April 7, 2006
VIA EDGAR CORRESPONDENCE AND VIA FACSIMILE AT (202) 772-9210
- ------------------------------------------------------------
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
Washington, D.C. 20549
Re: netGuru, Inc.
Form 10-KSB for the year ended March 31, 2005
File No. 0-28560
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Dear Ms. Collins:
This letter responds to your letter of comments dated January 31, 2006.
For your convenience, we have set forth below your comments in their entirety
and have keyed our responses to the numbers you placed adjacent to your
comments.
Form 10-KSB for the Year Ended March 31, 2005
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Item 8A. Controls & Procedures, page 35
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1. WE NOTE YOUR DISCLOSURE THAT AS OF MARCH 31, 2005 YOUR DISCLOSURE
CONTROLS AND PROCEDURES WERE EFFECTIVE TO ENSURE THAT INFORMATION
REQUIRED TO BE DISCLOSED BY US IN THE REPORTS FILED OR SUBMITTED BY US
UNDER THE EXCHANGE ACT IS RECORDED, PROCESSED, SUMMARIZED AND REPORTED,
WITHIN THE TIME PERIODS SPECIFIED IN THE SEC'S RULES AND FORMS,
INCLUDING TO ENSURE THAT THE INFORMATION REQUIRED TO BE DISCLOSED BY
YOU IN THE REPORTS YOU FILE OR SUBMIT UNDER THE EXCHANGE ACT IS
ACCUMULATED AND COMMUNICATED TO YOUR MANAGEMENT, INCLUDING YOUR CEO AND
CFO, AS APPROPRIATE TO ALLOW TIMELY DECISIONS REGARDING WHETHER OR NOT
DISCLOSURE IS REQUIRED. WE FURTHER NOTE THAT ON APRIL 20, 2005 YOU
RESTATED YOUR FINANCIAL STATEMENTS IN AMENDMENTS TO FORMS 10-QSB FOR
THE QUARTERLY PERIODS ENDED JUNE 30, 2004, SEPTEMBER 30, 2004 AND
DECEMBER 31, 2004. IN LIGHT OF THESE RESTATEMENTS, PLEASE EXPLAIN IN
REASONABLE DETAIL HOW YOUR OFFICERS CONCLUDED THAT THE CONTROLS AND
PROCEDURES WERE NONETHELESS EFFECTIVE AS OF MARCH 31, 2005.
As you noted, on April 20, 2005, we restated our quarterly financial
statements for the quarters ended June 30, 2004, September 30, 2004 and December
31, 2004. The restatement related to the accounting effects of an April 2004
amendment to add $1,000,000 in additional borrowings to a convertible promissory
note that we originally issued in December 2003.
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 2
In connection with the preparation of our Form 10-QSB for the quarter
ended June 30, 2004, we researched and analyzed available accounting literature,
including Emerging Issues Task Force ("EITF") No. 96-19, "Debtor's Accounting
for a Modification or Exchange of Debt Instruments". Based on this research and
analysis, we initially determined that it was appropriate to record this
amendment as a substantial modification of debt.
During the quarter ended March 31, 2005, we prepared a resale
registration statement and in the context of our review of our registration
statement in March 2005, management further evaluated our treatment of the debt
modification in light of additional information relating to the revised
interpretation of EITF 96-19 that had become available through a speech by SEC
staff in December 2004.
Based on our analysis of the additional information relating to the
interpretation of EITF 96-19 and consultations with our audit committee, on
April 1, 2005, our management promptly took steps to announce and perform a
restatement of the affected interim financial statements in April 2005.
As you note in your comment, our disclosure controls and procedures
disclosure contained in our Form 10-KSB for the fiscal year ended March 31, 2005
states that our officers concluded that our disclosure controls and procedures
were effective as of March 31, 2005. Our officers based this belief upon, among
other factors, the fact that the restatement related to accounting entries that
were made nearly one year earlier and the fact that at the time the entries were
made, the entries appeared to be correct based on company research and analysis
based on then-available information on EITF 96-19. Subsequent research indicated
the applicability of the speech by SEC staff member, Robert J. Comerford,
regarding application of EITF Issue No. 96-16 to modified convertible bond
transactions, and management took corrective action at that time.
While we acknowledge that the restatement of interim financial
information is an indicator of a potential material weakness, we reached the
conclusion that we did not have a material weakness as of March 31, 2005 in our
disclosure controls and procedures. We believe that our controls relating to our
disclosures and preparation of reports filed with the SEC were appropriate
because we had consistently applied the available accounting literature.
Further, when we determined based on subsequently available interpretive
information that our accounting no longer appeared to be appropriate, we
promptly took measures to announce and revise the accounting and disclosures and
to ensure that our interim information was properly reported and that our Form
10-KSB for the fiscal year ended March 31, 2005 was prepared based upon the
latest available interpretive information.
Consolidated Statements of Cash Flows, page F-8
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2. WE NOTE IN YOUR STATEMENT OF CASH FLOWS YOU INCLUDE A SEPARATE LINE
ITEM FOR CASH FLOWS FROM DISCONTINUED OPERATIONS. IF YOU INTEND TO
MAINTAIN THE PRESENTATION OF SEPARATE CASH FLOW INFORMATION FOR
DISCONTINUED OPERATIONS, YOUR STATEMENTS OF CASH FLOWS SHOULD
SEPARATELY DISCLOSE CASH FLOWS FROM OPERATING, INVESTING, AND FINANCING
ACTIVITIES RELATED TO DISCONTINUED OPERATIONS. ADDITIONALLY, YOUR
DISCLOSURE OF OPERATING CASH FLOWS SHOULD SHOW ALL COMPONENTS OF
OPERATING CASH FLOW RELATED TO DISCONTINUED OPERATIONS RATHER THAN THE
NET OPERATING CASH FLOWS. PLEASE TELL US HOW YOU INTEND TO COMPLY WITH
THESE REPORTING REQUIREMENTS. REFER TO FOOTNOTE 10 SFAS 95.
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 3
Consistent with the information presented in SEC staff member Joel
Levine's speech at the AICPA Annual Conference on SEC and PCAOB Current
Developments in December 2005, we retrospectively modified our presentation of
the statement of cash flows for discontinued operations in our Form 10-QSB for
the period ended December 31, 2005. On the face of the statement of cash flows,
we expanded the previous one-line caption display to separately disclose cash
flows from each of operating, investing, and financing activities from
discontinued operations for both the current and prior period. In addition, on
the face of the cash flow statement we have indicated the change by labeling the
marginal heading as "Revised - See note 16". The footnote that this refers to
reads as follows:
"AT DECEMBER 31, 2005, THE COMPANY HAS SEPARATELY DISCLOSED THE
OPERATING, INVESTING AND FINANCING PORTIONS OF THE CASH FLOWS
ATTRIBUTABLE TO ITS DISCONTINUED OPERATIONS, WHICH IN PRIOR PERIODS
WERE REPORTED ON A COMBINED BASIS AS A SINGLE AMOUNT."
Notes to Consolidated Financial Statements
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Revenue Recognition, page F-12
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3. WE NOTE YOUR DISCLOSURE THAT CUSTOMERS MAY CHOOSE TO PURCHASE THE RIGHT
TO RECEIVE UPGRADES. DESCRIBE THE TYPES OF UPGRADE RIGHTS THAT YOU
OFFER TO YOUR CUSTOMERS AND TELL US WHETHER YOUR ARRANGEMENTS DESCRIBE
SPECIFIC FEATURES AND/OR ADDITIONAL FUNCTIONALITY TO BE INCLUDED IN
FUTURE UPGRADES. TELL US YOUR CONSIDERATION OF PARAGRAPHS 37 AND 38 OF
SOP 97-2 WITH REGARD TO SPECIFIED UPGRADE RIGHTS IN YOUR ARRANGEMENTS.
Per Paragraph 37 of SOP 97-2, "if a multiple-element arrangement
includes an upgrade right, the fee should be allocated between the elements
based on vendor-specified objective evidence of fair value." The definition of
an upgrade right per SOP 97-2 is "the right to receive one or more specific
upgrades/enhancements that are to be sold separately. The upgrade right may be
evidenced by a specific agreement, commitment, or the vendor's established
practice." In our arrangements, when a customer purchases post contract customer
support ("PCS") we do not offer them the right to specific upgrades/enhancements
but instead offer them the right to UNSPECIFIED upgrades and enhancements that
may be released during their one-year PCS contract on a when-and-if-available
basis. The development efforts for such unspecified upgrades and enhancements
would generally not be significant in relation to the original development
effort for the software product and we would otherwise need to make those
changes to continue its product offering in the marketplace. We do not offer an
explicit commitment or agreement to deliver a specific version of the software
or an upgrade with specific features and functionality, nor do we assure the
customer that any upgrades or enhancements will be released during their PCS
period. If a new version is released with new features and functionality, the
customers have the right to receive it for free if they are under PCS. However,
at the time of purchase of PCS, we do not know what new features and upgrades
will be released with the new version, therefore our PCS arrangements do not
describe specific features and/or additional functionality to be included in
future upgrades.
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 4
We provide unspecified upgrades/enhancements to customers on a
when-and-if available basis as long as they have purchased PCS. Per SOP 97-2,
the definition of PCS is "the right to receive services or unspecified product
upgrades/enhancements, or both, offered to users or resellers, after the
software license period begins, or after another time as provided for by the PCS
arrangement. Unspecified upgrades/enhancements are PCS only if they are offered
on a when-and-if available basis." Our arrangements meet the definition of an
unspecified upgrade/enhancement that can be included in the PCS element of the
arrangement. We have reviewed paragraphs 37 and 38 and noted that our
arrangements do not provide specified upgrade rights that need to be allocated
separately.
In our Form 10-QSB for the period ended December 31, 2005, we included
in the revenue recognition section of the critical accounting policies
discussion in the MD&A section at page 22 and in the revenue recognition note in
the notes to consolidated financial statements at page 8 the following language:
"CUSTOMERS MAY CHOOSE TO PURCHASE MAINTENANCE CONTRACTS THAT INCLUDE
TELEPHONE, E-MAIL AND OTHER METHODS OF SUPPORT, AND THE RIGHT TO
UNSPECIFIED UPGRADES ON A WHEN-AND-IF AVAILABLE BASIS"
We intend to include similar language where appropriate in future filings.
Note (3) - Long-Term Debt, page F-17
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4. WE NOTE THAT YOUR 2002, 2003, AND 2004 NOTES AND REVOLVING CREDIT
FACILITY PROVIDE FOR THE CONVERSION OF DEBT INTO SHARES OF YOUR COMMON
STOCK. TELL US HOW THE COMPANY EVALUATED THE CONVERSION FEATURES
ASSOCIATED WITH THESE DEBT ISSUANCES TO DETERMINE WHETHER THERE ARE
EMBEDDED DERIVATIVES THAT MEET THE CRITERIA FOR BIFURICATION UNDER SFAS
133. SPECIFICALLY, TELL US HOW YOU CONSIDERED THE CRITERIA IN PARAGRAPH
12(A) THROUGH 12 (C) OF SFAS 133 AND THE SCOPE EXCEPTION OF PARAGRAPH
11(A) OF SFAS 133 IN YOUR ANALYSIS. PROVIDE US WITH YOUR ANALYSIS FOR
EACH DEBT ISSUANCE USING THE CONDITIONS OUTLINED IN PARAGRAPH 12-32 OF
EITF 00-19 TO SUPPORT YOUR CONCLUSIONS. SPECIFICALLY WE NOTE THAT THE
SHARES OF COMMON STOCK UNDERLYING CERTAIN ISSUANCES ARE SUBJECT TO
REGISTRATION RIGHTS AND LIQUIDATED DAMAGES. IF THE SCOPE EXCEPTION OF
PARAGRAPH 11(A) IS NOT MET, TELL US WHY YOU HAVE NOT CONSIDERED THE
CONVERSION FEATURES TO BE EMBEDDED DERIVATIVES THAT ARE SUBJECT TO
CLASSIFICATION AND MEASUREMENT AT FAIR VALUE.
The following is an analysis of how we evaluated the conversion
features associated with the 2002, 2003, and 2004 notes and Revolving Credit
Facility (the "debt issuances"), specifically our consideration of the criteria
in paragraphs 12(a) through 12(c) of SFAS 133 and the scope exception of
paragraph 11(a).
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 5
The debt instruments met the criteria in paragraph 12(a) and 12(b) of
SFAS 133 because the conversion option is not considered clearly and closely
related to the debt host and the debt instruments, in its entirety, is not
accounted for at fair value, with changes in fair value reported in earnings as
they occur. However, we believe the conversion options embedded in the debt
instrument fail to meet the criterion in paragraph 12(c) of SFAS 133 because
they meet the 11(a) scope exception. Therefore, the conversion options do not
meet the definition of a derivative under SFAS 133 and do not require separation
and fair value accounting. Additionally, we believe that each instrument meets
the definition of "conventional convertible debt" and therefore paragraphs 12-32
of EITF 00-19 were not applicable in our analysis of the conversion options.
Following is our analysis of why each instrument is considered conventional
convertible debt and why we believe the embedded conversion option meets the
11(a) scope exception.
For you reference we have provided a summary of terms for our note agreements as
follows:
2002 AND 2003 NOTES
The fixed conversion price to convert the note to Common Stock is
$1.60. The fixed conversion price was amended in the amended 2003 note to $1.30.
The Company has the sole option to determine whether to satisfy payment
of the Monthly Amount in full on each Repayment Date either in cash or in shares
of Common Stock, or a combination of both. If the Borrower repays all or a
portion of the Monthly Amount in shares of Common Stock, the number of such
shares to be issued for such Repayment Date shall be the number determined by
dividing (x) the portion of the Monthly Amount to be paid in shares of Common
Stock, by (y) the Conversion Price (as defined herein) as of such date.
Laurus has the right, but not obligation, to at any time until the Note
is repaid in full, to convert the principal portion of this Note and/or interest
and fees due and payable into shares of the Company's common stock as such stock
exists on the date of issuance of this Note at the conversion price. Upon
conversion, the Company must deliver the appropriate number of shares. The
Company does not have the option of cash settlement. Laurus will not be
permitted to convert on any conversion date, an amount of shares having a dollar
value exceeding 25% of the aggregate dollar trading volume during the 30 trading
days preceding such Conversion date.
The Company may provide Laurus with a "call notice" requiring the
conversion of all or a portion of the Note held by the Company (at the fixed
conversion price). The "call date" shall be at least 30 days following the date
of the call notice, provided a registration statement covering the resales of
that number of shares has been declared effective and is available for use. The
amount of common stock to be issued in connection with any such conversion for
the Call Notice shall not exceed 20% of the aggregate dollar trading volume for
the 22 trading days immediately preceding the Call Date.
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 6
2004 NOTE
The Holder shall convert into shares of Common Stock all or a portion
of the Monthly Amount due on each Repayment Date according to the following
guidelines (i) the average closing price of the Common Stock as reported by
Bloomberg, L.P. on the Principal Market for the five (5) trading days
immediately preceding such Repayment Date shall be greater than or equal to 110%
of the Fixed Conversion Price and (ii) the amount of such conversion does not
exceed twenty five percent (25%) of the aggregate dollar trading volume of the
Common Stock for the thirty (30) day trading period immediately preceding the
applicable Repayment Date. If the Conversion Criteria are not met, the Holder
shall convert only such part of the Monthly Amount that meets the Conversion
Criteria. Any part of the Monthly Amount due on a Repayment Date that the Holder
has not been able to convert into shares of Common Stock due to failure to meet
the Conversion Criteria, shall be paid by the Borrower in cash.
If the Monthly Amount is required to be paid in cash, then the Borrower
shall pay the Holder an amount equal to the Monthly Amount due and owing to the
Holder on the Repayment Date in cash. If the Monthly Amount is required to be
paid in shares of Common Stock pursuant to the above, the number of such shares
to be issued by the Borrower to the Holder on such Repayment Dateshall be the
number determined by dividing (x) the portion of the Monthly Amount converted
into shares of Common Stock, by (y) the then applicable Fixed Conversion Price.
The fixed conversion price to convert the note to Common Stock is
$1.29. Laurus has the right, but not obligation, to at any time until the Note
is repaid in full, to convert the principal portion of this Note and/or interest
and fees due and payable into shares of the Company's common stock as such stock
exist on the date of issuance of this Note at the conversion price. Upon
conversion, the Company must deliver the appropriate number of shares. The
Company does not have the option of cash settlement.
Laurus shall not be entitled to convert that amount of a Note in
connection with that number of shares that would be in excess of the difference
of: i) the number of shares of Common Stock beneficially owned by Laurus and ii)
4.99% of the outstanding shares of Company on the conversion date.
CONCLUSION
Under each of the 2002, 2003, and 2004 notes, the holder had an option
to convert into a fixed number of shares as the conversion price is fixed. These
notes meet the definition of a conventional convertible debt instruments since
Laurus 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. Since the embedded conversion feature was deemed to
be a conventional convertible debt instrument, the embedded conversion option
qualified for equity classification under EITF 00-19. Additionally, it qualifies
for the scope exception in SFAS 133 since it is classified in stockholders
equity per EITF 00-19 and was not required to be bifurcated from the host
instrument. Accordingly, the 2002, 2003 and 2004 notes were accounted for in
accordance with APB 14.
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 7
REVOLVING CREDIT FACILITY
At any time after the date of this agreement that the Borrower shall
have an effective registration statement covering 2,300,000 shares of its Common
Stock to be issued upon the conversion of this Note, the Borrower may elect to
prepay any Obligation, or a portion thereof using such registered shares of
Common Stock.
The fixed conversion price to convert the note to Common Stock is
$1.30. For every $1 million of conversions made, the fixed conversion price will
thereafter be adjusted upward to equal 110% of the volume weighted average
closing price for the 5 trading days prior to the last day of the period during
which such $1 million has been converted.
Laurus has the right, but not obligation, to at any time until the Note
is repaid in full, to convert the principal portion of this Note and/or interest
and fees due and payable into shares of the Company's common stock as such stock
exist on the date of issuance of this Note at the conversion price. Upon
conversion, the Company must deliver the appropriate number of shares - the
Company does not have the option of cash settlement.
Laurus shall not be entitled to convert that amount of a Note in
connection with that number of shares that would be in excess of the difference
of: i) the number of shares of Common Stock beneficially owned by Laurus and ii)
4.99% of the outstanding shares of Company on the conversion date.
In the event the common stock trades at a price greater than 110% of
the fixed conversion price for a period of at least 5 consecutive days, the
Company may provide Laurus with a "call notice" requiring the conversion of all
or a portion of the Note held by the Company (at the fixed conversion price).
The "call date" shall be at least 11 days following the date of the call notice,
provided a registration statement covering the resales of that number of shares
has been declared effective and is available for use. The amount of common stock
to be issued in connection with any such conversion for the Call Notice shall
not exceed 25% of the aggregate dollar trading volume for the 11 trading days
immediately preceding the Call Date.
The revolving credit facility had a fixed conversion price of $1.30.
However, for every $1 million of conversions made, the fixed conversion price
was thereafter to be adjusted upward. We concluded that until the first $1
million of debt was converted to equity, the convertible instrument had the
characteristics of a conventional convertible debt instrument because the
conversion price was fixed resulting in conversion into only a fixed number of
shares and, therefore, should have been accounted for in a manner consistent
with the 2002, 2003, and 2004 notes. However, once the first $1 million of debt
obtained under the revolver was converted into equity and the conversion price
reset, this instrument would no longer have had the characteristics of a
conventional convertible debt instrument. Once the instrument is no longer
considered conventional, it would thereafter be subject to the provisions of
SFAS 133, and the conversion feature should be accounted for as a freestanding
derivative, unless the criteria in paragraph 12-32 of EITF 00-19 are met. If the
instrument does not meet those requirements, the contract would be reclassified
as of the date of the event that caused the reclassification and accounted for
at fair value with changes recorded in earnings.
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 8
In November 2005, the 2002, 2003, and 2004 notes were paid off and the
revolver was terminated. Throughout the term of the revolver, we never reached
the $1 million conversion where the fixed price would have reset.
In conclusion, the 2002, 2003, and 2004 notes and Revolving Credit
Facility met the 11(a) scope exception of SFAS 133 because we believe the
instruments would qualify for equity classification per paragraph 4 of EITF
00-19 due to the fact that we believe all of the debt instruments met the
definition of conventional convertible debt.
5. WE NOTE THAT IN CONNECTION WITH SOME OF THE CONVERTIBLE DEBENTURES, THE
COMPANY ALSO ISSUED WARRANTS. TELL US HOW YOU ANALYZED OUTSTANDING
WARRANTS PURSUANT TO SFAS 133 AND EITF 00-19. SPECIFICALLY, TELL US IF
THE WARRANTS REQUIRE NET SETTLEMENT PURSUANT TO PARAGRAPH 6(C) OF SFAS
133. ALSO, TELL US HOW THE COMPANY DETERMINED THAT THE WARRANTS MET THE
SCOPE EXCEPTION OF PARAGRAPH 11 (A) OF SFAS 133. PROVIDE US WITH YOUR
ANALYSIS USING THE CONDITIONS OUTLINED IN PARAGRAPHS 12 TO 32 OF EITF
00-19 TO DETERMINE WHETHER THE WARRANTS SHOULD BE CLASSIFIED IN EQUITY
OR AS A LIABILITY. TELL US IF THE WARRANT AGREEMENTS INCLUDE
REGISTRATION RIGHTS AND/OR LIQUIDATED DAMAGES PROVISIONS.
Per Section IIB of Current Accounting and Disclosure Issues in the
Division of Corporation Finance, "since warrants are freestanding instruments,
the warrants should be analyzed to determine whether they meet the definition of
a derivative under SFAS 133 (paragraphs 6-9), and if so, whether they meet the
scope exception in paragraph 11 of SFAS 133. If the warrant does not meet the
definition of a derivative under SFAS 133, it must be evaluated under paragraphs
12-32 of EITF 00-19 to determine whether the instruments should be accounted for
as a liability or an equity instrument.
The following is an analysis pursuant to Paragraph 6 of SFAS 133 of the
warrants issued with the convertible notes. Per paragraph 6 of SFAS 133, a
derivative instrument is a financial instrument or other contract with ALL THREE
of the following characteristics.
a. It has (1) one or more UNDERLYINGS and (2) one or more NOTIONAL AMOUNTS
or payment provisions or both. Those terms determine the amount of the
settlement or settlements, and, in some cases, whether or not a
settlement is required.
All of the warrants have one underlying, which is the security exercise
price. The exercise prices for the 2002 warrants are 125,000 shares at
$1.76, 50,000 shares at $2.08 and 25,000 shares at $2.40. The exercise
price for all of the 2004 warrants is $1.56. The exercise prices for
the revolver warrants are 60,000 shares at $1.50, 60,000 shares at
$1.63, and 60,000 shares at $1.89.
b. It 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.
There was no initial net investment for any of the warrant agreements.
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 9
c. Its terms require or permit net settlement, it can readily be settled
net by a means outside the contract, or it provides for delivery of an
asset that puts the recipient in a position not substantially different
from net settlement.
In the warrant agreements, there are no specific terms that require or
permit net settlement. However, there are liquidated damages provisions
in the registration rights agreement that also cover the warrant
agreements. The amount of these damages is based on a percentage (1%)
of the outstanding principal amount of the note with which the warrants
agreement was issued. As per paragraph 14 of EITF 00-19, a contract
such as this that anticipates settlement of the contract to be only in
the form of registered shares results in an assumption that there will
be a requirement to net-cash settle the contract.
The warrants contain all three of the above characteristics; therefore
they meet the definition of a derivative under SFAS 133.
Pursuant to paragraph 11(a) of SFAS 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 SFAS 133. In order to
determine whether the warrants met the scope exception of paragraph 11 (a) the
warrants must first be evaluated under paragraphs 12-32 of EITF 00-19 to
determine whether the instrument should be accounted for as a liability or an
equity instrument. The following is an analysis of the conditions outlined in
paragraphs 12 to 32 of EITF 00-19 to determine whether the warrants should be
classified in equity or as a liability, noting that all conditions must be met
in order for the warrants to be classified in equity upon issuance:
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CRITERIA
NO. CONDITION SUMMARIZED MET DESCRIPTION
- ------------- ---------------------------------------------------- -------- -------------------------
12-13 Contracts that include any provision that could YES The warrants do not
require net-cash settlement cannot be accounted for provide any net cash
as equity of the company, except in those limited settlement provisions.
circumstances in which holders of the underlying
shares would also receive cash.
- ------------- ---------------------------------------------------- -------- -------------------------
14-18 THE CONTRACT PERMITS THE COMPANY TO SETTLE IN NO
UNREGISTERED SHARES
- ------------- ---------------------------------------------------- -------- -------------------------
14. If the contract permits the company to net The shares underlying the
share or physically settle the contract only by warrants are initially
delivering registered shares, it is assumed that the delivered as unregistered
company will be required to net-cash settle the with a legend on the
contract. As a result, the contract must be back, but the shares
classified as an asset or liability. underlying the warrants
are expected to be
registered by a
specific time
period. The warrant
contracts do not
specify how the
contract would be
settled in the event
that the company is
unable to deliver
registered shares.
- ------------- ---------------------------------------------------- -------- -------------------------
19 THE COMPANY HAS SUFFICIENT AUTHORIZED AND UNISSUED YES We have sufficient
SHARES AVAILABLE TO SETTLE THE CONTRACT AFTER authorized and unissued
CONSIDERING ALL OTHER COMMITMENTS THAT MAY REQUIRE shares available to
THE ISSUANCE OF STOCK DURING THE MAXIMUM PERIOD THE settle the contract.
DERIVATIVE CONTRACT COULD REMAIN OUTSTANDING
- ------------- ---------------------------------------------------- -------- -------------------------
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 10
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20-24 THE CONTRACT CONTAINS AN EXPLICIT LIMIT ON THE YES
NUMBER OF SHARES TO BE DELIVERED IN A SHARE
SETTLEMENT
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25 THERE ARE NO CASH PAYMENTS REQUIRED TO THE NO
COUNTERPARTY IN THE EVENT THE COMPANY FAILS TO MAKE
TIMELY FILINGS WITH THE SEC.
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25: If those contracts that permit share settlement Per the registration
but require net-cash settlement in the event that rights agreements, in the
the company does not make timely filings with the event the registration is
SEC, then it just be classified as an asset or a not filed or declared
liability. effective on time or if
the registration ceases
to be effective or the
common stock ceases
trading then until the
applicable Event is
cured, the Company shall
pay to each Holder an
amount in cash, as
liquidated damages and
not as a penalty, equal
to 1.0% for each thirty
(30) day period
(prorated for partial
periods) on a daily
basis of the original
principal amount of the
Note. Any unpaid
liquidated damages as of
the date when an Event
has been cured by the
Company shall be paid
within three (3) days
following the date on
which such Event has
been cured by the
Company. This is not for
settlement of the shares
but as additional
damages.
- ------------- ---------------------------------------------------- -------- -------------------------
26 THERE ARE NO CASH PAYMENTS REQUIRED TO THE YES No such provisions in the
COUNTERPARTY IF THE SHARES INITIALLY DELIVERED UPON warrant agreements
SETTLEMENT ARE SUBSEQUENTLY SOLD BY THE COUNTERPARTY
WITH FULL RETURN OF THE AMOUNT DUE (THAT IS,
"MAKE-WHOLE" PROVISION)?
- ------------- ---------------------------------------------------- -------- -------------------------
27-28 THE CONTRACT REQUIRES NET-CASH SETTLEMENT ONLY IN YES
SPECIFIC CIRCUMSTANCES IN WHICH HOLDERS OF SHARES
UNDERLYING THE CONTRACT ALSO WOULD RECEIVE CASH IN
EXCHANGE FOR THEIR SHARES?
- ------------- ---------------------------------------------------- -------- -------------------------
29-31 THERE ARE NO PROVISIONS IN THE CONTRACT THAT INDICATE YES
THAT THE COUNTERPARTY HAS RIGHTS THAT RANK HIGHER
THAN THOSE OF A SHAREHOLDER OF THE STOCK UNDERLYING
THE CONTRACT.
- ------------- ---------------------------------------------------- -------- -------------------------
32 THERE IS NO REQUIREMENT IN THE CONTRACT TO POST YES There is a security
COLLATERAL AT ANY POINT OR FOR ANY REASON. agreement where we post
collateral however that
agreement is only for
the convertible note,
not the warrant piece.
When we paid off our
entire loan balances in
November 2005 all of the
UCC liens were released
even though the warrants
are still outstanding.
- -----------------------------------------------------------------------------------------------------------
In the event that the Company's registration statement is not declared
effective, the warrants include a provision for liquidated damages equal to 1.0%
for each thirty (30) day period (prorated for partial periods) on a daily basis
of the original principal amount of the Note. Any unpaid liquidated damages as
of the date when an event has been cured by the Company shall be paid within
three (3) days following the date on which such event has been cured by the
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 11
Company. As such, the warrants do not meet all of the criteria listed in
paragraph 12-32 of EITF 00-19 and thus should not be classified in stockholders
equity. Since the warrants should not be classified in stockholders equity, they
do not meet the scope exception of paragraph 11(a) of SFAS 133. As such, these
warrants are considered to be a derivative and should have been classified as a
liability in our consolidated financial statements at fair value and the change
in fair value should have been recognized in earnings (see materiality
considerations below).
Per paragraph 10 of EITF 00-19, "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, the contract
should be reclassified as of the date of the event that caused the
reclassification." We believe that when the warrants meet all of the criteria in
paragraphs 12-32 of EITF 00-19 they would be reclassified to stockholders equity
and would then meet the scope exception of paragraph 11(a) of SFAS 133. These
warrants should have been classified as a liability until the shares became
registered and made effective. At that point all of the requirements in EITF
00-19 would have been met as there would be no obligation for liquidated damages
and we would be settling with registered shares. While the warrants are
classified as a liability on the balance sheet they should be measured at fair
value, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain as a liability. Once the
requirement is met and the shares have been registered, the warrants can then be
reclassified from a liability to equity.
All of the warrants were originally classified in stockholders' equity
at fair value. The fair values for the warrants were calculated using the
black-scholes model. The following is a chart which shows the fair value of the
warrants on the date they were recorded in stockholders' equity and total fair
value at the end of each fiscal year thereafter:
- -------------- -------------- --------------- ------------ ------------ ------------- ------------ ------------
Date Date Fair Value Fair Value Fair Value Fair Value Fair Value
warrants Registration warrants at at at at
were Statement was were 3/31/2003 3/31/2004 3/31/2005 6/30/2005
recorded declared recorded
effective at in
Equity
- -------------- -------------- --------------- ------------ ------------ ------------- ------------ ------------
December 2002 12/13/2002 10/15/2003 $ 199,638 $ 259,788 $ 209,223 $ 85,300 $ 52,753
Warrants
- -------------- -------------- --------------- ------------ ------------ ------------- ------------ ------------
July 2003 7/31/2003 3/29/2004 $ 201,336 -- $ 206,076 $ 96,282 $ 63,276
Warrants
- -------------- -------------- --------------- ------------ ------------ ------------- ------------ ------------
December 2004 12/23/2004 8/12/2005 $ 102,726 -- -- $ 85,670 $ 58,916
Warrants
- -------------- -------------- --------------- ------------ ------------ ------------- ------------ ------------
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 12
The following is a chart which shows the change in value of the
warrants for each fiscal year and interim period (expense)/income:
- ----------------------- ------------ ------------ ------------ ------------- ------------ ------------
Change in Change in Change in Change in Change in Total
value FY value FY value FY value in Q1 value in Q2 change in
2003 2004 2005 of FY 2006 of FY 2006 value
- ----------------------- ------------ ------------ ------------ ------------- ------------ ------------
December 2002 Warrants $ (60,150) $ 56,527 -- -- -- $ (3,623)
July 2003 Warrants -- $ (4,740) -- -- -- $ 4,740)
December 2004 Warrants -- -- $ 17,056 $ 26,754 (20,735) $ 23,075
------------ ------------ ------------ ------------ ------------ ------------
TOTALS (EXP)/INC $ (60,150) $ 51,787 $ 17,056 $ 26,754 $ (20,753) $ 14,712
============ ============ ============ ============ ============= ============
As of March 31, 2003, the shares underlying the warrants issued with
the December 2002 note should have been classified as a liability since the
registration statement did not become effective until October 15, 2003. The
total value of those warrants as of March 31, 2003 was $259,788, which is 0.8%
of total additional paid-in capital and 2.9% of total liabilities. This amount
should have been classified as a liability on our consolidated balance sheet and
the change in value should have been recorded as an expense in our consolidated
statement of operations. The total change in value for the year ending March
31, 2003 was an increase in net loss of $60,150 or 0.6% of the total net loss
for FY 2003
As of March 31, 2004, there would be no liability balance on our books
related to either the December 2002 warrants or the July 2003 warrants due to
the fact that the shares underlying both of these warrants were registered prior
to March 31, 2004 and the adjusted fair value should have been reclassified to
equity. The warrants as of March 31, 2004 decreased in value by $51,787,or 1.7%
of the total net loss for FY 2004, which should have been recorded as income in
our consolidated statement of operations.
As of March 31, 2005, the shares underlying the warrants issued with
the December 2004 note should have been classified as a liability since the
registration statement did not become effective until August 12, 2005. The total
value of those shares as of March 31, 2005 was $85,670. This amount represents
0.2% of total additional paid-in capital and 1.1% of total liabilities. During
the fiscal year ended March 31, 2005, the total value of the warrants decreased
by $17,056, or 2.2% of the total net loss for FY 2005, which should have been
recorded in income in our consolidated statement of operations for the period.
As of June 30, 2005 (Q1 of Fiscal 2006), the warrants associated with
the December 2004 note should have been classified as a liability since the
registration statements did not become effective until August 12, 2005. The
total value of those warrants as of June 30, 2005 was $58,916. This amount
represents 0.2% of total additional-paid-in capital and 0.7% of total
liabilities. During the three months ended June 30, 2005, the total value of the
warrants decreased by $26,754 or 8.1% of the total net loss for the three months
ended June 30, 2005, which should have been recorded in income in our
consolidated statement of operations for the period. As of September 30, 2005
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 13
(Q2 of Fiscal 2006), the liability for the 2004 warrants should have been
reclassified from a liability to equity since the registration became effective
as of August 12, 2005. The fair value of the warrants as of August 12, 2005 was
$79,651. During the three months ended September 30, 2005, the total value of
the warrants for the December 2004 note increased by $20,753, or 2.1% of the
total net loss for the three months ended September 30, 2005, which should have
been recorded as an expense in our consolidated statement of operations during
the three months. The total change in value for the six months ended September
30, 2005 was a decrease of $6,001 in net loss, or 0.9% of the total net loss for
the six months ended September 30, 2005.
We believe that the reclassifications that would be required on our
consolidated balance sheets to shift the warrant values from equity to a
liability and the related changes in earnings that would have been recorded had
we recorded the warrants as a liability instead of as equity at the time of
issuance and through the date the registration rights contingency was resolved
are both quantitatively and qualitatively immaterial to our annual and interim
consolidated financial statements. We further believe that this misstatement
would not have been viewed by the reasonable investor as having significantly
altered the "total mix" of information made available. We believe it is not
probable that the judgment of a reasonable person relying upon our financial
reports would have been changed or influenced by the classification of the
warrants. These misstatements did not mask a change in earnings or other trends,
they would not have changed a loss into income or vice versa, they did not
effect our compliance with our debt covenants, they would not have had an effect
on management's compensation, and they did not involve concealment of an
unlawful action. Since December 2002 and through the current date, the total
amount that was paid to Laurus Master Fund relating to penalties or liquidated
damages due to late registration effectiveness was $38,000. Of that amount,
$24,000 was charged in FY2003, $4,000 was charged in FY 2004, and $10,000 was
charged in FY 2006. As of November 17, 2005, the entire debt obligations
pertaining to the December 2002, July 2003, and December 2004 notes and the
revolving credit facility were repaid. As such, we have no continuing obligation
under the convertible debt and revolver agreements.
6. CERTAIN OF YOUR DEBT ISSUANCES PROVIDE FOR ADJUSTMENT TO INTEREST RATES
BASED ON MARKET PRICE OF YOUR COMMON STOCK AND/OR PROVIDE YOU THE
OPTION TO REDEEM NOTES AT A CERTAIN PREDETERMINED PERCENTAGE OF THE
OUTSTANDING PRINCIPAL AND ACCRUED INTEREST DEPENDING ON THE DATE OF
PREPAYMENT. TELL US HOW YOU EVALUATED THESE PROVISIONS PURSUANT TO SFAS
133 AND EITF 00-19.
As you noted, our 2002 and 2004 notes contain provisions to (i) adjust
interest rates based on the market price of our common stock and/or (ii) allow
us to call the notes and redeem them at a certain predetermined percentages of
the outstanding principal and accrued interest.
With respect to the interest rate modification, we evaluated this
provision within the framework of paragraph 12 and 13 of SFAS 133, which
addresses specific contract terms as follows: "the embedded derivative
instrument in which the underlying is an interest rate or interest rate index
that alters net interest payments that otherwise would be paid on an
interest-bearing host contract." We concluded that, as a result of our
evaluation of the interest rate provision's effect on the investor's rate of
return and investor recovery, the provision did not create the following
conditions:
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 14
a. The hybrid instrument can contractually be settled in such
a way that the investor (holder) would not recover substantially all of
its initial recorded investment; or
b. The embedded derivative could at least double the
investor's initial rate of return on the host contract and could also
result in a rate of return that is at least twice what otherwise would
be the market return for a contract that has the same terms as the host
contract and that involves a debtor with a similar credit quality.
Accordingly, we concluded that the conversion feature or the embedded
derivative instrument is clearly and closely related to the host contract and
thus does not qualify for separability as a derivative under the provisions of
SFAS No. 133 and, therefore accounted for such in accordance with the provisions
of EITF 00-19 along with the conversion and warrant features addressed in
response to your comments number 4 and 5 above.
With respect to the call option, we evaluated the provision in
accordance with paragraphs 12, 13 and the call option definitions in paragraph
61(d) and, likewise, determined that this feature is clearly and closely related
to the host contract due to the fact that the option can accelerate the
repayment of principal on a debt instrument that does not involve substantial
premium or discount and thus does not qualify for separability as a derivative
under the provisions of SFAS No. 133 and, therefore accounted for such in
accordance with the provisions of EITF 00-19 along with the conversion and
warrant features addressed in response to your comments number 4 and 5 above.
7. PLEASE NOTE, PURSUANT TO THE COMMENTS ABOVE RELATING TO YOUR DEBT AND
WARRANT ISSUANCES, YOU SHOULD PROVIDE US A THOROUGH ANALYSIS OF ALL THE
PROVISIONS OF YOUR DEBT INSTRUMENTS AND WARRANTS IN ORDER TO DETERMINE
WHETHER THERE ARE ANY PROVISIONS THAT MAY BE DERIVATIVES. IN YOUR
RESPONSE ADDRESS THE RELEVANT INFORMATION IN SECTION I.B OF CURRENT
ACCOUNTING AND DISCLOSURE ISSUES IN THE DIVISION OF CORPORATION
FINANCE, WHICH IS AVAILABLE ON OUR WEBSITE AT
HTTP://WWW.SEC.GOV/DIVISIONS/CORPFIN/ ACCTDIS120105.PDF. REVISE YOUR
DISCLOSURES WHERE NECESSARY TO CLARIFY YOUR ACCOUNTING FOR THESE
INSTRUMENTS.
In response to your comments numbered 4-6 relating to our debt and
warrant issuances, we have provided a thorough analysis of all of the provisions
of our debt instruments and warrants in order to determine whether there are any
provisions that may be derivatives. See comments above. In our response we have
addressed the relevant information in Section IIB of Current Accounting and
Disclosure Issues in the Division of Corporation Finance.
* * * *
Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Securities and Exchange Commission
April 7, 2006
Page 15
In connection with preparing our responses to your comments, we acknowledge
that:
o the company is responsible for the adequacy and accuracy of
the disclosure in the filing;
o staff comments or changes in disclosure in response to staff
comments do not foreclose the Commission from taking any
action with respect to the filing; and
o 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.
We trust the foregoing is responsive to your comments. If you have any
questions, please call Bruce Nelson at (714) 974-2500 ext 5215.
Sincerely yours,
NETGURU, INC.
/S/ BRUCE NELSON,
-----------------
Chief Financial Officer
cc: Mr. Thomas Ferraro
Mr. David Edgar