M E M O R A N D U M
FORM 20-F FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
Item 15. Controls and Procedures. Page 77
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1. YOU STATE THAT SINCE THE EVALUATION PERFORMED IN CONNECTION WITH THE
EFFECTIVENESS OF THE COMPANY'S DISCLOSURE CONTROLS AND PROCEDURES AS OF
DECEMBER 31, 2004, "THERE HAVE BEEN NO 'SIGNIFICANT CHANGES' IN OUR
INTERNAL CONTROLS OR IN FACTORS THAT COULD SIGNIFICANTLY AFFECT OUR
INTERNAL CONTROLS..." PLEASE NOTE THAT RULE 13A-15(D) REQUIRES THE
DISCLOSURE OF "ANY" CHANGE IN YOUR INTERNAL CONTROLS. TELL US WHETHER
THERE WERE CHANGES IN YOUR INTERNAL CONTROL OVER FINANCIAL REPORTING
THAT OCCURRED DURING THE APPLICABLE PERIOD THAT HAVE MATERIALLY
AFFECTED, OR ARE REASONABLY LIKELY TO MATERIALLY AFFECT, YOUR INTERNAL
CONTROL OVER FINANCIAL REPORTING.
The Company confirms that there were no changes in its internal controls during
the period covered by the annual report that have materially affected, or are
reasonably likely to materially affect, its internal control over financial
reporting. The Company also wishes to advise the Staff supplementally that there
has been no change in the Company's internal control over financial reporting
that occurred in 2005 to date, that has materially affected, or is reasonably
likely to materially affect, the Company's internal control over financial
reporting.
2. YOU STATE THAT SINCE THE EVALUATION PERFORMED IN CONNECTION WITH THE
EFFECTIVENESS OF THE COMPANY'S DISCLOSURE CONTROLS AND PROCEDURES AS OF
DECEMBER 31, 2004, "THERE HAVE BEEN NO 'SIGNIFICANT CHANGES' IN OUR
INTERNAL CONTROLS OR IN FACTORS THAT COULD SIGNIFICANTLY AFFECT OUR
INTERNAL CONTROLS..." PLEASE NOTE THAT ITEM 15(D) OF FORM 20-F REQUIRES
THAT YOU PROVIDE INFORMATION CONCERNING CHANGES IN INTERNAL CONTROLS
THAT ARE IDENTIFIED IN CONNECTION WITH THE EVALUATION OF THE
EFFECTIVENESS OF THE FILER'S DISCLOSURE CONTROLS AND PROCEDURES THAT
"OCCURRED DURING THE PERIOD COVERED BY THE ANNUAL REPORT". PLEASE TELL
AS WHETHER THERE WERE ANY CHANGES IN INTERNAL CONTROLS THAT OCCURRED
DURING THE YEAR ENDED DECEMBER 31, 2004. IN PREPARING FUTURE PERIODIC
FILINGS, PLEASE GIVE APPROPRIATE CONSIDERATION TO THESE REQUIREMENTS.
As noted above, the Company confirms that there were no changes in its internal
controls during the period covered by the annual report that have materially
affected, or are reasonably likely to materially affect, its internal control
over financial reporting. The Company notes the Staff's comment with respect to
future periodic filings and shall endeavor to provide the required disclosure.
Exhibits 12.1 and 12.2
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3. THE CERTIFICATIONS SIGNED BY MESSRS. MORAN AND MAOR CONTAIN LANGUAGE
THAT HAS BEEN ALTERED FROM THE LANGUAGE REQUIRED BY SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002 AND OUR RULES UNDER THAT SECTION. WE
SPECIFICALLY REFER YOU TO THE USE OF THE TERMS "COMPANY" AND "ANNUAL
REPORT." THE LANGUAGE OF THE CERTIFICATIONS REQUIRED BY SECTION 302 OF
SARBANES-OXLEY AND THE RELATED RULES SHALL NOT BE ALTERED. REFER TO
ITEM 601(B)(31) OF REGULATION S-K, WHICH STATES THAT THE CERTIFICATION
MUST BE PROVIDED EXACTLY AS STATED THEREIN. SEE ALSO RELEASE NO.
3446427 (AUG. 28, 2002) AND STAFF ALERT (MAR. 5 2005). PLEASE ENSURE
THAT CERTIFICATIONS DO NOT VARY FROM THE REQUIRED FORMAT.
The Company notes the Staff's comment and will ensure that all future filings
contain the correct form of certification.
Consolidated Financial Statements
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Consolidated Statements of Operations-page 5
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4. WE NOTE THAT YOU HAVE PRESENTED INCOME FROM THE VENTURE AS REVENUE IN
THE CONSOLIDATED STATEMENTS OF OPERATIONS. TELL US WHY YOU BELIEVE THIS
PRESENTATION IS APPROPRIATE. THE STAFF BELIEVES THAT AN INVESTOR'S
EQUITY IN INCOME OR LOSS OF THE INVESTEE SHOULD NOT BE INCLUDED IN
REVENUE OR AS A SEPARATE ITEM IN A REVENUE SUBTOTAL. SEE SEC REGULATION
COMMITTEE MINUTES SECTION XI(B) DATED MARCH 11, 2003. RULE 5-03 OF
REGULATION S-X REQUIRES EQUITY METHOD EARNINGS TO BE PRESENTED BELOW
THE INCOME TAX LINE. HOWEVER, THE STAFF ALSO BELIEVES THAT EQUITY
EARNINGS MAY BE PRESENTED IN OPERATING INCOME IF INTEGRAL TO
OPERATIONS.
The Company supplementally advises the Staff as follows:
a. The Venture is a legal entity that only operates between Toshiba and
the Company and is essentially an extension of the Company's flash
sourcing arrangements for manufacture of DiskOnKey ("DOK") products. As
such, the Venture's operations are integral to the Company's
operations.
Toshiba has a long historical relationship with the Company, beginning
in the mid-nineties, primarily as one of the Company's principal flash
memory component suppliers, and specifically as a supplier of
components for the Company's DOK product since the Company began to
sell the product in 2001. In 2003, the Company and Toshiba decided to
expand their relationship and established a joint venture in the form
of a limited partnership. The Venture was formed for the mutual benefit
of both members, with each member sharing the risks and rewards in the
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operations of the Venture - namely the manufacture and sale of DOK
products. DOK is a thumb-sized flash drive for the storage and transfer
of data files, manufactured utilizing (1) a standard silicon memory
chip (flash memory), representing the substantial majority of the cost
of each DOK unit, (2) a controller component that manages the data, (3)
other minor electronic components, and (4) a plastic shell. The Venture
sources the flash memory component solely from Toshiba and the
controller component through the Company. The Venture then manufactures
the DOK using contract manufacturers (who also act as contract
manufacturers for the Company's activities outside of the Venture) and
sells DOK units only to the Company and Toshiba. The accumulated
profits of the Venture are equally divided between the Company and
Toshiba. The Venture does not have any employees. Essentially, the
Venture is a separate entity designed as an extension of the Company's
flash sourcing arrangements for DOK products with Toshiba and its other
flash vendors, whereby the Company sources flash memory components from
these vendors, adds a controller component and manufactures the DOK
units using contract manufacturers. As such, the Venture operates in a
manner that is essentially the same as the Company's ordinary course
method of operation.
Since (i) the Venture operates in a manner that is essentially the same
as the Company's ordinary course method of operation (i.e., the Venture
buys the essential components from Toshiba and from the Company and
sells the finished products to Toshiba and to the Company) and (ii) the
Venture has no other customers, selling only to the Company and
Toshiba, the Company believes that the Venture's operations are
integral to the Company's operations. Consequently, equity earnings
resulting from the Venture are presented as part of the Company's
operating income.
b. The Company presents its statement of operations using a single-step
form.
The Staff has stressed the importance of evaluating whether amounts in
the statement of operations are appropriately classified according to
their character or nature, as specified by Rule 5-03 of Regulation S-X.
The Staff observed in the 2002 AICPA Conference on Current SEC
Developments that in certain circumstances the presentation of gross
margin might be misleading, including, for example:
o Instances where there is no cost of sales related to a
particular revenue source (i.e. royalties, license fees,
etc.); and
o Instances where for a particular revenue source separating the
cost of sales from operating expenses is impracticable.
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Based on the above, the Company believes that in its case, where it has
sources of revenues with no related cost of revenues (including
licensing fees and royalties), it would be more appropriate in
accordance with the Staff's guidance to exclude the measure of gross
profit, thus presenting its statement of operations using the
single-step form, rather than the multi-step form.
Under the single-step form, as no gross profit is presented, all
operating income sources and all operating expenses are each presented
within one group, with a sub total of operating income presented
thereafter. Accordingly, since the Company follows the single-step
form, all of the Company's operating income sources, including income
from the Venture (which, as described above, is integral to the
business as a whole) are presented under a single group titled
"revenues".
The Company further advises the Staff that the Company's operating
income sources are product sales, royalties, licensing fees and equity
earnings from the Venture that are integral to its operations.
Notes to the Consolidated Financial Statement
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Note 2-Significant Accounting Policies
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Revenue Recognition-page 14
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5. WE NOTE YOUR DISCLOSURE ON PAGE 20 OF THE FILING THAT INDICATES THAT
THE MARKETING STRATEGY FOR THE DISKONCHIP RELIES ON YOUR SOFTWARE BEING
INCLUDED IN THE MAJOR OPERATING SYSTEMS. WE ALSO NOTE FROM YOUR PRESS
RELEASE DATED SEPTEMBER 6, 2005 THAT MIGO SOFTWARE IS INCLUDED WITH
SEVERAL PRODUCTS. TELL US HOW YOU CONSIDERED THE GUIDANCE IN EITF 03-05
AND PARAGRAPH 2 OF SOP 97-2 IN DETERMINING THE APPLICABLE AUTHORITATIVE
LITERATURE FOR REVENUE RECOGNITION. FOOTNOTE 2 OF PARAGRAPH 2 OF SOP
97-2 INDICATES THAT IF THE SOFTWARE IS A SIGNIFICANT FOCUS OF THE
MARKETING EFFORT THAT COULD BE AN INDICATION THAT THE SOFTWARE IS
INCIDENTAL TO THE PRODUCT AS A WHOLE.
The Company supplementally advises the Staff as follows:
With respect to the disclosure on page 20 of the filing, the Company sells
DiskOnChip to its customers who integrate the chip into their products (such as
mobile telephone handsets). These products require an operating system in order
to function. The Company makes available, at no charge, software drivers to
operating system developers (such as Microsoft and Linux) in order to enable the
DiskOnChip to interoperate easily with those operating systems, reducing the
need for the Company's customers to use additional software to enable
interoperability. These software drivers are made available by the Company to
operating system developers prior to selling its products to its customers in
order to facilitate the usage of its products in the market.
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With respect to the Migo software, the Company notes that its press release
dated April 6, 2005 referred to software developed by PowerHouse Technologies,
the developer of Migo software. The Company offers its OEM customers the option
to purchase its DOK product with Migo software provided by PowerHouse
Technologies pre-loaded onto the Company's DOK product. The Company's first
sales of the DOK product together with pre-loaded Migo software occurred in
September 2005. These units are essentially a DOK with an additional feature.
The price of such DOKs does not differ significantly from other DOKs that do not
include the Migo software. Support services, if any, are provided directly
through PowerHouse Technologies to the end-user without any involvement of the
Company. Effectively, the marketing focus is on the product being a flash drive,
to which the Company can add different types of features if requested by the OEM
customer, one of which is the Migo software. The DOKs function with or without
the Migo software; Migo software is just an additional feature added to the DOK.
Accordingly, the Company concluded that the Migo software is incidental to the
product as a whole (which is the DOK) and therefore the guidance in SOP 97-2 for
revenue recognition is not applicable.
6. WE NOTE YOUR DISCLOSURE ON PAGE 13 OF THE FILING THAT YOU CUSTOMIZE THE
MOBILE DISKONCHIP PRODUCT TO MEET CUSTOMER DESIGN REQUIREMENTS. TELL AS
HOW YOU RECOGNIZE REVENUE FOR ARRANGEMENTS THAT INVOLVE CUSTOMIZATION.
YOUR RESPONSE SHOULD ADDRESS HOW YOU CONSIDERED THE GUIDANCE IN EITF
00-21 AND SOP 81-1.
To clarify, the Company sells its Mobile DiskOnChip products to mobile handset
manufacturers. In advance of producing a particular handset model, these
manufacturers generally provide to the Company the specifications of the memory
solution that they are seeking to incorporate into the handset. At times, this
requires the Company to make some modifications to its product in order to meet
the specifications of the manufacturer. The Company refers to this in the filing
as customization. All such customization is completed in advance of the
manufacturer's actual purchase of the product from the Company, as the
manufacturer requires that the product be complete and fully tested prior to
placing a purchase order for the product. Therefore, all costs incurred prior to
the customized product being completed and tested by the customer are expensed
as incurred as part of operating expenses. Prior to placing a purchase order,
the manufacturer is under no obligation to purchase the product from the
Company. At the time the customer places a firm purchase order with the Company,
the Company has already concluded the customization of the Mobile DiskOnChip
product and the product is generally sold from the inventory accumulated by the
Company. Accordingly, sale of such products is accounted for under the guidance
of SAB 104, while EITF 00-21 and SOP 81-1 are not applicable. The Company
further advises the Staff that, in fact, the Company often builds an initial
inventory position of the customized product prior to receiving a firm purchase
order for the full amount of such inventory, exposing the Company to the risk of
holding inventory that may not be saleable to other potential customers.
7. WE NOTE THAT YOU PROVIDE UPGRADES AND ENHANCEMENT AS WELL AS TECHNICAL
SUPPORT FOR THE TRUEFFS FLASH MANAGEMENT SOFTWARE TO ALL OF TOSHIBA'S
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CUSTOMERS. WE FURTHER NOTE THAT SUPPORT FEES ARE CALCULATED AS A
PERCENTAGE OF THE XDOC REVENUE AND COMBO REVENUE AS DEFINED IN YOUR
XDOC DEVELOPMENT AND LICENSE AGREEMENT DATED JULY 15, 2003. TELL US HOW
YOU RECOGNIZE REVENUE FOR THE SUPPORT SERVICES AND WHAT THE
AUTHORITATIVE GUIDANCE YOU RELIED UPON IN REACHING YOUR CONCLUSION.
Under the XDOC development and license agreement, the Company granted Toshiba a
license to use its technology for the manufacturing of XDOC products (including
Combo units). XDOC products are closed solutions that cannot be altered or
modified once installed in a handset or other embedded device. All support
services provided to Toshiba under the agreement relate to pre-sale activities
which support Toshiba's efforts to develop and integrate XDOC products into
their customers' solutions during the period that the product is being tested by
Toshiba's customers and prior to the sale of the product to them. The XDOC
product is integrated into their customers' solutions using the then current
version of the Company's TrueFFS software. Periodically, the Company develops an
improved version of the software in part to support the next generation of
handsets. Under the agreement, the Company is required to provide Toshiba these
upgraded and enhanced versions of the TrueFFS software, as well as provide
Toshiba technical support in connection therewith, to facilitate Toshiba's sales
efforts of a newer version of XDOC products for next generation handsets to be
developed by their existing and potential new customers. All these support
services provided by the Company relate to pre-sale efforts and are concluded
prior to Toshiba's sales of XDOC products to its customers. All fees for these
services are paid only upon sale of XDOC products to Toshiba's customers and are
contingent upon such sales. As a result, the Company recognizes this income only
upon the receipt of Toshiba's notification of their sales to their customers,
which is therefore subsequent to the Company completion of the applicable
support services to Toshiba.
8. WE NOTE THAT YOU RECOGNIZE REVENUE FOR LICENSE FEES AND ROYALTIES FROM
THE PATENT CROSS LICENSE AND THE DEVELOPMENT LICENSE AGREEMENT. TELL US
HOW YOU DETERMINE THE AMOUNT OF THE LICENSE FEE TO ALLOCATE TO FUTURE
PERIODS AND WHAT IMPACT, IF ANY, THE AMOUNT OF THE LICENSE FEE HAS ON
THE AMOUNT OF VOLUME-BASED ROYALTIES GOING FORWARD. INDICATE HOW YOU
CONSIDERED SAB TOPIC 13(A)(3)(F) IN DETERMINING WHETHER ANY PORTION OF
THE LICENSE FEE IS CONSIDERED AN UP-FRONT FEE IN WHICH DEFERRAL OF
REVENUE MIGHT BE APPROPRIATE.
The Company advises the Staff that all fees received by the Company in
consideration for the XDOC development and license agreement, whether defined
therein as royalties or otherwise represent royalty payments, which are
contingent upon and calculated as a percentage of the sales made by Toshiba to
its customers. As described in the Company's response to comment No. 7 above,
all support services provided to Toshiba relate to pre-sale activities provided
prior to Toshiba selling the products to its customers. Accordingly, and as all
fees under the agreement relate to specific Toshiba sales, such fees are
recognized upon the receipt of Toshiba's notification of their sales. As such,
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no up-front fee is received by the Company and SAB Topic 13(A)(3)(f) is not
applicable in this case.
9. WE NOTE THAT IN EXCHANGE FOR A LICENSE TO ALL OF YOUR PATENTS, SAMSUNG
HAS AGREED TO PAY A FIXED STREAM OF PAYMENTS THROUGHOUT THE TERM OF THE
AGREEMENT. TELL US HOW REVENUE IS BEING RECOGNIZED DURING THE FOUR-YEAR
TERM LICENSE AGREEMENT AND WHAT AUTHORITATIVE GUIDANCE YOU RELIED UPON
IN REACHING YOUR CONCLUSION.
In December 2003, the Company entered into an agreement with Samsung. The
agreement is effective for a period of four years. As part of the agreement, the
Company granted Samsung a perpetual license to all its patents for any products
produced by Samsung. According to the agreement, Samsung is required to pay the
Company in consideration for this license an amount of $25 million in 16 equal
quarterly installments. The Company considered the guidelines of SAB 104 for the
interpretation of the "fixed or determinable" criteria for recognizing revenues,
as indicated in footnote 5 with reference to SOP 97-2, and determined with
respect to the installment payments under the agreement that the price is not
fixed or determinable. This determination was reached because the arrangement
with Samsung contains extended payment terms and the Company had no past
experience with similar arrangements either with Samsung or other licensees. As
a result, the Company, in reliance upon SAB 104, recognizes such revenues when
payment becomes due.
Note 5-Investment in a Venture-page 21
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10. WE NOTE IN EXHIBIT 8.8 OF THE FILING THAT YOUR OWNERSHIP IN TWINSYS
DATA STORAGE L.P. IS 50.10%, HOWEVER, IN NOTE 1 OF THE TWINSYS DATA
L.P. FINANCIAL STATEMENTS YOU DISCLOSE THAT YOUR RESPECTIVE INTEREST IS
49.9%. PLEASE RECONCILE THIS INCONSISTENCY. WE ALSO NOTE THAT YOU USE
THE EQUITY METHOD OF ACCOUNTING TO ACCOUNT FOR THE VENTURE. TELL US
WHAT CONSIDERATION YOU GAVE TO CONSOLIDATING THE VENTURE. YOUR RESPONSE
SHOULD ADDRESS HOW YOU CONSIDERED THE GUIDANCE IN FIN 46(R) AND EITF
04-05.
TwinSys Data Storage LP is an Israeli limited partnership held as follows: 49.9%
by the Company, as a limited partner; 49.9% by First Flash Limited (an Israeli
company 100% owned by Toshiba), as a limited partner; and 0.2% by TwinSys
Limited, an Israeli company, as the general partner. TwinSys Limited, the
general partner, is held as follows: 50.1% by the Company and 49.9% by First
Flash Limited.
The Company therefore owns 49.9% of the limited partnership directly. When
indirect holdings are included, however, the Company actually owns 50.1% of the
limited partnership: (a) 49.9% direct limited partner holding plus (b) 0.2% due
to its majority interest in TwinSys Limited, the general partner. We note,
however, that although the Company holds a larger interest in the general
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partner of the Venture, all significant decisions in connection with the Venture
require the unanimous agreement of both Toshiba and the Company.
With respect to the Company's use of the equity method of accounting, the
Company first evaluated whether the Venture is included within the scope of FIN
46 and once it concluded that the investment in the Venture is within the scope
of FIN 46, it evaluated whether the Venture is a variable interest entity
("VIE") and if so, what variable interest holder is the primary beneficiary.
Entities that are VIEs are subject to the provisions of FIN 46(R) and are to be
evaluated for consolidation based on the rights and obligations of holders of
all variable interests in the entity and not based on the ownership of
outstanding voting shares. Accordingly, when the Company concluded that the
Venture is a VIE, as detailed below, the Company did not evaluate the Venture
for consolidation based on its voting interests in the Venture and did not
consider the guidance in FAS 94, EITF 96-16 or EITF 04-05.
When evaluating whether the investment in the Venture falls within the scope of
FIN 46(R), the Company concluded that none of the scope exceptions apply to the
aforementioned investment and particularly the scope exception provided in Par.
4(h) of FIN 46(R). When evaluating whether the Venture represents a business as
defined in Appendix C to FIN 46(R), the Company concluded that the Venture is
not a self-sustaining integrated set of activities and assets and does not
contain all of the inputs and processes necessary for it to conduct normal
operations and to sustain a revenue stream. In particular, the Venture does not
hold any intellectual property (IP) or employ any employees and it does not sell
its products to any customers, other than to its partners. The Venture is
dependent on its partners to provide it with IP and other inputs and to sell its
products to customers. In light of the above, the Company concluded that the
investment in the Venture falls within the scope of FIN 46(R) and consequently
it evaluated whether the Venture is a VIE.
FIN 46-R's paragraph 5 provides that the Company's initial determination of
whether the Venture is a VIE should be made when the Company first became
involved with the Venture. The Company concluded that the Venture is a VIE in
light of the agreement that was made between the Company, Toshiba and the
Venture. According to such agreement, the Venture purchases flash memory
components from Toshiba and controller components from the Company at a price
that is less than their respective market prices. In addition, the agreement
provides that Toshiba and the Company purchase the finished goods from the
Venture at a price that is equal to (i) the cost to the Venture, plus (ii) a
certain percentage of the expected gross profit that would result on sale of
such product in the market. As such, the Venture and consequently the equity
holders (in their capacity as equity holders of the Venture) by design, are
protected from the expected losses in the Venture, as the price paid to the
Venture for its products would at least cover the cost to the Venture. According
to Par. 5(b)(2) of FIN 46(R), an entity where the holders of the equity
investment at risk lack the obligation to absorb the expected losses is
considered to be a VIE. The investors do not have that obligation if they are
protected from the expected losses or are guaranteed a return by the entity
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itself or by other parties involved with the entity. In this case, the investors
are protected from the expected losses by the Venture agreement and accordingly
the Venture is a VIE.
Paragraph 16 of FIN 46-R also provides that for purposes of determining whether
an enterprise is the primary beneficiary of a VIE, an enterprise with variable
interests shall treat any variable interest in that same entity held by its
related parties as its own.
Pursuant to the Venture agreement, neither Toshiba nor the Company can sell,
transfer, or encumber their interests in the Venture without the prior approval
of the other party. According to Paragraph 16 of FIN 46-R, the right of prior
approval creates a de facto agency relationship if that right constrains the
other party's ability to manage the economic risks or realize the economic
rewards from its interests in a variable interest entity through the sale,
transfer, or encumbrance of those interests. In this case each party can
restrict the other from realizing the economic rewards from its interests in the
Venture through the sale, transfer or encumbrance of those interests, thus
creating a de facto agency relationship between the Company and Toshiba.
Accordingly, the Company treated the variable interests owned by it and Toshiba
as its own. These variable interests represent 100% of the variable interests in
the Venture, causing this related party group to be the primary beneficiary.
Paragraph 17 of FIN 46-R provides that the party, within the related party
group, that is most closely associated with the VIE is the primary beneficiary.
Further evaluating the guidance of paragraph 17 to determine which party is most
closely associated with the VIE, the Company considered and analyzed certain
facts and circumstances, including:
a. The existence of a principal-agency relationship between
parties within the related party group
In this case each party is both acting as principal
and agent to other since both parties have to receive
prior approval of each other for the sale, transfer
or encumbrance of their interests. Therefore, in this
case no party is effectively acting on behalf of the
other.
b. The relationship and significance of the activities of the
variable interest entity to the various parties within the
related party group:
The Company evaluated the following facts in
determining that the relationship and significance of
the activities of the VIE are more significant to
Toshiba than the Company:
>> Both parties together significantly influenced the
design of the Venture and the determination of its
primary operations.
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>> Both parties jointly make all significant decisions
related to the VIE and no party could independently
make any decision that would have a significant
effect on the VIE.
>> Toshiba is supplying the Venture with flash memory
components produced by it while the Company supplies
the Venture with the intellectual property ("IP") for
the DOK. Flash components are considered to be more
of a commodity in the market, while the Company
contributes to the Venture its IP, which is owned and
controlled only by the Company. Without the
relationship with the Company, Toshiba does not have
the legal rights to the IP necessary to manufacture
and sell the DOK. In contrast, the Company owns the
IP related to the DOK and only requires the flash
components, which can be purchased from any supplier
owning a fabrication facility that manufactures the
flash components, which are available from numerous
sources. As Toshiba benefits from its relationship
with the Company by receiving all required IP for the
DOK, this Venture represents a more significant input
to Toshiba's operations.
>> As mentioned above, the Company supplies the Venture
with the controller component, which has a relatively
low cost to the Company. For Toshiba, a meaningful
percentage of its flash manufacturing capacity is
designated to be utilized as a component in the DOK
products manufactured through the Venture. If not
utilized by the Venture, Toshiba would need to find
an alternate customer for its flash components so it
would not be left with unused capacity. Accordingly,
the Venture in its capacity as a customer is more
significant to Toshiba than the Company.
c. Party's exposure to the expected losses of the variable
interest entity:
The Company believes that Toshiba has a higher
exposure to losses because, although the equity
interests are held equally by the parties, Toshiba
extends more credit to the Venture in its capacity as
the principal supplier of raw materials to the
Venture, thus exposing it to more than 50% of the
expected losses of the Venture.
Based on the above analysis, the Company concluded that Toshiba is more closely
associated with the Venture than the Company and therefore the Company will not
be considered the primary beneficiary of the Venture. However, as the Company
has significant influence over the financial and operating policies of the
Venture, the Company applies the equity method when accounting for its
investment in the Venture.
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Form 6-K filed on September 30. 2005
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Balance Sheet - page 2
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11. WE NOTE THAT YOU HAVE RECORDED "EXCESS OF LOSSES OVER INVESTMENT IN
EQUITY METHOD INVESTEE" AS A LIABILITY. EXPLAIN WHY YOU BELIEVE THAT
THIS INVESTMENT SHOULD BE PRESENTED AS A LIABILITY. INDICATE HOW THIS
LIABILITY AFFECTS YOUR ANALYSIS OF ACCOUNTING FOR THIS ENTITY UNDER FIN
46(R). SEE PARAGRAPH 11 OF EITF 98-13.
The investment in this equity method investee relates to U3, LLC ("U3"), a joint
venture formed by the Company and SanDisk Corporation ("SanDisk") for the
promotion of the U3 standard, 50% owned by each party. The Company first
evaluated whether U3 is included within the scope of FIN 46(R). Paragraph 4(h)
to FIN 46(R) determines that an entity that is deemed to be a business (as
defined in Appendix C to FIN 46(R)) need not be evaluated to determine if it is
a variable interest entity unless certain conditions exist.
The Company concluded that U3 is a business since it has a set of activities and
assets conducted and managed for the purpose of providing a return to its
investors. U3 operations consist of: (1) Inputs, such as the perpetual license
for certain of the Company's and SanDisk's intellectual property and employees
to carry on its sales and marketing activities; (2) Processes, such as extensive
marketing and promotion activities for the licensing of the U3 standard,
operational processes and strategic management for its operations; (3) Outputs,
as U3 has the ability to obtain potential customers to which it will license the
U3 standard starting in 2006. It should be noted that at the inception date, U3
was not in development stage and the planned principal operations of U3 had
already commenced. U3 already had at inception in its possession the essential
IP related to the U3 standard, and marketing efforts performed by its investors
prior to U3's inception already yielded collaboration with third parties to use
the U3 standard in their products.
Having established that U3 is deemed to be a business, the Company further
evaluated whether the conditions detailed in paragraph 4(h) exist, so that it
would still not be required to evaluate whether U3 is a variable interest
entity, as detailed below:
(a) The Company significantly participated in the design of the U3 standard,
however, this condition does not apply since U3 is an operating joint venture,
under joint control of the Company and SanDisk (an unrelated and independent
party).
(b) U3 is not designed so that substantially all of its activities either
involve or are conducted on behalf of the Company and its related parties. U3
operates independently for the benefit of both investors.
(c) The Company and its related parties did not provide more than half of the
total of the equity and other form of subordinated financial support to U3. The
Company and SanDisk each hold 50% of the shares of U3, while SanDisk is also
committed to grant U3 a loan. Consequently, SanDisk and not the Company provides
U3 with more than half of the total of the equity and other form of the
subordinated financial support.
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(d) The activities of U3 are not related to securitizations, other forms of
assets-backed financings or single-lessee leasing arrangements.
In light of the above, the Company concluded that the investment in U3 is not
within the scope of FIN 46(R) and that the equity method of accounting should be
applied.
According to the agreements with SanDisk, both parties share equally any profit
or losses incurred by U3. In addition, currently U3 is financed by both
SanDisk and the Company through receivables resulting from operating activities.
Accordingly, as prescribed by paragraph 19(i) to APB 18, the Company continued
to apply the equity method (i.e. record its 50% share in the losses of U3) even
after its investment was reduced to zero but up to the amount of the receivables
from U3, resulting in the Company's presentation of the investment in U3 as a
liability separate from the receivables.
Note 1-General-page 6
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12. WE NOTE THAT IN MARCH 2005, YOU ISSUED CONVERTIBLE SENIOR NOTES THAT
ARE CONVERTIBLE, AT THE OPTION OF THE HOLDERS AT ANY TIME BEFORE THE
MATURITY DATE, INTO ORDINARY SHARES AT A CONVERSION RATE OF 35.1328
ORDINARY SHARES PER ONE THOUSAND DOLLARS PRINCIPAL ACCOUNT OF NOTES,
REPRESENTING A CONVERSION PRICE OF APPROXIMATELY $ 28.46 PER SHARE.
TELL US WHETHER YOU BELIEVE THAT THE CONVERTIBLE SENIOR NOTES ARE
CONVENTIONALLY CONVERTIBLE IN ACCORDANCE WITH PARAGRAPH 4 OF EITF
00-19. YOUR RESPONSE SHOULD ADDRESS THE ANTIDILUTION PROVISIONS
DISCLOSED IN THE SENIOR INDENTURE AGREEMENT DATED MARCH 23, 2005. REFER
TO PARAGRAPH 8 OF EITF 05-02. IN ADDITION, WE NOTE THAT YOU HAVE
GUARANTEED THE CONVERTIBLE SENIOR NOTES. INDICATE HOW YOU WILL COMPLY
WITH RULE 3-10 OF REGULATION S-X IN FUTURE FILINGS.
EITF 00-19 imposes additional conditions for equity classification of
freestanding derivative contracts. Paragraph 4 of Issue 00-19 provides 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 Issue 00-19 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). EITF 05-2 clarified
the meaning of the term "conventional convertible debt". The Company notes,
however, that Issue 05-2 consensuses apply prospectively to all new instruments
issued, and to existing instruments that are modified, in fiscal periods
beginning after June 29, 2005, and since the Company's Convertible Senior Notes
(the "Debt") were issued in March 2005, Issue 05-2 is not applicable with
respect to the Debt.
When evaluating whether the Debt issued by the Company represents a
"conventional convertible debt instrument" according to the guidelines in Par. 4
to EITF 00-19, taking into account the antidilution provisions set forth in the
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Senior Note Indenture (the "Indenture"), the Company concluded that this debt is
conventionally convertible. In the Company's case, the holder of the Debt may
realize the value of the conversion option only by exercising the option and
receiving the entire proceeds in a fixed number of shares. The antidilution
provisions include conversion rate adjustments in the event of equity
restructuring transactions and in the event of dividends or other distributions
in the form of cash. These provisions do not preclude the conclusion that the
debt is convertible into a fixed number of shares, since these provisions are
common conventional provisions included in many convertible instruments and they
are designed to maintain the value of the conversion option. Specifically with
regard to the adjustment occurring upon a dividend distribution, according to
the Company's dividend distribution policy it does not intend to pay cash
dividends in the foreseeable future and distribution of dividends is within the
Company's control. Therefore, the dividend adjustment provision does not change
the conclusion that the amount of shares to which the Debt is convertible is
fixed. The Company further advises the Staff that the adjustment of the
conversion ratio in the case of certain Fundamental Changes (i.e. a change of
control transaction where the Company or its assets are acquired for cash,
property or non-traded securities and the notes become convertible into such
consideration, thus losing the ability to convert the Debt into a traded
security) also does not preclude the conclusion that the debt is convertible
into a fixed number of shares since such provision is a common conventional
provision similar in substance to an antidilution provision, where the provision
is designed to maintain the value of the conversion option.
Notwithstanding the above, the Company evaluated whether the embedded option
meets the additional requirements of paragraphs 12-32 of Issue 00-19. The
Company concluded that the conversion option meets all such additional
requirements, as detailed below:
o The Indenture permits the Company to settle in unregistered
shares. Pursuant to a registration rights agreement dated as
of March 23, 2005, the Company and M-Systems Finance Inc.,
jointly and severally, agreed to pay certain liquidated
damages to the holders if a registration statement is not
filed within 120 days following the closing date or not
declared effective by the SEC within 210 days after the
closing date. The Company, in its analysis, considered whether
the existence of liquidated damages would result in liability
classification in accordance with EITF 00-19. The Company
concluded that the Debt and the registration rights agreement
should be accounted for separately. Although entered into
contemporaneously, the registration rights agreement and the
Indenture are nevertheless separate legal agreements.
Additionally, the payment of the liquidated damages penalty
under the registration rights agreement does not alter the
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debt holders' rights under the Debt. Therefore, if the Company
fails to have the registration statement declared effective by
the designated deadline, the Debt holder will receive the
liquidated damages penalty and still have the right to
exercise the full notional amount of the conversion option
embedded in the Debt at any time within its term. The payoff
of the embedded conversion option (based on the stock price)
is not dependent on the payoff of the registration rights
penalty (based on how long the shares are unregistered)--the
two are independent of one another. Accordingly, the Company
analyzed the classification of the option instrument embedded
in the Debt based only on the terms of the Debt, and since the
Debt is a contract that is indexed to and potentially settled
in the Company's own stock with gross physical settlement and
with no net-cash settlement alternative, the Company concluded
that the embedded option feature would be classified as
equity. In addition, the Company has concluded that liquidated
damages should be accounted for in accordance with SFAS No. 5,
"Accounting for Contingencies". Accordingly, the Company will
assess in each reporting period whether it is probable that a
provision for liquidated damages should be recorded for that
period.
o The Company has sufficient authorized and unissued share
available to settle the Debt after considering all other
commitments that may require the issuance of stock during the
maximum period the Debt could remain outstanding.
o The Debt cannot be net settled in shares.
o The Indenture does not require net-cash settlement in the
event the Company fails to make timely filings with the SEC.
o There are no required cash payments to the Debt holders if the
shares initially delivered upon settlement are subsequently
sold by the Debt holders and the sales proceeds are
insufficient to provide the Debt holders with full return of
the amount due (that is, there are no cash settled "top-off"
or "make-whole" provisions).
o No provision of the Indenture permits net-cash settlement for
the conversion option embedded in the Debt. As previously
indicated, the registration rights agreement is a separate
legal agreement and the payment of the liquidated damages
penalty under the registration rights agreement does not alter
the Debt holders' rights under the Debt.
o There are no provisions in the Indenture that indicate that
the Debt holder has rights that rank higher than those of a
holder of the shares underlying the Debt, other than the right
14
to be paid principal and interest on the notes underlying the
Debt as a creditor of the Company.
o The Indenture does not provide for the posting of any
collateral at any point or for any reason.
With respect to compliance with Rule 3-10 of Regulation S-X, the Company intends
to omit the financial statements of M-Systems Finance Inc., its 100%-owned
finance subsidiary, from its SEC filings in reliance upon Rule 3-10(b) of
Regulation S-X. The Company satisfies the requirements set forth in clauses (1),
(2) and (3) of Rule 3-10(b) of Regulation S-X and intends to include in its
financial statements the footnote referred to in clause (4) of Rule 3-10(b) of
Regulation S-X.
Liquidity and Capital Resources. page 16
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13. YOUR STATEMENTS OF CASH FLOWS SHOWS THAT THE DECREASE IN INVENTORY HAD
A SIGNIFICANT IMPACT ON CASH FLOWS PROVIDED BY OPERATIONS. EXPLAIN WHY
INVENTORY DECREASED WHILE REVENUES CONTINUE TO INCREASE SIGNIFICANTLY.
INDICATE HOW THE LIQUIDITY DISCUSSION ADDRESSES THIS CHANGE IN YOUR
LIQUIDITY NEEDS INCLUDING ANY REASONABLY LIKELY IMPACT ON TRENDS. WE
FARTHER NOTE THAT THE OPERATING CYCLE (I.E., TIME BETWEEN THE
ACQUISITION OF INVENTORY AND THE REALIZATION OF CASH FROM SALES OF
INVENTORY) HAD CREATED WORKING CAPITAL NEEDS PRIMARILY DUE TO YOUR
GROWTH RATE.
TELLS HOW YOU CONSIDERED THIS WORKING CAPITAL NEED AND ITS EFFECT ON
YOUR LIQUIDITY IN ORDER TO CONTINUE TO FUND YOUR SIGNIFICANT GROWTH
WITHIN YOUR LIQUIDITY DISCUSSION. IT APPEARS THAT YOU HAVE RELIED ON
EXTERNAL FINANCING TO MEET YOUR WORKING CAPITAL NEEDS, THE DISCLOSURE
OF THAT FACT AND THE COMPANY'S ASSESSMENT OF WHETHER THIS FINANCING
WILL CONTINUE TO BE AVAILABLE SHOULD BE CONSIDERED. SEE SEC RELEASE
33-8350.
The Company supplementally advises the Staff that in 2005, the Company managed
its inventory to allow it to hold lower levels of inventory than in prior
periods, in part due to the Company's decision in the first half of 2005 to
reduce its inventory levels in order to lessen its exposure to potential
devaluation of on-hand inventory. As a result, notwithstanding the significant
increase in its revenues, the Company reduced its overall inventory levels in
the first six months of 2005. The Company does not believe that this reduction
has a material effect on its liquidity needs, and the Company expects its
inventory levels in future periods to grow as its revenues grow. Although the
Company's growth in revenues creates greater working capital needs, the growth
in revenues has been accompanied by a growth in profits and positive cash flows
and the Company believes that it will be able to fund its working capital needs
in future periods from cash generated from operations. As a result, the Company
does not believe that it will need to rely upon external financing to fund its
future working capital needs.
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