and the
SEC Services Group of Deloitte & Touche, the appointment of David
Barnes as a director of the Company who has extensive accounting
experience and will serve on our audit committee, the subscription to
accounting journals and the attendance of accounting seminars by our
personnel. This effort has been undertaken to improve our operational
and financial reporting efficiency.
-18-
Although we have undertaken steps to prevent further material
weaknesses or significant deficiencies in our internal controls, we
cannot assure that we will not in the future identify further material
weaknesses or significant deficiencies in our internal control over
financial reporting that have not previously been identified, or that
all the material weaknesses identified in this report will be
remediated by December 31, 2005.
(B) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
Except the material weaknesses identified including the Company's
failure to appropriately apply accounting standards to two convertible
debenture financings, there were no changes in the Company's internal
control over financial reporting during the quarter ended June 30,
2005, other than as described above, that materially affected, or are
reasonably likely to materially affect, the Company's internal control
over financial reporting."
9. WE NOTE YOUR DISCLOSURE THAT "SINCE THE EVALUATION DATE, THERE HAVE NOT BEEN
ANY SIGNIFICANT CHANGES IN [Y]OUR INTERNAL CONTROLS OR IN OTHER FACTORS THAT
COULD SIGNIFICANTLY AFFECT SUCH CONTROLS. AS PREVIOUSLY REQUESTED IN PRIOR
COMMENT NUMBER 6 OF OUR LETTER DATED JULY 28, 2005, PROVIDE US WITH AND INCLUDE
IN ANY AMENDMENT TO YOUR FILING A DEFINITIVE STATEMENT REGARDING WHETHER THERE
HAS BEEN ANY CHANGE IN YOUR INTERNAL CONTROL OVER FINANCIAL REPORTING IDENTIFIED
IN CONNECTION WITH YOUR EVALUATION THAT OCCURRED DURING THE PERIOD COVERED BY
THE REPORT THAT HAS MATERIALLY AFFECTED OR IS REASONABLY LIKELY TO MATERIALLY
AFFECT YOUR INTERNAL CONTROL OVER FINANCIAL REPORTING. REFER TO SECTION II.F.4
OF RELEASE NO. 33-8238 FOR ADDITIONAL GUIDANCE.
RESPONSE
Please see the response to comment 8 above. We have revised the disclosure to
state that "there were no changes in the Company's internal control over
financial reporting during the quarter ended June 30, 2005, other than as
described above, THAT MATERIALLY AFFECTED, or are REASONABLY LIKELY TO
MATERIALLY AFFECT, the Company's internal control over financial reporting."
[emphasis added].
10. IN LIGHT OF THE FACT THAT MATERIAL WEAKNESSES EXISTED AS OF DECEMBER 31,
2004, TELL US AND DISCLOSE IN ANY AMENDMENT IN REASONABLE DETAIL THE BASIS FOR
THE OFFICERS' CONCLUSION THAT YOUR DISCLOSURE CONTROLS AND PROCEDURES WERE
NONETHELESS EFFECTIVE AS OF JUNE 30, 2005. IN THIS REGARD, DESCRIBE WHY YOU
BELIEVE THAT THE MATERIAL WEAKNESSES NO LONGER EXIST.
RESPONSE
See the response to comment 8 above. We have revised to disclose that the
material weaknesses still existed as of June 30, 2005 and we are working to
eliminate such material weaknesses by the year ending December 31, 2005.
***
The Company acknowledges that it is responsible for the adequacy and
accuracy of the disclosure in the filings; that staff comments or changes to
disclosure in response to staff comments do not foreclose the Commission from
taking any action with respect to the filing; and the Company may not assert
staff comments as a defense in any proceeding initiated by the Commission or any
person under the federal securities laws of the United States.
-19-
Prior to filing a clean copy of the Form 10-K/A and Forms 10-QSB/A on
Edgar we respectfully request a conference call to ensure that we have addressed
the above matters to your satisfaction.
Sincerely,
Kelly L. Hankinson
Chief Financial Officer
Tel: 905-460-3042
Fax: 905-460-3050
cc: Arthur Marcus, Esq.
Gersten Savage LLP
-20-
Schedule A
Calculation of Adjustments to BCF 2003 and 2004
31-Dec-04
Alpha Alpha
Investor Prior to: Bristol Camden Cap 1 Aspen Standard Tazbaz Stonestreet Cap Filter Cap 2
Issue Date 26-Jun-05 5-Dec-02 5-Dec-02 5-Dec-02 5-Dec-02 5-Dec-02 31-Dec-02 21-Jan-03 21-Jan-03 21-Jan-03
- -----------------------------------------------------------------------------------------------------------------------------------
Principal: $ 200,000 $ 200,000 $ 250,000 $ 100,000 $ 50,000 $ 100,000 $ 75,000 $ 75,000 $ 25,000
Allocate to Warrants: $ 158,868 $ 158,868 $ 198,565 $ 79,434 $ 39,715 $ 71,456 $ 51,972 $ 51,972 $ 181,123
Allocate to Debenturess: $ 41,132 $ 41,132 $ 51,415 $ 20,566 $ 10,285 $ 28,544 $ 23,028 $ 23,028 $ 93,877
Most Beneficial
Conversion Price:
Stock Price @ Issue Date
# of Shares on Conversion
Effective Conversion Price
- -----------------------------------------------------------------------------------------------------------------------------------
Beneficial Conversion on Issue
===================================================================================================================================
Limit to beneficial
conversion $ 41,132 $ 41,132 $ 51,415 $ 20,566 $ 10,285 $ 28,544 $ 23,028 $ 23,028 $ 7,676
Beneficial
conversion amount
Q4 2002 $ 41,132 $ 41,132 $ 51,415 $ 20,566 $ 10,285 $ 28,544 $ 23,028 $ 23,028 $ 93,877
Q1 2003
Q2 2003
Q3 2003
Q4 2003
Q1 2004
Q2 2004
Q3 2004
Q4 2004
Total warrant and
beneficial conversion
amounts $ 200,000 $ 200,000 $ 250,000 $ 100,000 $ 50,000 $ 100,000 $ 75,000 $ 75,000 $ 275,000
Amortization of debt discount
and beneficial conversion
Q4 2002 14,130 14,130 17,663 7,065 3,533 3,533
Q1 2003 110,870 50,000 62,500 25,000 12,500 41,467 26,000 14,063 33,628
Q2 2003 75,000 50,000 62,500 25,000 12,500 55,000 49,000 18,750 68,750
Q3 2003 85,870 62,500 25,000 12,500 -- -- 27,187 68,750
Q4 2003 44,837 17,935 8,967 -- -- 15,000 103,872
Q1 2004
Q2 2004
Q3 2004
Q4 2004
Unamortized balance
Dec 31, 2004 $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ --
===================================================================================================================================
Alpha Alpha
Investor Prior to: Camden 2 Bristol 2 Stonestreet 2 Cap 3 Camden 3 Cap 3 Camden 4 Tazbaz 2
Issue Date 26-Jun-05 14-Feb-03 14-Feb-03 14-Feb-03 14-Mar-03 8-Apr-03 2-May-03 8-May-03 28-May-03
- -----------------------------------------------------------------------------------------------------------------------------------
Principal: $ 275,000 $ 200,000 $ 125,000 $ 100,000 $ 225,000 $ 100,000 $ 40,000 $ 60,000
Allocate to Warrants: $ 181,123 $ 131,725 $ 82,328 $ 30,865 $ 71,124 $ 20,561 $ 9,588 $ 15,548
Allocate to Debenturess: $ 93,877 $ 68,275 $ 42,672 $ 69,135 $ 153,876 $ 79,439 $ 30,412 $ 44,452
Most Beneficial
Conversion Price:
Stock Price @ Issue Date
# of Shares on Conversion
Effective Conversion Price
- -----------------------------------------------------------------------------------------------------------------------------------
Beneficial Conversion on Issue
===================================================================================================================================
Limit to beneficial
conversion $ 93,877 $ 68,275 $ 42,672 $ 69,135 $ 153,876 $ 79,439 $ 30,412 $ 44,452
Beneficial
conversion amount $ 93,877 $ 68,275 $ 42,672 $ 69,135 $ 153,876 $ 79,439 $ 30,412 $ 44,452
Q4 2002
Q1 2003
Q2 2003
Q3 2003
Q4 2003
Q1 2004
Q2 2004
Q3 2004
Q4 2004
Total warrant and
beneficial conversion
amounts $ 275,000 $ 200,000 $ 125,000 $ 100,000 $ 225,000 $ 100,000 $ 40,000 $ 60,000
Amortization of debt discount
and beneficial conversion
Q4 2002
Q1 2003 33,628 24,457 15,285
Q2 2003 68,750 50,000 31,250 4,620 50,747 20,000 5,761 5,380
Q3 2003 68,750 125,543 31,250 25,000 56,250 25,000 10,000 54,620
Q4 2003 103,872 47,215 25,000 118,003 55,000 24,239
45,380
Q1 2004 45,380
Q2 2004
Q3 2004
Q4 2004
Unamortized balance
Dec 31, 2004 $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ --
===================================================================================================================================
Alpha
Investor Prior to: Bristol 3 Tazbaz 3 Bristol 4 Bristol 5 Filter 2 Cap 5 Tazbaz 2 Bristol 6
Issue Date 26-Jun-05 30-Jun-03 17-Jul-03 22-Jul-03 14-Oct-03 14-Oct-03 20-Oct-03 24-Oct-03 31-Oct-03
- -----------------------------------------------------------------------------------------------------------------------------------
Principal: $ 150,000 $ 50,000 $ 150,000 $ 100,000 $ 50,000 $ 75,000 $ 100,000 $ 100,000
Allocate to Warrants: $ 103,322 $ 7,502 $ 108,598 $ 79,800 $ 39,049 $ 58,574 $ 11,550 $ 78,099
Allocate to Debenturess: $ 46,678 $ 42,498 $ 41,402 $ 20,200 $ 10,951 $ 16,426 $ 88,450 $ 21,901
Most Beneficial
Conversion Price:
Stock Price @ Issue Date
# of Shares on Conversion
Effective Conversion Price
- -----------------------------------------------------------------------------------------------------------------------------------
Beneficial Conversion on Issue
===================================================================================================================================
Limit to beneficial
conversion $ 46,678 $ 42,498 $ 41,402 $ 20,200 $ 10,951 $ 16,426 $ 88,450 $ 21,901
Beneficial
conversion amount $ 46,678 $ 42,498 $ 41,402 $ 20,200 $ 10,951 $ 16,426 $ 88,450 $ 21,901
Q4 2002
Q1 2003
Q2 2003
Q3 2003
Q4 2003
Q1 2004
Q2 2004
Q3 2004
Q4 2004
Total warrant and
beneficial conversion
amounts $ 150,000 $ 50,000 $ 150,000 $ 100,000 $ 50,000 $ 75,000 $ 100,000 $ 100,000
Amortization of debt discount
and beneficial conversion
Q4 2002 408
Q1 2003 37,500 50,000 28,533
Q2 2003 112,092 121,467 70,000 20,000 14,878 25,000 16,576
Q3 2003 30,000 30,000 60,122 75,000 83,424
Q4 2003 30,000 30,000 18,750 75,000 83,424
18,750
Q1 2004 18,750
Q2 2004 3,872
Q3 2004
Q4 2004
Unamortized balance
Dec 31, 2004 $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ --
===================================================================================================================================
Investor Prior to: Tazbaz 5 Bristol 7 Tazbaz 6 Bristol 8 Tazbaz 7 Bristol 9 Tazbaz 8
Issue Date 26-Jun-05 8-Jan-04 24-Mar-04 29-Mar-04 20-May-04 24-May-04 18-Jun-04 18-Jun-04
- -----------------------------------------------------------------------------------------------------------------------------------
Principal: $ 25,000 $ 350,000 $ 100,000 $ 150,000 $ 100,000 $ 250,000 $ 200,000
Allocate to Warrants: $ 2,778 $ 253,001 $ 68,963 $ 113,192 $ 73,871 $ 202,231 $ 157,068
Allocate to Debenturess: $ 22,222 $ 96,999 $ 31,037 $ 36,808 $ 26,129 $ 47,769 $ 42,932
Most Beneficial
Conversion Price: $ 0.00115 $ 0.00050 $ 0.00045 $ 0.00045 $ 0.00040 $ 0.00050 $ 0.00050
Stock Price @ Issue Date $ 0.0023 $ 0.0010 $ 0.0009 $ 0.0008 $ 0.0008 $ 0.0010 $ 0.0010
# of Shares on Conversion 21,739,130 700,000,000 222,222,222 375,000,000 250,000,000 500,000,000 400,000,000
Effective Conversion
Price $ 0.001022212 $0.000138570 $0.000139667 $0.000098155 $0.000104516 $ 0.000095538 $0.000107330
- -----------------------------------------------------------------------------------------------------------------------------------
Beneficial Conversion on Issue $ 27,778 $ 603,001 $ 168,963 $ 443,192 $ 259,585 $ 452,231 $ 357,068
===================================================================================================================================
Limit to beneficial
conversion $ 22,222 $ 96,999 $ 31,037 $ 36,808 $ 26,129 $ 47,769 $ 42,932
Beneficial
conversion amount
Q4 2002
Q1 2003
Q2 2003
Q3 2003
Q4 2003 $ 22,222 $ 96,999 $ 31,037
Q1 2004 $ 36,808 $ 26,129 $ 47,769 $ 42,932
Q2 2004
Q3 2004
Q4 2004
Total warrant and
beneficial conversion
amounts $ 25,000 $ 350,000 $ 100,000 $ 150,000 $ 100,000 $ 250,000 $ 200,000
Amortization of debt discount
and beneficial conversion
Q4 2002 25,000 5,833 556
Q1 2003 -- 116,167 99,444 16,896 10,165 8,242 6,593
Q2 2003 -- 87,500 -- 37,500 89,835 62,500 50,000
Q3 2003 -- 87,500 -- 37,500 -- 62,500 143,407
Q4 2003
Q1 2004
Q2 2004
Q3 2004
Q4 2004
Unamortized balance
Dec 31, 2004 $ -- $ 53,000 $ -- $ 58,104 $ -- $ 116,758 $ --
===================================================================================================================================
Investor Prior to: Bristol 10 Alpha 6 Tazbaz 9
Issue Date 26-Jun-05 12-Nov-04 12-Nov-04 12-Nov-04 12-Nov-04
- -----------------------------------------------------------------------------------------------------------------------------------
Principal: $ 312,500 $ 312,500 $ 250,000
Allocate to Warrants: $ 169,290 $ 154,781 $ 123,825
Allocate to Debenturess: $ 143,210 $ 157,719 $ 126,175
Most Beneficial
Conversion Price: $ 0.00016 $ 0.00016 $ 0.00016
Stock Price @ Issue Date $ 0.0002 $ 0.0002 $ 0.0002
# of Shares on Conversion 1,953,125,000 1,953,125,000 1,562,500,000
Effective Conversion
Price $ 0.000073324 $ 0.000080752 $ 0.000080752
- -----------------------------------------------------------------------------------------------------------------------------------
Beneficial Conversion on Issue $ 247,414 $ 232,906 $ 186,235 $ 2,978,373
===================================================================================================================================
Limit to beneficial
conversion $ 143,210 $ 157,719 $ 126,175 $ 1,848,450
Beneficial
conversion amount $ -- Booked Diff
Q4 2002 $ 193,074 2,898,328 -$ 2,705,254
Q1 2003 $ 327,691 4,029,216 -$ 3,701,525
Q2 2003 $ 354,857 621,490 -$ 266,633
Q3 2003 $ 104,100 1,528,700 -$ 1,424,600
Q4 2003 $ 137,728 1,067,739 -$ 930,011
Q1 2004 $ 150,258 624,211 -$ 473,953
Q2 2004 $ 153,638 916,229 -$ 762,591
Q3 2004 -- 967,440 -$ 967,440
Q4 2004 $ 143,210 $ 157,719 $ 126,175 $ 427,104 1,298,952 -$ 871,848
$ 1,848,450 13,952,305 -$12,103,855
Total warrant and
beneficial conversion
amounts $ 312,500 $ 312,500 $ 250,000
Amortization of debt discount
and beneficial conversion Booked Diff
Q4 2002 $ 60,054 2,898,328 -$ 2,838,274
Q1 2003 $ 420,458 4,029,216 -$ 3,608,758
Q2 2003 $ 590,916 621,490 -$ 30,574
Q3 2003 $ 931,753 1,528,700 -$ 796,947
Q4 2003 $ 847,893 1,067,739 -$ 219,846
$ 323,926
Q1 2004 $ 313,943 624,211 -$ 310,268
Q2 2004 $ 276,257 916,229 -$ 639,972
Q3 2004 $ 346,085 967,440 -$ 621,355
Q4 2004 41,610 41,610 40,000 $ 457,999 1,298,952 -$ 840,953
Unamortized balance
Dec 31, 2004 $ 270,890 $ 270,890 $ 210,000 $ 979,642 13,952,305 -$ 9,906,947
===================================================================================================================================
REVISED AS FILED DIFF
------- -------- ----
Face Value 1,484,600
Revised Disc. (979,958)
------------
2004 504,958 566,653 (61,695) - AJE - B/S
============
Revised As Filed Diff
2004 1,394,284 3,806,832 (2,412,548) - AJE - P&L
2003 460,000
(323,926)
------------
136,074 215,558 (79,484) - AJE - B/S
============
2003 2,591,020 7,247,145 (4,656,125) - AJE - P&L
2002 900,000
(839,946)
----------------------------
60,054 192,950 (132,896) - AJE - B/S
============================
2002 60,054 2,989,328 (2,838,274) - AJE - P&L
EXHIBIT B
30-Jun-05
Reported Adj Revised
LIABILITIES
CURRENT LIABILITIES
Laurus Funds
Principal 2,929,111 2,929,111 Group as "Laurus Funds"
Unamortized Beneficial
Conversion Feature -951,126 951,126 Group as "Laurus Funds"
Unamortized Debt Discount -763,904 763,904 Group as "Laurus Funds"
Deferred Financing Costs -1,623,675 -1,623,675 Group as "Laurus Funds"
Conversion Option 857,787 857,787 Group as "Current Derivatives"
Interest Adjustment Clause -83,024 -83,024 Group as "Current Derivatives"
Accounts payable 1,627,646 1,627,646
Current portion long-term debt 116,495 116,495
------------ ---------------
2,958,222 3,824,340
LONG-TERM LIABILITIES
Long-term portion of debt 138,678 138,678
Warrants 677,747 677,747 Group as "Long-Term Derivatives"
Options 175,687 175,687 Group as "Long-Term Derivatives"
138,678 992,112
------------ ---------------
3,096,900 4,816,452
============ ===============
STOCKHOLDERS' EQUITY
CAPITAL STOCK 51,801,313 -1,719,741 50,081,572
DEFICIT -45,170,552 189 -45,170,363
ACCUMULATED OTHER COMPREHENSIVE LOSS -1,335,957 -1,335,957
------------ ---------------
5,294,804 3,575,252
------------ ---------------
8,391,704 8,391,704
============ ===============
30-Sep-05
Reported Adj Revised
Liabilities
Current Liabilities
Laurus Funds
Principal 2,958,117 2,958,117 Group as "Laurus Funds"
Unamortized Beneficial
Conversion Feature -871,865 871,865 Group as "Laurus Funds"
Unamortized Debt Discount -700,244 700,244 Group as "Laurus Funds"
Deferred Financing Costs -1,488,369 -1,488,369 Group as "Laurus Funds"
Conversion Option 574,840 574,840 Group as "Current Derivatives"
Interest Adjustment Clause -40,687 -40,687 Group as "Current Derivatives"
Accounts payable 1,192,707 1,192,707
Current portion long-term debt 117,165 117,165
--------------- -------------
2,695,880 3,313,773
Long-term Liabilities
Long-term portion of debt 113,449 113,449
Warrants 459,202 459,202 Group as "Long-term Derivatives"
Options 105,415 105,415 Group as "Long-term Derivatives"
113,449 678,066
--------------- -------------
2,809,329 3,991,839
=============== =============
STOCKHOLDERS' EQUITY
CAPITAL STOCK 52,139,370 -1,719,741 50,419,629
DEFICIT -45,704,887 537,231 -45,167,656
ACCUMULATED OTHER COMPREHENSIVE LOSS -1,335,275 -1,335,275
--------------- -------------
5,099,208 3,916,698
--------------- -------------
7,908,537 7,908,537 (test)
=============== =============