[Letterhead of GigaMedia Limited]
September 5, 2006
VIA FACSIMILE AND EDGAR
- -----------------------
Ms. Kathleen Collins
Accounting Branch Chief
Division of Corporation Finance
Mail Stop 7010
Securities and Exchange Commission
100 F Street N.E.
Washington, D.C. 20549
RE: GigaMedia Limited (File No. 000-30540)
Form 20-F for the Fiscal Year Ended December 31, 2005
Form 6-K Filed on March 24, 2006
Form 6-K Filed on May 17, 2006
------------------------------
Dear Ms. Collins:
On behalf of GigaMedia Limited, a company limited by shares, incorporated
under the laws of the Republic of Singapore (the "Company"), set forth below
are the Company's responses to the comments of the staff of the Securities and
Exchange Commission (the "Staff") to the above-referenced Form 20-F (the "2005
20-F") and Forms 6-K of the Company set forth in your letter dated July 20,
2006 (the "Comment Letter"). For the convenience of the Staff, each comment in
the Comment Letter is reprinted in bold and italics and is followed by the
corresponding response of the Company. As per the telephone conversation of
Alec P. Tracy, Esq. of Skadden, Arps, Slate Meagher & Flom LLP with Ms. April
Coleman, the
Ms. Kathleen Collins
September 5, 2006
Page 2 of 38
Company will file an amended Form 20-F reflecting these comments
once all comments are resolved.
Form 20-F for the Fiscal Year Ended December 31, 2005
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Report of Independent Registered Public Accounting Firm, page F-2
- -----------------------------------------------------------------
1. We note that the audit report dated May 26, 2005 and covering the
fiscal years ended December 31, 2004 and 2003 does not specify the
audit firm who performed the audit, nor is it signed. Revise to include
a signed audit report pursuant to Article 2.02 of Regulation S-X.
The Company's 2004 and 2003 financial statements were audited by
PricewaterhouseCoopers. The Company, in its filing, inadvertently
omitted the signature of PricewaterhouseCoopers' from its audit report
and will amend its Form 20-F to include a signed audit report.
2. We note that your auditors GHP Horwath, P.C. are located in Colorado.
It appears that the majority of your assets, liabilities, revenues and
expenses relate to operations located in Taiwan. Please tell us how the
audit of the operations in Taiwan, including the associated assets and
liabilities, was conducted. Your response should include a discussion
of the following:
o Whether another auditor was involved in the audit of the
Taiwanese operations. If so, please tell us the name of the
firm and indicate whether they are registered with the Public
Company Accounting Oversight Board (PCAOB). Additionally,
please tell us how your U.S. auditor assessed the
qualifications of the other auditor and the other auditor's
knowledge of U.S. GAAP and PCAOB standards.
o Whether your U.S. auditor performed all the required audit
procedures within the United States or whether a portion of the
audit was conducted by your U.S. auditor within Taiwan.
o The percentage of your total assets, liabilities, revenues and
expenses of operations located in Taiwan that the other
auditor, if any, audited for each period presented.
Ms. Kathleen Collins
September 5, 2006
Page 3 of 38
The Company's auditors, GHP Horwath, P.C., are a member firm of Horwath
International, an international association of public accounting firms
specializing in international accounting and auditing with
approximately 120 member firms in 85 countries and represented by
approximately 19,200 partners and professional employees. As such, it
is the 8th or 9th largest international association of public
accounting firms in the world. GHP Horwath has been involved in
auditing international companies since 1990, is registered with the
Public Company Accounting Oversight Board (PCAOB) and is a member of
the AICPA Center for Public Company Audit Firms. In completing their
audit, the Company understands that GHP Horwath utilized the services
of Horwath & Company, Taichung, Taiwan, a firm registered with the
PCAOB. Additionally, GHP Horwath utilized the services of Horwath Appel
in Montreal, Canada, also registered with the PCAOB, as the Company's
entertainment software business is located in Montreal and
Massachusetts. Both firms worked under the direct supervision of GHP
Horwath. The Company's initial audit contact was with Donald Pangburn,
a director (partner) in GHP Horwath. Prior to GHP Horwath being engaged
as auditors, Mr. Pangburn came to Taiwan and met with the Company's
audit committee and, together with two partners of Horwath & Company,
Taichung, met with the Company's prior auditors and reviewed their 2004
work papers.
The Company understands that standardized audit forms and procedures
from the GHP Horwath audit manual were provided to the other auditors
involved in its audit and their completion was monitored by the GHP
Horwath audit team. The Company was informed that the audit programs
were all prepared by GHP Horwath. During the portion of the audit in
which Horwath & Company, Taichung assisted GHP Horwath, a
Chinese-speaking manager from GHP Horwath came to Taiwan and worked
closely with the Horwath Taiwan firm to supervise the audit in process.
Additionally, during the audit, the senior manager on the engagement
from GHP Horwath came to Taiwan where he supervised audit work in
process. The senior manager also spent time during the audit in
Montreal supervising audit work being performed under GHP Horwath's
instructions by Horwath Appel.
The Company understands that both non-U.S. firms which assisted GHP
Horwath in the Company's audit have been involved in international
engagements, and that both firms have had training and
Ms. Kathleen Collins
September 5, 2006
Page 4 of 38
experience in applying U.S. GAAP as well as international accounting
standards. Furthermore, as discussed above, the Company understands
that all audit programs were developed by GHP Horwath, and during
the audit GHP Horwath provided detailed supervision to the firms
assisting them with the audit. Thus, all of the assets, liabilities,
revenues and expenses of the Company were audited by GHP Horwath.
Consolidated Statements of Operations, page F-5
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3. Tell us how you considered the guidance in Rule 5-03 of Regulation S-X
which states that costs and expenses applicable to sales and revenues
as described under Rule 5-03.2 shall be combined in the same manner as
revenues. Also describe the types of expenses included under the
caption 'operating expenses'. [OK -KAC]
The Company acknowledges that it did not provide a breakdown of costs
applicable to sales and revenues as described under Rule 5-03.2 in the
Financial Statements filed as part of its Form 20-F. However, the
Company believes the differences obtained by breaking down costs by
revenue streams versus the information on costs originally provided in
the MD&A section under Item 5 in its 20-F filing on pages 53-56 are
immaterial. The following table presents a breakdown of the costs by
revenue stream pursuant to Rule 5-03.2 for the years 2003-2005:
- -------------------------------------------------------------------------------------------------------
(in US$ thousands, except 2003 % 2004 % 2005 %
percentage figures)
- -------------------------------------------------------------------------------------------------------
Cost of software licensing NA NA 1,592 9.9 3,327 19.1
and online entertainment
revenues
- -------------------------------------------------------------------------------------------------------
Cost of Internet access
revenues 15,344 95.2 14,093 87.5 13,794 79.4
- -------------------------------------------------------------------------------------------------------
Cost of other revenues 771 4.8 424 2.6 262 1.5
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Total 16,115 100 16,109 100 17,383 100
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Going forward, the Company undertakes to segregate costs applicable to
each major type of revenues in its statement of
Ms. Kathleen Collins
September 5, 2006
Page 5 of 38
operations in the same manner it discloses revenues to ensure full
compliance with Rule 5-03.2.
Note 1. Business Overview, Basis of Presentation and Summary of Significant
- ----------------------------------------------------------------------------
Accounting Policies
- -------------------
Revenue Recognition, page F-10
- ------------------------------
4. Disclosure under Item 4 indicates that during the periods covered by
this annual report you derived revenues from a variety of sources,
including the sale of broadband internet access and related services
and sales of music media through your retail music business. Describe
in detail your revenue recognition policy for each type of product and
service that you sell. Clearly indicate the timing and measurement of
revenue from each type of earnings activity. Identify the elements
included in each type of sales transaction and describe how you've
considered the guidance in EITF 00-21 in accounting for any
multiple-element arrangements.
The Company's revenue recognition policies are as follows:
Software licensing and online entertainment revenues: The Company
recorded revenues from its entertainment software business from
licensing its software and providing support services. These revenues
are recognized monthly as a fixed percentage of the licensee's gross
receipts. The results of Ultra Internet Media, S.A. ("UIM"), the
licensee, have been incorporated into the Company's 2004 and 2005
consolidated financial statements. Therefore, software licensing and
support services revenues the Company received from UIM have been
eliminated in consolidation.
UIM earns revenues by providing and promoting online games of skill and
chance. Specifically, UIM operates online casino destinations in which
players place bets against the house. UIM also operates an online
multi-player poker platform in which players place bets among
themselves and UIM charges a small transaction fee in each game played.
As a result, elements of UIM's revenues are net house win and
transaction fees. Revenues derived from the Company's online casino
destinations are recognized upon the time games are played and are net
of player winnings. Player account balances are presented as current
liabilities, which are first accrued for in full upon the receipt of
player deposits, and increased / decreased based on
Ms. Kathleen Collins
September 5, 2006
Page 6 of 38
player activities, including player wins or losses, withdrawals and
refunds. Transaction fee revenues derived from the Company's online
multi-player poker platform are recognized as services are provided.
Internet access revenues: The Company recorded Internet access revenues
from cable modem Internet access services and from its asymmetrical
digital subscriber line ("ADSL") business, which it sold in May 2006.
Such revenues are recognized for the period in which the service is
performed, if no significant Company obligations remain and collection
of the receivables is reasonably assured. Customers have a choice of
paying either monthly or in advance for a certain period of time, for
which they receive corresponding discounts. The Company records any
such advanced payment receipts as other current liabilities on the
balance sheet and amortizes such revenues over the subscription period.
Other revenues: Other revenues consist of subscription revenues on
value-added services and sales of other Internet access-related
products generated from the Company's broadband ISP business, which are
recognized when services are provided or products are delivered.
Furthermore, in connection with the provision of its broadband ISP
services, the Company also recognizes rental income from the lease of
Internet access-related equipment to its subscribers. Such rental
income is recognized over the same period as the access service is
rendered and is reported under the "Other Revenues" caption due to
immateriality.
Discontinued operations:
------------------------
For 2004 and 2003, a significant portion of the Company's revenues were
generated from retail sales of music merchandise comprised of
pre-recorded music (including compact discs and audio cassettes), video
(including DVD and pre-recorded videocassettes), video games and other
complementary products (including electronics, accessories, blank tapes
and CD-Rs). Revenues from these retail sales were recognized at the
point of sale to the consumer, at which time payment was tendered.
Company policy was to not accept sales refunds or exchanges.
The Company disposed of its music distribution business in September
2005, and as a result has classified the income from these
revenue-generating activities as part of discontinued operations.
Ms. Kathleen Collins
September 5, 2006
Page 7 of 38
Evaluation of EITF 00-21:
-------------------------
The Company has considered the guidance in EITF 00-21 in accounting for
any multiple-element sales arrangements, which states in paragraph 9 of
EITF 00-21 that "in an arrangement with multiple deliverables, the
delivered item(s) should be considered a separate unit of accounting if
all of the following criteria have been met:
a. The delivered item(s) has value to the customer on a
stand-alone basis. That item(s) has value on a stand-alone
basis if it is sold separately by any vendor or the
customer could resell the delivered item(s) on a
stand-alone basis. In the context of a customer's ability
to resell the delivered item(s), the Task Force observed
that this criterion does not require the existence of an
observable market for that deliverable(s).
b. There is objective and reliable evidence of the fair value
of the undelivered item(s).
c. If the arrangement includes a general right of return
relative to the delivered item, delivery or performance of
the undelivered item(s) is considered probable and
substantially in the control of the vendor."
Online entertainment services and products:
-------------------------------------------
With regard to UIM's operation of online games of skill and chance, the
Company believes that there is only one element to all revenue
transactions. End users download and install the software on their
personal computers for free and the Company's revenues are generated
only when end users decide to participate in real-money transactions.
Revenues are recognized as end users play the games that are available
in the software. Given the fact that the Company's deliverables contain
software and non-software elements, under paragraph 4(a) of EITF 00-21,
the total arrangement fee should be allocated between elements within
the scope of SoP 97-2, "Software Revenue Recognition," ("SoP 97-2"),
the authoritative higher-level accounting literature, and non-SoP 97-2
elements. Based on the guidance provided in EITF 03-5, "Applicability
of SoP 97-2 to Non-Software Deliverables in an Arrangement Containing
More Than Incidental Software," the Company believes the functionality
of its online gaming services is dependent upon the software-related
elements to function and the software-related elements are more than
Ms. Kathleen Collins
September 5, 2006
Page 8 of 38
incidental to the online gaming service as a whole. Thus, the Company
considers the non-software element is within the scope of SoP 97-2.
Pursuant to the requirements of SoP 97-2, the total arrangement fee
should be allocated to each element based on vendor-specific objective
evidence ("VSOE") of fair value, which is limited to the following:
- The price charged when the same element is sold separately;
and
- For an element not yet being sold separately, the price
established by management having the relevant authority; it
must be probable that the price, once established, will not
change before the separate introduction of the element into
the marketplace.
On the basis that the Company's online gaming service is inseparable
from the software-related element and it does not sell each element
separately, management does not believe there is VSOE of fair value for
the software-related and non-software related elements. Paragraph 12 of
SOP 97-2 states that if VSOE of fair value does not exist for all
elements in an arrangement, all revenue should be deferred until all
items are delivered or until VSOE of fair value exists. Paragraph 12
provides certain exceptions including cases where the only undelivered
element is service that does not involve significant production,
modification, or customization of software, in which case all revenue
is recognized over the period when the service is provided. As the
Company's online gaming services do not involve significant production,
modification, or customization of the free download gaming software,
the Company applies the exception provided in paragraph 12 and
recognizes gaming revenue over the period when players play the
Company's online games. Going forward, the Company intends to clarify
this in its accounting policy.
Internet access services and products:
--------------------------------------
With respect to its Internet access business, the Company generates
revenues primarily from provision of ADSL broadband access services and
cable modem-based broadband access services to retail customers, and
dedicated Internet access services to corporate customers. Customers
may choose between these services, which
Ms. Kathleen Collins
September 5, 2006
Page 9 of 38
are not bundled together as a group of broadband services within one
contract.
The Company's ADSL access services do not include installation services
or sale of related hardware/equipment. All revenues are derived from
the provision of broadband Internet access through ADSL technology.
Since there are no multiple deliverables, the Company does not believe
there is a multiple element issue to accounting for related revenues.
As part of its cable modem access services, the Company also provides
cable modem equipment to its subscribers. All of the cable modems it
provides are on an operating lease basis. The rental service is bundled
with the access service contract. To facilitate the provision of cable
modem Internet access services, the Company normally does not charge
its subscribers a rental fee for the cable modems and such practice is
commonly adopted in the market place. Under paragraph 4(a)(ii) and
footnote 3 of EITF 00-21, the lease of a cable modem is subject to FAS
13, "Accounting for Leases," the authoritative higher-level accounting
literature, while the remaining non-FAS 13 deliverable(s) are subject
to EITF 00-21 accounting. Pursuant to EITF 00-21, the contract
considerations shall be allocated among/between the FAS 13 deliverable
and the non-FAS 13 deliverable(s) based on their relative fair values.
On the basis that the Company has not entered into any other agreement
pursuant to which it leases its cable modems on a separate basis and no
other vendor provides the rental services on a stand-alone basis, there
is consequently no readily available fair value for the cable modem
rental services in the market place.
The Company therefore used its best estimate to determine the fair
value of the rental services and it believes such amount is minimal for
allocation purposes. This is based on the facts that (1) neither the
Company nor other vendors charge a cable modem rental fee and (2) the
purchase price of a single modem from 2003 through 2005 approximated
US$40 and each modem has an economic useful life of 5 years. From a
customer's perspective, and disregarding the time value of money, the
benefit received from the cable modem rental services each year is only
US$8 (US$40/5 years) and on an aggregate basis, the fair values in
2003, 2004 and 2005 are US$238,184, US$183,292 and US$153,280,
respectively, which are calculated based on the average number of cable
modem subscribers
Ms. Kathleen Collins
September 5, 2006
Page 10 of 38
in each year and the benefit received by each cable modem subscriber
per year as a result of the rental services (i.e., US$8 per
subscriber per year). The Company believes such amounts are
immaterial for allocation purposes as they only represented 1.3
percent, 0.9 percent and 0.7 percent of Internet access revenue in
2003, 2004 and 2005, respectively. Furthermore, the allocation would
not affect the total revenue presentation as revenues from the
monthly rental of cable modems would be recognized over the same
period as the access service is rendered. The Company therefore does
not allocate the FAS 13 deliverable separately from the total
contract considerations.
The only non-FAS 13 deliverable in the Company's cable modem
Internet access service is Internet access services, which does not
constitute multiple elements warranting separate accounting under
the requirements of EITF 00-21. On an occasional basis, the Company
also sells cable modems which are deemed obsolete to certain system
operators, which are not the Company's subscribers, as a way of
salvaging residual value of the Company's obsolete cable modem
inventory. Such sales are negligible in comparison to the Company's
total revenues for each of the fiscal periods presented in the 2005
20-F (2005 - 0.009 percent, 2004 - 0.001 percent, 2003 - 0.009
percent). Since the sale of obsolete cable modems to non-subscribers
and the provision of Internet access services are not bundled and
are to different customers, the Company does not believe there is a
multiple element issue to accounting for related revenues.
The Company also provides a variety of value-added services,
including premium email, web storage space, and online photo albums,
etc. to its retail customers for a subscription fee. Customers may
choose among these value-added services, which are not bundled
together as a group of services within one contract, nor bundled
with any of the Company's broadband access services. Revenue is
recognized on a straight-line basis over the subscription period and
is reported under the "Other Revenues" caption. Such revenues are
negligible in comparison to the Company's total revenues for each of
the fiscal periods presented in the 2005 20-F (2005 - 0.32 percent,
2004 - 0.76 percent, 2003 - 1.98 percent). Since there are no
multiple deliverables, the Company does not believe there is a
multiple element issue to accounting for its subscription revenues.
Ms. Kathleen Collins
September 5, 2006
Page 11 of 38
In limited cases, the Company provides certain Internet access-related
equipment solutions, such as routers and switches, to its corporate
customers on an operating lease basis. Pursuant to paragraph 4(a)(ii)
and footnote 3 of EITF 00-21, the Company accounts for the lease under
FAS 13 and allocates the contract considerations between the FAS 13
deliverable (the lease equipment), and the non-FAS 13 deliverable
(Internet access services) based on its best estimates of the fair
values. Such solutions are customer specific and due to the fact that
no other vendors provide similar solutions in the market on a
stand-alone basis, the Company does not believe objective and reliable
evidence of fair value exists. Therefore, the allocation is performed
based on management's best estimate. For the non-FAS 13 deliverable,
the Company applies EITF 00-21 as discussed in the previous paragraph
and does not believe there are multiple units of accounting. For the
years 2003 - 2005, total allocated rental revenues arising from the
lease of Internet access-related equipment and its percentage as to
total revenues are summarized as follows:
- --------------------------------------------------------------------------------------------------------------
(in US$, except percentage figures) 2003 % of total 2004 % of total 2005 % of total
revenues revenues revenues
- --------------------------------------------------------------------------------------------------------------
Internet access-related equipment 0 0.00 34,063 0.10 37,126 0.08
rental revenue
- --------------------------------------------------------------------------------------------------------------
Such amounts are reported under the "Other Revenues" caption. The
Company believes these amounts are immaterial for the purposes of
disclosing separately. However, going forward, the Company intends to
clarify this in its accounting policy disclosure.
Additionally, as part of its dedicated Internet access services to its
corporate customers, the Company provides nonrefundable activation
services to such customers. Such activation services are customer
specific and provide dedicated connection to the Company's broadband
infrastructure and are, therefore, inseparable from the provision of
Internet access service. No other vendors provide such activation
services on a stand-alone basis as the connection is dedicated to the
Company's broadband infrastructure and the Company's customers cannot
resell such activation services as they are customer specific and carry
no value to a third party. Therefore, the Company does not believe the
activation fee warrants separate unit of accounting treatment as it
does not meet the criteria set forth in
Ms. Kathleen Collins
September 5, 2006
Page 12 of 38
paragraph 9(a) of EITF 00-21. Activation fees are combined with the
Company's Internet access revenues as a single unit of accounting and
are recognized at the time the Internet access service is activated.
However, the Company notes its current accounting for recognizing
activation fees is not fully consistent with the guidance provided in
the Staff Accounting Bulletins (SAB) Topic 13 which states that
"unless the up-front fee is in exchange for products delivered or
services performed that represent the culmination of a separate
earnings process, the deferral of revenue is appropriate." The impact
of deferral of the activation fees on the Company's statements of
operations and balance sheets is summarized below.
Impact on Statements of Operations
-----------------------------------------------------------------------------------------------
(in US$, except percentage figures) 2003 2004 2005
-----------------------------------------------------------------------------------------------
Impact of deferral of activation fee (10,366) 3,856 4,988
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% impact of broadband ISP segment (0.05%) 0.02% 0.02%
revenue
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% impact of total revenue (0.05%) 0.01% 0.01%
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% impact of income (loss) from (0.11%) 0.31% 0.08%
continuing operations
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Cumulative effect of deferral of (10,366) (6,510) (1,522)
activation fee
-----------------------------------------------------------------------------------------------
% impact of income (loss) from (0.11%) (0.52%) (0.02%)
continuing operations
-----------------------------------------------------------------------------------------------
Ms. Kathleen Collins
September 5, 2006
Page 13 of 38
Impact on Balance Sheets
----------------------------------------------------------------------
(in US$, except percentage 2004 2005
figures)
----------------------------------------------------------------------
Deferred revenue activation fee 7,183 2,046
----------------------------------------------------------------------
% impact of total liabilities 0.03% 0.02%
----------------------------------------------------------------------
Based on the above quantitative analysis, the Company has determined
that the impact of not deferring the activation fees on the Company's
broadband ISP segment revenue, total revenue, income from continuing
operations and balance sheets is not material. In reaching this
conclusion, the Company has considered the guidance provided by SAB
Topic 1 M, "Materiality."
In addition to the above quantitative analysis, from a qualitative
perspective, the Company assessed the nine bullet points contained in
SAB Topic 1M which address qualitative as well as quatitative
considerations in determining materiality. Management believes that
only the first bullet point regarding precise measurement is
applicable. However, the Company believes that the impact on the
balance sheets and statements of operations is not of the magnitude
that it is probable that the judgment of a reasonable person relying
on the financial statements would have been changed or influenced by
revising the accounting for the activation fees. The remaining 8
factors listed in SAB Topic 1M are discussed below:
o not deferring the activation fees did not mask a change in the
Company's earnings or other trends as the amount involved was
relatively small;
o not deferring the activation fees did not hide a failure to
meet analysts' expectations as the amount involved was
relatively small;
Ms. Kathleen Collins
September 5, 2006
Page 14 of 38
o not deferring the activation fees did not change a loss into
income or vice versa;
o not deferring the activation fees did not concern a segment of
the Company's business that plays a significant role in the
Company's operations or profitability as the amount involved
was related to the Company's non-core legacy business that has
traditionally been unprofitable;
o not deferring the activation fees did not affect the Company's
compliance with regulatory requirements or debt covenant;
o not deferring the activation fees did not affect the Company's
compliance with loan covenants or other contractual
requirements;
o not deferring the activation fees did not have the effect of
increasing management's compensation; and
o not deferring the activation fees did not involve concealment
of an unlawful transaction.
Based on above, the Company does not believe any of the other eight
considerations listed in SAB Topic 1M would be triggered and it doesn't
believe that revising the accounting for the activation fees would
result in a significant positive or negative market reaction. The
Company has discussed its conclusions with regard to this matter with
its auditors, and they concur with the Company's position.
Going forward, the Company undertakes to record the activation fees in
accordance with SAB Topic 13 beginning in 2006.
For all of its Internet access service subscribers, including those of
its ADSL broadband access services, cable modem-based broadband access
services, and dedicated Internet access services, the Company provides
troubleshooting and customer support services on a 365-day basis during
their subscription period. These services are bundled together with
each of the Internet access contracts. The Company does not believe its
troubleshooting and customer support services have a stand-alone value
to its subscribers. This is based on the following facts: (1) neither
the Company nor other vendors charge a fee for these services; (2) no
other vendor provides such services on a stand-alone basis, and (3) the
Company's subscribers cannot resell these services on a stand-alone
basis. Accordingly, the Company believes the troubleshooting and
customer support services do not warrant separate unit of accounting
under EITF 00-21.
Discontinued operations:
------------------------
Ms. Kathleen Collins
September 5, 2006
Page 15 of 38
With regard to its music distribution business, the Company generated
revenues only from retail sales of music merchandise. Since there were
no multiple deliverables, the Company does not believe there is a
multiple element issue to accounting for related revenues.
Note 3. Variable Interest Entity, page F-17
- --------------------------------------------
5. We note that the Company determined you were the primary beneficiary of
UIM based on your contractual relationship in the software license with
this entity. Tell us how you considered the scope exception of
paragraph 4(h) of FIN 46R in determining whether such guidance should
be applied to the license arrangement. Also, provide us a detailed
analysis under FIN 46R that supports your conclusions to consolidate
UIM. Are all of UIM's revenues generated from sales of on-line games
that are supported by the Company's software license? If not, tell us
what percentage of their revenues relate to your software products.
Evaluation of the scope exception of paragraph 4(h) of FIN 46(R):
-----------------------------------------------------------------
The Company considered the scope exception of paragraph 4(h) of FIN
46(R) in determining whether such guidance should be applied to the
Company's license arrangement with UIM and also conducted analyses in
2004 and 2005 which led to the consolidation of UIM. The following
provides background on this issue and a description of the analyses and
conclusions in 2004 which were updated in 2005 with no change to the
Company's conclusions.
Certain founding shareholders (the "Shareholders") owned Grand Virtual
and UIM. Grand Virtual developed online gaming software and UIM
operated online gaming activities. On March 31, 2004, the Company
acquired Grand Virtual through a wholly-owned subsidiary, Cambridge
Entertainment Software Limited ("CESL") (previously named GVIL), for
US$32.5 million. On March 31, 2004, the Shareholders also sold UIM to
an unrelated third party for US$250,000.
On April 1, 2004, CESL entered into a 10-year software and licensing
agreement with UIM relating to the software necessary for UIM to
operate its Internet-based entertainment sites. The gaming license held
by UIM was considered to have limited value without the associated
software now owned by CESL. Pursuant to the agreement,
Ms. Kathleen Collins
September 5, 2006
Page 16 of 38
CESL is entitled to payments equal to 45 percent of UIM's monthly
gross receipts, as payment for (1) the royalty associated with the
license and (2) as payment for certain services provided to UIM. UIM
does not have the right to terminate this agreement for any reason,
however CESL does have the right to terminate the agreement
immediately if certain events set forth in the agreement occur, such
as untimely payment of royalties payable to CESL, material breach of
the agreement by UIM, or if UIM is required to liquidate. The
purpose of this non-termination clause was to ensure a constant
revenue stream to CESL, as UIM was CESL's only gaming operator at
the date the agreement was entered into. The agreement does not
carry exclusivity rights such that either party is permitted to
engage in other contracts with other gaming operators or gaming
software providers.
The Company has reviewed the scope exceptions of FIN 46(R) that apply
to reporting enterprises with variable interests in an entity. As of
April 1, 2004, the initial determination date, and the end of each of
the reporting periods December 31, 2004 and December 31, 2005, all of
UIM's revenues were derived from its online operations using the
software licensed from CESL. Furthermore, UIM was CESL's only customer
of gaming software in both 2004 and 2005.
Paragraph 4(h) of FIN 46(R) provides certain scope exceptions for
reporting enterprises with variable interests in an entity, which
states that an entity that is deemed to be a business under the
definition in Appendix C (of FIN 46(R)) need not be evaluated by a
reporting enterprise to determine if the entity is a variable interest
entity under the requirements of this Interpretation unless one or more
of the following conditions exist (however, for entities that are
excluded by this provision of this Interpretation, other generally
accepted accounting principles should be applied):
(1) The reporting enterprise, its related parties, or both
participated significantly in the design or redesign of
the entity. However, this condition does not apply if the
entity is an operating joint venture under joint control
of the reporting enterprise and one or more independent
parties or a franchisee.
(2) The entity is designed so that substantially all of its
activities either involve or are conducted on behalf of
the reporting enterprise and its related parties.
Ms. Kathleen Collins
September 5, 2006
Page 17 of 38
The Company believes that certain factors indicate that CESL and
UIM do not meet the scope exceptions under the following
considerations:
o For paragraph 4(h)(1), indicators that the reporting enterprise
was involved in the design (or redesign) of the entity include
input to activities, involving a) capital structure; b)
governance structure; or c) operating activities. With regard
to c) operating activities, CESL participated significantly in
the design of UIM's activities, including its ongoing cash
management and marketing programs and its fraud control
functions. Thus, the scope exception is deemed not to apply to
CESL and UIM.
o For paragraph 4(h)(2), in order for UIM to be the gaming
operator, UIM has to obtain gaming software from certain
application software providers. As of December 31, 2004 and
December 31, 2005, all of UIM's gaming software were licensed
from CESL, which does not meet the scope exception.
For this reason, the Company believes that UIM falls within the
scope of FIN 46(R).
Detailed analysis under FIN 46(R):
After considering whether UIM and the Company were within the
scope of FIN 46(R), the next step in the Company's analysis was
to:
Determine whether a variable interest exists:
---------------------------------------------
UIM's investors have variable interests through their equity
investments. CESL has a contractual arrangement whose fee is
based on the changes in UIM's gross receipts. Therefore, the
service contract and license agreement is a variable interest.
The Company considered the definition of variable interest in
paragraph 2 (c) of FIN 46(R):
"Variable interests in an entity are contractual, ownership, or
other pecuniary interests in an entity that change with changes
in the fair value of the entity's net assets exclusive of
variable interests...."
Paragraph B4 of FIN 46(R) further states:
"The identification of variable interests involves determining
which assets, liabilities, or contracts create the entity's
variability and which
Ms. Kathleen Collins
September 5, 2006
Page 18 of 38
assets, liabilities, equity, and other contracts absorb or
receive that variability. The latter are the entity's variable
interests."
Appendix B of FIN 46(R) includes guidance for evaluating
whether a service contract is a variable interest. Since a
portion of the fee is for services rendered, that guidance must
be evaluated. Since the service contract does not contain
cancellation provisions, the arrangement is a variable
interest. Additionally, the guidance in paragraph B22 states
that if the fees are not commensurate with the level of effort
required to provide the service, then the fee is a variable
interest. That analysis is evaluated pursuant to the guidance
on "commensurate with the level of effort required..." in
paragraph B21. That paragraph states that if the fee is "large"
compared to the overall return of the entity or "large" in
terms of its variability, then the fee is a variable interest.
Given the magnitude of the fee (i.e., 45 percent of UIM's gross
receipts), the fee certainly participates in a large portion of
the expected residual returns. Based on historical records, the
margin in UIM's business is 1.2 percent of total gross
receipts, the Company considers that the UIM equity investor's
ability to receive the residual return is restricted by the
agreement and met the criteria set forth in paragraph 5(b)(3)
of FIN 46(R) where an entity is subject to consolidation if by
design, the holders of the equity investment at risk lack the
right to receive residual of the entity, i.e., the investors do
not have that right if their return is capped by the entity's
governing documents or arrangements with other variable
interest holders or the entity.
UIM's variability is created primarily by the volume of
gambling bets made and winnings paid out (i.e., its net
revenues) as based on its gaming licenses, its services, and
its software rights. CESL and UIM's equity investors stand
either to lose or to gain from changes in the value of the
gaming business and thus each have a variable interest in the
entity.
Determine whether UIM is a VIE:
-------------------------------
To determine whether UIM was a variable interest entity
("VIE"), the Company considered the criteria outlined in
paragraph 5 of FIN 46(R). Per paragraph 5(a) thereunder, the
equity investment at risk is the fair value of the equity
invested in UIM as of the evaluation date. The amount of equity
invested by the owners of UIM at April 1, 2004 was US$250,000.
Ms. Kathleen Collins
September 5, 2006
Page 19 of 38
The Company then proceeded to consider if the equity investment
at risk had any of the five characteristics of a VIE, including
whether there was insufficient equity investment at risk. In
evaluating whether UIM's equity was thinly capitalized, a
combined qualitative and quantitative analysis was performed by
comparing UIM's equity investment to its expected losses, using
the definition of expected losses given in paragraph 8 of FIN
46(R): "A variable interest entity's expected losses are the
expected negative variability in the fair value of its net
assets exclusive of variable interests."
First, the Company determined UIM's variability is created
primarily by the volume of gaming bets made and winnings paid
out (i.e., its net revenues) as based on its gaming licenses,
its services, and its software rights, of which the latter two
elements are provided by CESL. CESL and UIM's equity investors
stand either to lose or to gain from changes in the value of
the gaming business and thus each have a variable interest in
the entity. The Company considered the capital of UIM,
US$250,000, as of April 1, 2004, in relation to UIM's projected
12-month revenues, which were approximately US$10 million
immediately after the sale, and determined that the expected
losses derived from the negative variability of a business with
US$10 million in revenues could likely exceed US$250,000. The
conclusion from this qualitative analysis was that UIM may be
thinly capitalized and not able to absorb all of the expected
losses. Accordingly, UIM would qualify as a VIE.
The Company also conducted a quantitative analysis by
referencing paragraph 9(c) of FIN 46(R), which states that the
equity investment at risk can be presumed to be sufficient if
it exceeds the estimate of the entity's expected losses based
on reasonable quantitative evidence. If the expected losses of
UIM were greater than the fair value of the total equity
investment at risk, UIM would qualify as a VIE. Based on UIM's
business model, the Company prepared an extensive quantitative
analysis using historical metrics and financial forecasts for
the entire contract term, primarily focusing on the expected
loss and returns derived from the variability of UIM's revenue,
winning payout and commission payments to various marketing
partners. Results of the analysis showed the expected losses
for the software licensing contract period to be US$4.173
million, which was greater than the fair value of the UIM
equity investment. Based on the above qualitative and
quantitative analyses, the Company determined UIM to be a VIE.
Ms. Kathleen Collins
September 5, 2006
Page 20 of 38
Determine which party is the primary beneficiary:
-------------------------------------------------
Having determined that UIM is a VIE, the Company then
considered whether it was a primary beneficiary of UIM. The
Company first identified whether there were other variable
interest holders in UIM.
Per UIM's business model, other than CESL, UIM's success relies
on the various Web site operators that provide URLs or links to
UIM to attract players and increase the gaming play. Each of
the Web site operators (the "partners") is assigned a unique
URL link for the purpose of tracking players tagged to the
partner's account. Wager, game outcome and activities are
tracked on an account-by-account basis and a partner is paid
based on a fixed percentage of revenue made through its
account, net of winnings payout (i.e., net gaming revenue,
"NGR"). The percentage typically ranges from 20 percent to 25
percent and is negotiated on a case-by-case basis. If the
profits or volumes reach certain thresholds, a higher
percentage is applied to the NGR as incentives. When these
combined players lose more than they win, the partner earns
money based on the negotiated percentage. If the players win
more than they lose, the gaming Web site is losing money. The
contract states under this situation, the amount of the loss is
therefore a "negative balance" and is carried forward to the
next period. The partner will have to make up the negative
balance before the partner starts earning profits again. The
term of the contract is indefinite as long as partners exercise
good Web site manners, i.e., they do not engage in any
unsavory, intrusive, deceitful, deceptive, pernicious,
obnoxious or socially irresponsible practices. Based on the
2002 to 2004 historical records, the overall partner fees were
25.7 percent of NGR. Approximately 3,000 Web site operators
entered the partner program with UIM as of December 31, 2004.
In determining whether the partners are other service providers
or variable interest holders of UIM, the Company evaluated the
partners against service provider criteria set forth in FIN
46(R).
Paragraph B22 of FIN 46(R) states: "Service contracts with
hired service providers other than the entity's decision maker
are not variable interests if all three conditions below are
met:
Ms. Kathleen Collins
September 5, 2006
Page 21 of 38
a. The fees are compensation for services provided and are
commensurate with the level of effort required to provide those
services.
b. Substantially all of the fees are at or above the same level
of seniority as other operating liabilities of the entity that
arise in the normal course of the entity's activities, such as
trade payables.
c. The service contracts are subject to cancellation provisions
that are customary for such contracts and there is an adequate
number of qualified replacement service providers."
The fees paid to partners are not deemed to be variable
interests as they are akin to normal operating liabilities
whose market rates are based upon profitability metrics. These
fees are seen as creators of variability within the entity
since they are critical to the determination of the future
value of the business and therefore are not considered variable
interests of the entity for the purposes of the April 1, 2004
FIN 46(R) analysis.
As a result, CESL is the only variable interest holder that
shares in the expected loss and expected residual return with
UIM's equity investors.
Identify the primary beneficiary of UIM:
----------------------------------------
A quantitative analysis was performed by the Company to
determine UIM's primary beneficiary. The Company is prepared to
submit a summary of this quantitative analysis to the Staff, if
such detailed analysis is requested. The expected loss and
expected residual returns based on the Company's detailed
calculations are summarized in the following schedule:
(in US$ thousands)
---------------------------------------------------------------------------------------------------------
CESL UIM Equity Investor Total
---------------------------------------------------------------------------------------------------------
Expected Losses Expected Expected Losses Expected Expected Losses Expected
Residual Returns Residual Returns Residual Returns
---------------------------------------------------------------------------------------------------------
(2,593) 2,593 (4,173) 4,173 (6,766) 6,766
---------------------------------------------------------------------------------------------------------
38.3% 38.3% 61.7% 61.7% 100.0% 100.0%
---------------------------------------------------------------------------------------------------------
Ms. Kathleen Collins
September 5, 2006
Page 22 of 38
Management's calculation showed UIM's equity investor absorbed
an expected loss of US$4.173 million, or 61.7 percent of total
expected loss on the gaming business. However, considering the
fact that UIM's equity at risk was only US$250,000, which was
insufficient to absorb the expected loss as calculated, UIM's
equity investor was deemed not the primary beneficiary. CESL
then became the primary beneficiary and under paragraph 14 of
FIN 46(R), CESL should consolidate UIM.
Subsequent to the initial analysis performed as of April 1,
2004, there have been no substantial changes to the capital
structure and business of UIM. As of December 31, 2004 and
2005, UIM's capital increased to US$414 thousand and US$564
thousand, respectively, primarily as a result of increases in
retained earnings. The Company refers to paragraph 15 of FIN
46(R) for a list of specific events that would trigger a
reconsideration of CESL's primary beneficiary status, none of
which has occurred that would cause the Company to believe its
primary beneficiary status has changed. During 2005, UIM
launched a new product line under the same master software
agreement with CESL. The new product line called for a
different revenue sharing percentage which was determined based
on certain services provided to UIM. As this arrangement
increased CESL's exposure to UIM's expected loss, the Company
believes that this does not constitute a reconsideration event.
Nevertheless, the Company continued to conduct a quantitative
analysis using the same methodology from the prior year and
confirmed the conclusions it had reached in 2004.
6. If you continue to believe that consolidation of UIM is
appropriate, then tell us what consideration you have given to
enhancing your Item 4 Information of the Company disclosures to
include a discussion of the main categories of products sold
and/or services performed by this entity. Indicate any
significant new products and/or services that have been
introduced and, to the extent the development of new products
or services has been publicly disclosed, give the status of
development. In this regard, we note that UIM launched its new
online casino website everestcasino.com in October 2005. See
Item 4.B of Form 20-F.
The Company notes the Staff's comment and respectfully advises
the Staff as follows: The Company does not beneficially own any
equity interest in UIM and cannot otherwise exercise any
control over it. As
Ms. Kathleen Collins
September 5, 2006
Page 23 of 38
a result, the extent of the information on UIM and its business
available to the Company is limited. While UIM in each of 2004
and 2005 has provided access to its financials to the Company
and its auditors for the purposes of preparing the Company's
annual consolidated financial results, the Company does not
have full access to all corporate documents and materials of
UIM and does not have any contractual rights to gain such
access.
Nevertheless, the Company included in its Form 20-F a
substantial discussion regarding UIM. This information
included, among other disclosures, risk factors relating to
UIM's business, competition information relating to UIM's
industry and regulatory information. In addition, the Company
included a brief description of UIM in the section entitled
"Our Licensee" on page 24 of its Form 20-F.
With respect to the Staff's suggestion to include a discussion
regarding new products introduced by UIM, the Company advises
the Staff as follow: UIM operates online casinos and virtual
poker rooms through a number of Web sites. While each of these
Web sites carries a unique appearance and theme, the services
provided by each one of them are substantially similar. The
Company therefore believes that a description of each of UIM's
Web sites would not be helpful for investors. The Company
further believes that the launching of UIM's new Web site
(www.everestcasino.com) in 2005 that is referenced in the
Staff's comment did not include any expansion of UIM's business
and that this Web site was not materially different from UIM's
existing Web sites. It is therefore the Company's view that a
discussion of this launch is not necessary.
Notwithstanding the above, and in light of the Staff's comment,
the Company proposes to amend its Form 20-F by replacing the
paragraph entitled "Our Licensee" on page 24 with the following
disclosure:
Our Licensee
Our software entertainment business is dependent upon Ultra
Internet Media, S.A. ("UIM"), our sole licensee. The following
is a brief description of UIM's business. Since we have no
equity interest in UIM and do not exercise any control over it,
the information below has been obtained from publicly available
sources, and in part was provided to us by officers of UIM.
Though we have no reason to
Ms. Kathleen Collins
September 5, 2006
Page 24 of 38
believe the information below is inaccurate, we could not
independently verify the accuracy thereof.
UIM is an online entertainment operator that provides online
gaming services, including online casinos and virtual poker
rooms. By utilizing our software, UIM offers these services
through several Web sites, including Everest Casino
(www.everestcasino.com) and Everest Poker
(www.everestpoker.com). While each of these Web sites carries a
unique appearance and theme, the services provided by each of
them is substantially similar. UIM markets its Web sites, in
part, through Affiliated Web Attractions' "United Partner
Program" (www.affiliatedweb.com), which also utilizes our
software. Under this program, private and commercial owners of
Web sites are invited to place on their Web sites banners
containing links to UIM's Web sites, in return for fees based
on the revenues generated by users that have been directed to
UIM's Web site from such banners. Our software package also
includes the platform to operate this aspect of the business.
UIM is located in and operates exclusively from computer
servers located in the Kahnawake Territory in Canada under a
gaming license issued by the Kahnawake Gaming Commission,
subject to continuing compliance with applicable licensing
requirements. See "--- Regulation --- Regulation Relating to
Online Gaming." In addition to licensing our software, we
provide UIM with application services and consulting services
for its Internet property and infrastructure, including Web
site design, payment gateways and database and operating
systems, in return for a fixed percentage of UIM's gross
receipts.
While we have no equity shareholding in UIM, we consolidated
UIM's assets, liabilities and results of operations as of and
for the nine months ended December 31, 2004 and for the year
ended December 31, 2005 in our consolidated financial
statements in accordance with the requirements under FIN 46(R).
See Item 5 -- "Operating and Financial Review and Prospects --
Overview -- Consolidation of UIM Under FIN 46(R)" for
additional information. We are entitled to fees from UIM based
upon its revenues.
Ms. Kathleen Collins
September 5, 2006
Page 25 of 38
Note 4. Divestiture, page F-18
- -------------------------------
7. We note that in September 2005 you completed the sales of your music
distribution business. Tell us how you considered disclosing the
carrying amounts of the major classes of assets and liabilities
included in the disposal group as required by paragraph 47(a) of SFAS
144.
Sale of the Company's music distribution business was authorized by a
board resolution on September 15, 2005 and completed by September 30,
2005. As of December 31, 2004, the Company had no plan to sell its
music distribution business and the criteria for being classified as
held for sale had not been met. Consequently, no specific disclosure
pursuant to paragraph 47(a) of SFAS 144 was necessary as of December
31, 2004. The Company proposes to amend its Form 20-F by adding the
following language to Footnote No. 4 to its financial statements:
Major classes of assets and liabilities which comprised the music
distribution business at the date of disposal included:
Ms. Kathleen Collins
September 5, 2006
Page 26 of 38
-----------------------------------------------------------------
(in US$ thousands)
-----------------------------------------------------------------
Cash (including restricted cash) 3,098
-----------------------------------------------------------------
Accounts receivable 1,842
-----------------------------------------------------------------
Inventory 6,679
-----------------------------------------------------------------
Other current assets 683
-----------------------------------------------------------------
Property and equipment 1,666
-----------------------------------------------------------------
Intangible assets 4,689
-----------------------------------------------------------------
Other assets 1,553
-----------------------------------------------------------------
Total assets 20,210
-----------------------------------------------------------------
Accounts payable 11,239
-----------------------------------------------------------------
Other liabilities 1,945
-----------------------------------------------------------------
Total liabilities 13,184
-----------------------------------------------------------------
Note 21. Related Party Transactions, page F-35
- -----------------------------------------------
8. We note that you previously issued warrants to Microsoft and that
Microsoft returned the warrants unexercised in September 2004. Tell us
the circumstances surrounding the issuance of these warrants, including
the date of issuance, a description of the significant components of
the transaction, the number of shares subject to issuance under the
warrants, whether any shares were issued in connection with the
warrants and how you accounted for the warrants with reference to the
authoritative accounting literature applied.
On October 27, 1999, the Company entered into a share and warrant
purchase agreement (the "Warrant Agreement") with Microsoft Corporation
("Microsoft"). Pursuant to the Warrant Agreement, the Company agreed to
issue four million common shares to Microsoft, at a price of US$8.75
per share, for an aggregate amount of US$35
Ms. Kathleen Collins
September 5, 2006
Page 27 of 38
million, and a warrant (the "Warrant") which entitled Microsoft to
purchase up to 10 million shares of the Company's common shares, at
a price of US$6.60 per share. In return, Microsoft agreed to enter
into business agreements with the Company to cooperate on the
following:
a. Provide, host and maintain a narrowband MSN portal for Internet
access customers in Taiwan, and include some of the Company's
content on such portal.
b. Co-market the Company's broadband service products to
narrowband MSN portal end users.
c. Co-brand with the Company a broadband MSN portal.
d. Jointly develop shopping channels with the Company on both the
narrowband and broadband portals.
e. Jointly explore cable and other media business and broadband
Internet-related business opportunities in the Greater China
region.
f. Not to acquire any equity interest in any broadband cable ISP
company which was an affiliate of the Company's major
competitors in Taiwan.
The major terms and conditions surrounding the Warrant were specified
in the Warrant Agreement, which are summarized as follows:
a. Issuance date and expiration date: The Warrant was issued on
November 23, 1999 and expired five years from the issuance
date, which was November 23, 2004. The Warrant was exercisable
upon issuance.
b. Exercise price: The initial exercise price was US$6.60 and was
subject to adjustments for dilutions, such as stock dividends,
stock splits and capital restructurings, on a pro rata basis.
Additionally, if prior to the Warrant expiration date, the
Company issued any additional shares for a per share price
below the Warrant exercise price, the exercise price was to
have been reduced to the per share price of the additional
shares. The maximum number of share purchasable by
Ms. Kathleen Collins
September 5, 2006
Page 28 of 38
exercising the Warrant was 10 million shares, subject to
anti-dilution adjustment.
c. Transfer of the Warrant: With the exception that Microsoft
could assign the Warrant to any entity controlled by or under
common control with Microsoft, the Warrant was not
transferable.
d. Change in control: In the event of capital reorganization,
merger, consolidation with another entity or the sale of all or
substantially all of the Company's assets, Microsoft was
entitled to receive stock, securities, cash or assets that the
common shareholders were entitled to receive.
e. Dissolution, liquidation or wind-up: At any time prior to the
exercise of the Warrant, if the Company dissolved, liquidated
or executed a wind-up of its affairs, Microsoft was entitled,
upon the exercise of this Warrant, to receive the same kind and
amount of assets or liquidating distribution with common
shareholders on a proportionate basis.
f. Anti-dilution: In the event that the Company paid any special
dividend or, other than in the ordinary course of business,
made any other distribution to its common shareholders in the
form of cash or property other than stock dividend, Microsoft
could elect either a) to adjust the exercise price to reflect
such distribution, or b) to receive a dilution fee equal to the
amount of the special dividend or distributions Microsoft would
have been entitled to receive had the Warrant been exercised
for common shares.
No shares were issued in connection with the Warrant.
In respect of the Staff's question of how the Company accounted for the
Warrant, the Company refers the Staff to the Company's responses to
Comment 9, in which the Company provides a detailed discussion of the
basis of accounting for the Warrant with reference to the authoritative
accounting literature.
9. Tell us how you accounted for the Microsoft warrants. Specifically,
tell us how the Company determined that the warrants meet the scope
except of paragraph 11(a) of SFAS 133. Provide us with your analysis of
the warrants using the conditions outlined in paragraphs 12 to 32 of
EITF 00-19 in
Ms. Kathleen Collins
September 5, 2006
Page 29 of 38
support of your classification of the warrants as permanently
equity. If the scope exception of paragraph 11(a) has not been met,
tell us why you have not classified the warrants as a liability,
initially measured at fair value, with changes in fair value
reported in earnings and disclosed in the financial statements. We
may have further comments.
The Company accounts for the Warrant and the business cooperation
with Microsoft in accordance with the guidance of EITF 96-18,
"Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or
Services." That is, the fair value of the Warrant was used to
account for the intangible assets acquired related to the business
cooperation. The fair value of the Warrant in the amount of
approximately US$48.2 million (NT$1,543 million) was calculated
based on the Black-Scholes valuation model with the following
assumptions: fair value per common share of US$8.75 dollars,
expected volatility of 44 percent, dividend yield of 0, risk-free
interest rate of 6 percent and an expected life of five years. The
intangible assets were fully written off as of December 31, 2002.
In response to the Staff comment on whether the Warrant meets the
scope of exception of paragraph 11(a) of SFAS 133, the Company first
evaluated if the Warrant met the definition of derivative under
paragraphs 6-9 of SFAS 133. Paragraph 6 of SFAS 133 states, in part,
that:
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.
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.
c. Its terms require or permit net settlement, it can readily be
settled net by a means outside the contract, or it provides for
Ms. Kathleen Collins
September 5, 2006
Page 30 of 38
delivery of an asset that puts the recipient in a position not
substantially different from net settlement.
The Company determined that the Warrant met conditions a) and b)
above in that a) the Warrant contained both an underlying (i.e., the
price of the stock that is to be purchased), as well as a notional
amount (i.e., the number of shares of common stock), and that b) the
initial net investment was smaller than the market price of the
underlying shares on the date the Warrant was issued.
In evaluating whether the Warrant met the net settlement criteria in
c) above, the Company considered the three net settlement methods
outlined in paragraph 57(c) of SFAS 133 (i.e., contractual net
settlement, market mechanism that facilitates net settlement, or
readily convertible to cash). The Company determined the first two
net settlement methods were not applicable since 1) the Warrant
Agreement did not implicitly or explicitly require or permit any
gains and losses on the Warrant to be settled in cash, assets or
shares, and 2) the Warrant was not transferable outside Microsoft
and entities under its common control did not effect the net
settlement of the Warrant Agreement through a market mechanism.
The Company considered the third and last method of net settlement,
which would have been fulfilled if the Warrant's underlying shares
were readily convertible to cash. Prior to the Company's IPO in
February 2000, the Warrant's underlying shares were not publicly
traded and therefore, during the period of the Warrant issuance date
(November 1999) to the Company's IPO (February 2000), the Warrant
did not qualify as a derivative.
Subsequent to the Company's IPO in February 2000, the Warrant met
the definition of a derivative and the Company then analyzed whether
the Warrant Agreement met the scope exception criteria of paragraph
11(a) of SFAS 133, which states, in part, that:
The reporting entity shall not consider the following contracts to
be derivative instruments for purposes of this Statement:
a. 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.
Ms. Kathleen Collins
September 5, 2006
Page 31 of 38
The Company considered that paragraph 11(a)(1) had been met as the
exercise price was indexed only to its own stock price.
As to paragraph 11(a)(2), regarding whether the Warrant was
classified in stockholders' equity if exercised or settled,
paragraphs 12-32 of EITF 00-19, "Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock," ("EITF 00-19") were considered. The following summarizes the
Company's considerations:
a. Cash settlement outside the Company's control: Except for a
change in control and final dissolution which would have
resulted in cash settlement, the Warrant Agreement did not
include any provision which required or permitted the
Company to cash settle (net cash or physical) the Warrant.
Cash settlement was permitted in the same manner and in the
same form of consideration made available to common
shareholders upon a change in control and final dissolution
of the Company. In the event of special dividend payments
or, other than in the ordinary course of business, any
other distributions to common shareholders in the form of
cash or property other than stock dividend, Microsoft could
have elected either a) to adjust the exercise price to
reflect such distribution or b) to receive a dilution fee
equal to the amount of the special dividend or
distributions Microsoft would have been entitled to receive
had the Warrant been exercised for common shares. However,
neither of these would have made the Warrant cash settled.
Accordingly, equity classification criteria under
paragraphs 12 - 13, 25 and 27 - 28 of EITF 00-19 was met.
b. Settlement in unregistered shares: The Warrant Agreement
permitted the Company to settle the Warrant using either
unregistered or registered shares. Accordingly, the equity
classification criteria under paragraphs 14 - 18 of EITF
00-19 was met.
c. 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 could remain outstanding: At the time
of entering the Warrant Agreement, the Company had
authorized shares of 80 million. The table below shows
that, after deducting the outstanding shares and other
commitments to issue its shares,
Ms. Kathleen Collins
September 5, 2006
Page 32 of 38
the Company had sufficient authorized and unissued shares
available to settle the Warrant Agreement during its
five-year contract period. Accordingly, criteria set forth
in paragraph 19 of EITF 00-19 were met.
Number of Shares
(In thousands of shares)
Authorized shares 80,000
Less: Outstanding shares as of November 23, 1999 ( 36,000)
Less: Shares sold to Microsoft pursuant to the Share and Warrant Purchase Agreement ( 4,000)
Less: Shares issuable pursuant to the 1999 Employee Share Option Plan ( 2,000)
Less: Shares issued in Feb. 2000 in connection with the IPO ( 10,154)
Less: Shares issuable pursuant to the 2002 Employee Share Option Plan ( 3,000)
Less: Shares issuable pursuant to the 2004 Employee Share Option Plan ( 7,000)
Less: Shares issuable pursuant to the 2004 Employee Share Purchase Plan ( 2,000)
-----------------------------
Remaining authorized shares 15,846
=============================
Maximum shares issuable upon the exercise of the Warrant 10,000
=============================
d. Explicit limit on the number of shares to be delivered in a
share settlement: Paragraph 20 of EITF 00-19 indicates "if
the number of shares that could be required to be delivered
to net-share settle the contract is indeterminate, a
company will be unable to conclude that it has sufficient
available authorized and unissued shares and, therefore,
net-share settlement is not within the control of the
company." Per the Warrant Agreement, except for the
standard anti-dilution adjustments, the maximum number of
shares issuable to the holder of the Warrant was capped at
10 million shares. Thus, criteria set forth in paragraphs
20-24 of EITF 00-19 were met.
e. Cash payment 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
(i.e., "top-off" or "make-whole" provisions): The Warrant
Agreement did not contain top-off or make-whole provisions
to reimburse the
Ms. Kathleen Collins
September 5, 2006
Page 33 of 38
Warrant holder for any losses it incurred or to transfer to
the Company the gains it recognized on the differences
between the settlement date value and the value received by
the Warrant holder in subsequent sales of the shares.
Therefore, criteria set forth in paragraph 26 of EITF 00-19
were met.
f. Higher priority than the common shareholders in the event
of the company's bankruptcy: If a contract gives the
counterparty any of the rights of a creditor in the event
of the company's bankruptcy, equity classification is
precluded. The Warrant Agreement did not give the holder of
the Warrant rights that ranked higher than those of common
shareholders. Rather, at any time prior to the exercise of
the Warrant, if the Company had dissolved, liquidated or
wound up its affairs, the Warrant holder would have been
entitled, upon the exercise of the Warrant, to receive the
same kind and amount of assets or liquidating distribution
with common shareholders on a proportionate basis.
Accordingly, the conditions set forth in paragraphs 29 - 31
of EITF 00-19 were met.
g. Requirement to post collateral at any point or for any
reason: According to paragraph 32, "a requirement to post
collateral of any kind (other than the company's shares
underlying the contract, but limited to the maximum number
of shares that could be delivered under the contract) under
any circumstances is inconsistent with the concept of
equity and, therefore would preclude equity classification
of the contract." Due to the fact that no collateral was
required under the Warrant Agreement, the criteria in
paragraph 32 of EITF 00-19 were met.
Based on the above long-form analysis of paragraphs 12-32 of EITF
00-19, the Company believed that the Warrant met all the conditions
set forth in the preceding paragraphs, that the Warrant met the
scope exception criteria of 11(a) of SFAS 133 and thus classified
the Warrant in shareholders' equity.
General
- -------
10. We note that the Company filed a Form S-8 on October 8, 2004. Tell
us what consideration your independent auditors, GHP Horwath, P.C.,
gave to including a consent in the Company's
Ms. Kathleen Collins
September 5, 2006
Page 34 of 38
Form 20-F for incorporation of their audit opinion in the open
registration statement.
The Company will amend its Form 20-F to include signed consents from
its independent auditors, GHP Horwath, P.C. for incorporation of
their audit opinion in the open registration statement.
Form 6-K Filed on March 24, 2006 and Form 6-K Filed on May 17, 2006
- -------------------------------------------------------------------
11. We note that you have presented a non-GAAP measure that you refer to
as EBITDA, and that you define this measure as earnings before
interest, taxes, depreciation, amortization and minority interest.
Tell us what consideration you have given to the guidance in
Question 14 of the FAQ Regarding the Use of Non-GAAP Financial
Measures which states that measures that are calculated differently
than those described as EBIT and EBITDA, in the adopting release
should not be characterized as "EBIT" or "EBITDA." Instead, the
titles of these measures should clearly identify the earnings
measure being used and all adjustments. In this regard, you should
either discontinue the use of the term EBITDA in connection with the
presentation of this non-GAAP financial measure or calculate EBITDA
in the same manner as described in the adopting release. Please
advise.
As noted, the Company had used, in its earning release which was
furnished on Form 6-K, a definition of EBITDA which differs from the
definition described in Question 14 of the FAQ Regarding the Use of
Non-GAAP Financial Measures (the "FAQs"), insofar as it excluded
income from discontinued operations, as well as minority interests.
The Company used that definition based on its belief that it
provided meaningful supplemental information regarding its operating
performance by excluding income from discontinued operations, which
is non-recurring, and minority interest, which is non-cash and not
indicative of the operating performance of its business.
The tables below present EBITDA calculated in the same manner as
described in the FAQs, compared to the definition used by the
Company in its earning releases furnished to the Commission in its
March 24, 2006 and May 17, 2006 Form 6-K filings:
Ms. Kathleen Collins
September 5, 2006
Page 35 of 38
- --------------------------------------------------------------------------------------------------
GIGAMEDIA RESULTS - MARCH 24, 2006 FORM-6K
- --------------------------------------------------------------------------------------------------
(in US$ thousands) FY05 FY04 4Q05 4Q04 3Q05
- --------------------------------------------------------------------------------------------------
Earnings before interest, taxes, 12,018 6,947 3,771 1,188 3,037
depreciation, amortization and
minority interests, excluding
discontinued operations
- --------------------------------------------------------------------------------------------------
EBITDA 11,714 7,212 3,452 1,826 3,023
- --------------------------------------------------------------------------------------------------
Difference 304 (265) 319 (638) 14
- --------------------------------------------------------------------------------------------------
- --------------------------------------------------------------------------------------------------
GIGAMEDIA RESULTS - MAY 17, 2006 FORM-6K
- --------------------------------------------------------------------------------------------------
(in US$ thousands) 1Q06 1Q05 4Q05
- --------------------------------------------------------------------------------------------------
Earnings before interest, taxes, depreciation, 4,916 2,128 3,771
amortization and minority interests, excluding
discontinued operations
- --------------------------------------------------------------------------------------------------
EBITDA 4,803 2,474 3,452
- --------------------------------------------------------------------------------------------------
Difference 113 (346) 319
- --------------------------------------------------------------------------------------------------
The Company believes that the differences between the EBITDA as
defined in the FAQs and the EBITDA as used in the Company's earning
releases were immaterial in each of the FY 2005 and FY 2004 periods
(2.6 percent in fiscal year 2005 and 3.7 percent in fiscal year
2004).
As discussed above, the Company believes that its presentation of
EBITDA complied in all material respects with the requirements of
Regulation G as the Company explained the reasons for including it
and provided a clear reconciliation to the most comparable GAAP
measurement.
However, in light of the Staff's comment, the Company has decided,
going forward, to present EBITDA in the same manner as defined in
the FAQs as well as to enhance its disclosure regarding the use of
Non-GAAP measures. The Company refers the Staff to its earnings
release for the second quarter of fiscal year 2006, furnished on
Form
Ms. Kathleen Collins
September 5, 2006
Page 36 of 38
6-K on August 10, 2006, in which the Company has already implemented
such decision and has presented EBITDA in the same manner as defined
in the FAQs and has included a more enhanced disclosure regarding
its use of Non-GAAP measures.
12. Furthermore, tell us how you considered Questions 8 and 15 of
Frequently Asked Questions Regarding the Use of the Non-GAAP
Financial Measures to include the following disclosures for each
unique non-GAAP financial measure included your Forms 6-K:
o The manner in which management uses the non-GAAP measure to
conduct or evaluate its business;
o The economic substance behind management's decision to use such
a measure;
o The material limitations associated with use of the non-GAAP
financial measure as compared to the use of the most directly
comparable GAAP financial measure;
o The manner in which management compensates for these
limitations when using the non-GAAP financial measure; and
o The substantive reasons why management believes the non-GAAP
financial measure provides useful information to investors.
Please see the Company's response to Comment No. 11 as it relates to
the use of EBITDA by the Company.
In addition, the Company provided non-GAAP consolidated operating
income from continuing operations that excludes share-based
compensation charges based on its belief that it provided meaningful
supplemental information allowing investors to more easily compare
the results to prior periods.
As stated in the Company's May 17, 2006 Form 6-K filing, effective
January 1, 2006, the Company adopted the fair value recognition
provisions of the Financial Accounting Standards Board Statement No.
123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)"), using the
modified-prospective transition method. Thus, in sum, the
Ms. Kathleen Collins
September 5, 2006
Page 37 of 38
Company believes that the exclusion of stock-based compensation
enhanced the comparability of results against prior periods.
The Company provided non-GAAP consolidated net income excluding
share-based compensation charges based on its belief that it
provided a more meaningful comparison of the results between
reporting periods.
In addition, the Company had noted in its disclosures that non-GAAP
measures should be considered in addition to results prepared in
accordance with GAAP, but should not be considered a substitute for,
or superior to, other financial measures prepared in accordance with
GAAP. Reconciliations to the GAAP equivalents of the non-GAAP
financial measures were provided in the Form 6-K filings.
Notwithstanding the above, the Company has decided, going forward,
to enhance its disclosure regarding the use of Non-GAAP measures. In
that respect, the Company refers the Staff to its earning release
for the second quarter of fiscal year 2006, furnished on Form 6-K on
August 10, 2006, in which the Company has already implemented such
decision and has presented EBITDA in the same manner as defined in
the FAQs and has included a more enhanced disclosure regarding its
use of Non-GAAP measures.
* * * *
Ms. Kathleen Collins
September 5, 2006
Page 38 of 38
In connection with its responses to the Staff's comments, the Company
acknowledges that:
o The Company is responsible for the adequacy and accuracy of the
disclosure in its filings;
o Staff comments or changes to disclosure in response to staff
comments in the filings reviewed by the Staff do not foreclose
the Commission from taking any action in respect of 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.
If you have any questions regarding the responses to the Staff's
comments, or require additional information, please contact the undersigned at
(886) 2 3518 1101 or Alec P. Tracy in Skadden Arps' Hong Kong office at (852)
3740 4710. You may also contact Skadden, Arps' New York Office at (212) 735
3000 and ask to be transferred.
Sincerely,
/s/ Arthur M. Wang
Chief Executive Officer
cc: Alec P. Tracy, Esq.
Skadden, Arps, Slate, Meagher & Flom LLP
Thomas T. Hui
Chief Financial Officer
GigaMedia Limited