Quarterly report pursuant to Section 13 or 15(d)

Convertible Notes and Warrants

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Convertible Notes and Warrants
6 Months Ended
Jun. 30, 2013
Convertible Notes and Warrants  
Convertible Notes and Warrants

10.                               Convertible Notes and Warrants

 

Features of the Convertible Notes and Investor Warrants

 

On February 22, 2011 (the “Original Issue Date”), the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) and a 5% Senior Secured Convertible Debenture Agreement (the “Note Agreement”) with GCP IV LLC (the “Investors” or “Holders”) pursuant to which the Company agreed to issue and sell in a private placement to the Investors an aggregate principal amount of $4,000,000 of convertible notes due February 22, 2014 (the “2011 Convertible Notes”) and warrants to purchase 40,000,000 shares of common stock at $0.15 per share (the “2011 Warrants”).  Under the terms of the Securities Purchase Agreement, the Company had the opportunity to raise up to an additional $2,000,000 from the Holders in two separate $1,000,000 tranches, based upon meeting certain operational milestones within certain periods of time.  The deadline for achieving the operational milestones for the first $1,000,000 tranche expired in February 2012 without the Company achieving such milestones; however, the Investors agreed to waive both the deadline and the achievement of these milestones as a condition for the investment of the first additional $1,000,000 tranche (the “2012 Convertible Notes”) and issuance of warrants to purchase 10,000,000 shares of common stock at $0.15 per share and 10,000,000 shares of common stock at $0.25 per share (the “2012 Warrants”) which was completed on July 2, 2012.  On January 16, 2013 the Company entered into an amendment and waiver to the Purchase Agreement to provide for the issuance of an additional $250,000 of 5% Senior Secured Convertible Debentures (the “Third Tranche Convertible Notes”) maturing on January 16, 2016 and warrants exercisable for a period of five years to purchase up to 2,500,000 shares of common stock at an exercise price of $0.15 per share (the “Third Tranche Warrants”).

 

The convertible notes and warrants and the Purchase Agreement covering both are secured by a security interest in all assets of the Company and its subsidiaries and all such obligations are guaranteed jointly and severally by the Company’s Subsidiaries. The convertible notes also contain non-financial covenants which limit the Company and its subsidiaries from incurring subsequent indebtedness, incur liens, and amend organizational documents, repurchasing or repaying other debt, paying cash dividends and entering into affiliate transactions.

 

On February 22, 2013, simultaneous with the closing of the SPA, the Company entered into an Amendment and Waiver Agreement (the “Amendment and Waiver Agreement”) with the Holder under which the Holder agreed to (a) increase the number of shares exercisable under the 2011 and 2012 Warrants from an aggregate 50,000,000 shares to 81,578,946 shares and to modify both the exercise price and the “VWAP price” of the 2011 and 2012  Warrants to $0.098 and $0.155, respectively, (b) return to the Company for forfeiture the remaining warrants previously issued to purchase an aggregate 12,500,000 shares of common stock, (c) extend the due date for the 2012 Convertible Notes from February 22, 2014 to June 30, 2015, (d) until February 22, 2014, without the prior written consent from the majority of the investors under the SPA, forbear from declaring any Event of Default (as defined in the original debenture, and (e) relinquish its right to purchase up to an additional $750,000 in debentures under the terms of the original 2011 Securities Purchase Agreement.  The terms of the individual tranches of convertible notes and warrants issued pursuant to this agreement and the impact of the Amendment and Waiver Agreement are discussed below.

 

2011 Convertible Notes

 

The Convertible Notes require payment of interest on the outstanding principal amount, in cash, at the rate of 5% per annum, payable quarterly on January 1, April 1, July 1, and October 1, beginning on the first such date following the Original Issue Date, on each conversion date (for the principal amount then being converted), on each optional redemption date (for the principal amount then being redeemed) and on the maturity date. Interest is calculated on the basis of a 360-day year and accrues daily commencing on the Original Issue Date until payment in full of the outstanding principal, together with all accrued and unpaid interest, liquidated damages and other amounts that may become due in connection with the Convertible Notes, has been made.

 

The Holders may convert the outstanding principal amount of the Convertible Notes into shares of the Company’s common stock at the conversion price of $0.10 per share (“Conversion Price”). The Conversion Price is subject to adjustment in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

At any time after February 2012, and upon entering into a change of control transaction or Fundamental Transaction, as defined in the Debenture Agreement, the Company may deliver a notice to the Holders of its irrevocable election to redeem all of the then outstanding principal of the Convertible Notes for cash in an amount equal to the sum of (a) the greater of (i) the outstanding amount of the Convertible Notes divided by the Conversion Price on the date of the mandatory default amount, as defined in the Purchase Agreement, is either (A) demanded or (B) paid in full, whichever has a lower conversion price, multiplied by the Volume Weighted Average Price (“VWAP”) of the date of the mandatory default amount is either (x) demanded or otherwise due or (y) paid in full, whichever has higher VWAP, plus all accrued and unpaid interest, or (ii) 130% of the outstanding principal amount of the Notes, plus 100% of accrued and unpaid interest, and (b) all other amounts, costs, expenses and liquidated damages due under the various agreements covering issuance of the Convertible Notes. Such amount would include the liquidated damages due under the default provision of the Purchase Agreement.

 

Due to the Amendment and Waiver agreement, the Company is required to repay, in cash, any outstanding principal amount of the Convertible Notes on June 30, 2015 and is not permitted, except upon entering into a change of control transaction or fundamental transaction as noted above, to prepay any portion of the principal amount without prior written consent of the Holders.

 

2011 Warrants

 

On February 22, 2011, in connection with the issuance of the 2011 Convertible Notes, the Company issued warrants for the purchase of up to 40,000,000 shares of common stock at the exercise price of $0.15 per share and with an expiration date of February 22, 2016 (the “Warrants”). On February 22, 2013, as per the terms of the Amendment and Waiver Agreement, the Company canceled the original warrants and re-issued new warrants for the purchase of up to 65,263,156 shares of common stock at an exercise price of $0.098 per share.

 

The 2011 Warrants are exercisable by a cashless exercise to purchase shares of the Company’s common stock (the “Warrant Shares”). The Exercise Price of the Warrants shall be adjusted in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Exercise Price.

 

In connection with a Fundamental Transaction, as defined in the Purchase Agreement, that is an all-cash transaction, the Company shall have the right to purchase from the Holders all, but not less than all, of the unexercised portion of the Warrants by paying in cash to the Holders an amount equal to 30% of the Exercise Price multiplied by the number of shares of Common Stock for which the Warrants are exercisable immediately prior to such change of control transaction.

 

During the six months ended June 30, 2013, 29,085,523 of the 2011 Warrants were exercised pursuant to the cashless exercise provisions resulting in the issuance of 10,695,967 shares of common stock.

 

The following is a summary of the 2011 Warrants outstanding for the six months ending June 30, 2013:

 

 

 

2011 Warrants

 

Exercise
Price

 

Beginning balance — December 31, 2012

 

40,000,000

 

$

0.15

 

Less: Canceled

 

(40,000,000

)

0.15

 

Add: Issued

 

65,263,156

 

0.098

 

Less: Exercised

 

(29,085,523

)

0.098

 

Ending Balance — June 30, 2013

 

36,177,633

 

$

0.098

 

 

2012 Convertible Notes

 

The 2012 Convertible Notes contains the same terms as the 2011 Convertible Notes and require payment of interest at the rate of 5% per annum, payable quarterly and mature on July 2, 2015.  The Second Tranche Convertible Notes provide the Investors the option at any time prior to the repayment of the notes to convert any portion of the outstanding Second Tranche balance into fully-paid and non-assessable restricted shares of common stock of the Company at an initial conversion price of $0.10 per share (the “Conversion Price”). The Conversion Price is subject to adjustment in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

The Second Tranche Convertible Notes may be redeemed at the option of the Company on the same terms as the Convertible Notes only in connection with a change of control or other fundamental transaction of the Company and subject to the satisfaction of other conditions including, without limitation, that the shares issuable upon conversion of the debentures are freely tradable and that there is no event of default.

 

2012 Warrants

 

On July 2, 2012, in conjunction with the issuance of the 2012 Convertible Notes, the Company issued warrants for the purchase of up to 20,000,000 shares of common stock with five year terms.  The warrants were issued to allow the Investors to purchase up to 10,000,000 shares of common stock at an initial purchase price of $0.15 per share and the remaining 10,000,000 shares of common stock at an initial purchase price of $0.25 per share. The terms of the 2012 Warrants are identical to those of the 2011 Warrants, except that the 2012 Warrants are exercisable for a period of five years from the date of issuance and contain different exercise prices. On February 22, 2013, as per the terms of the Amendment and Waiver Agreement, the Company canceled the original warrants and re-issued new warrants for the purchase of up to 16,315,790 shares of common stock at an initial purchase price of $0.098. The following is a summary of the 2012 Warrants outstanding for the six months ending June 30, 2013:

 

$0.15 Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at December 31, 2012

 

10,000,000

 

$

0.15

 

Less: Canceled

 

(10,000,000

)

0.15

 

Add: Issued

 

16,315,790

 

0.098

 

Less: Exercised

 

 

 

Ending balance at June 30, 2013

 

16,315,790

 

$

0.098

 

 

$0.25 Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at December 31, 2012

 

10,000,000

 

$

0.25

 

Less: Canceled

 

(10,000,000

)

0.25

 

Ending balance at June 30, 2013

 

 

$

 

 

Third Tranche Convertible Notes

 

The Third Tranche Convertible Notes, which were issued on January 16, 2013, contains the same terms as the 2011 and 2012 Convertible Notes and require payment of interest at the rate of 5% per annum, payable quarterly and mature on January 16, 2016.  The Third Tranche Convertible Notes provide the Investors the option at any time prior to the repayment of the notes to convert any portion of the outstanding Third Tranche balance into fully-paid and non-assessable restricted shares of common stock of the Company at an initial conversion price of $0.10 per share (the “Conversion Price”). The Conversion Price is subject to adjustment in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

The Third Tranche Convertible Notes may be redeemed at the option of the Company on the same terms as the 2011 and 2012 Convertible Notes only in connection with a change of control or other fundamental transaction of the Company and subject to the satisfaction of other conditions including, without limitation, that the shares issuable upon conversion of the debentures are freely tradable and that there is no event of default.

 

Third Tranche Warrants

 

On January 16, 2013, in connection with the Third Tranche Convertible Notes, the Company issued warrants for the purchase of up to 2,500,000 shares of common stock with five year terms.  The warrants were issued to allow the Investors to purchase up to 2,500,000 shares of common stock at an initial purchase price of $0.15 per share. On February 22, 2013, per the terms of the Amendment and Waiver Agreement, the Third Tranche Warrants were canceled. The following is a summary of the 2012 Warrants outstanding for the six months ending June 30, 2013:

 

Third Tranche Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at December 31, 2012

 

 

$

 

Add: Issued

 

2,500,000

 

$

0.15

 

Less: Canceled warrants

 

(2,500,000

)

0.15

 

Ending balance at June 30, 2013

 

 

$

 

 

Accounting for the 2011 Convertible Notes, 2012 Convertible Notes, Third Tranche Convertible Notes, 2011 Warrants, 2012 Warrants, and Third Tranche Warrants

 

2011 Convertible Notes, 2012 Convertible Notes, and Third Tranche Convertible Notes

 

The Company has determined that the 2011 Convertible Notes, 2012 Convertible Notes and Third Tranche Convertible Notes constitute a hybrid instrument that has the characteristics of a debt host contract containing several embedded derivative features that would require bifurcation and separate accounting as a derivative instrument pursuant to the provisions of ASC 815. The Company has identified all of the derivatives associated with each convertible note.  As permitted under ASC 825-10-10 — Financial Instruments, as it relates to the fair value option, the Company has elected, as of the original issuance date of each convertible note, to measure the 2011 Convertible Notes, 2012 Convertible Notes, and the Third Tranche Convertible Notes in their entirety at fair value with changes in fair value recognized in the Consolidated Statement of Operations as either a gain or loss until the notes are settled.  As such, the Company has appropriately valued the embedded derivatives as a single hybrid contract together with the convertible notes. This election was made by the Company after determining the aggregate fair value of the convertible notes to be more meaningful in the context of the Company’s financial statements than if separate fair values were assigned to each of the multiple embedded instruments contained in the convertible notes.

 

Pursuant to the guidance of ASC 815-40-15 (formerly EITF 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock), the 2011 Warrants, 2012 Warrants and Third Tranche Warrants were not considered indexed to the Company’s own stock.  As a result these instruments have been account for as freestanding derivative instruments and classified as a liability recorded at fair value at each reporting period.

 

The Amendment and Waiver Agreement triggered a greater than 10% change in the present value of cash flows of the convertible notes and associated warrants.  As a result, the Company has treated the Amendment and Waiver Agreement as a debt extinguishment where the carrying value of the convertible notes and warrants prior to the amendment were removed from the Company’s books and the fair value of the amended convertible notes and warrants was recorded.  The resulting difference in value was recorded as a $1,283,000 loss on the extinguishment of debt.  The impact to each of the convertible notes and associated warrants is discussed below.

 

2011 Convertible Notes and 2011 Warrants

 

Upon issuance of the 2011 Convertible Notes, the Company allocated the proceeds received to the 2011 Convertible Notes and 2011 Warrants on a relative fair value basis. As a result of such allocation, the Company determined the initial carrying value of the Notes to be $3,208,000. The debt discount in the amount of $792,000 (resulting from the allocation of proceeds) was being amortized to interest expense using the effective interest method over the expected term of the 2011 Convertible Notes.  The carrying value of the 2011 Convertible Notes has been adjusted to fair value each reporting period.  During the three and six months ended June 30, 2012 the Company amortized $66,000 and $132,000 of the debt discount and recorded a $3,107,000 and $354,000 adjustment to the fair value of the notes as a component of other income (expense), respectively.

 

As a result of the Amendment and Waiver Agreement the carrying value of the 2011 Warrants was adjusted at February 22, 2013 to reflect the revised terms.  As of June 30, 2013, the 2011 Warrants have been marked to fair value resulting in a derivative liability of $1,809,000.  The impact to other income (expense) for the change in fair value of the 2011 Warrants for the three and six months ended June 30, 2013 was a gain of $2,118,000 and $104,000, respectively.

 

The Company has accounted for the Amendment and Waiver Agreement as an extinguishment of debt at February 22, 2013.  The fair value of the 2011 Convertible Notes prior to the extinguishment was replaced by the fair value of the amended 2011 Convertible Notes, resulting in a fair value of $6,070,000 as of February 22, 2013.  In connection with the extinguishment of the debt as of February 22, 2013, the Company had amortized $38,000 of the debt discount and wrote off the remaining debt discount of $265,000.  As of June 30, 2013, the 2011 Convertible Notes have been marked to fair value resulting in a derivative liability of $4,380,000.  The impact to other income (expense) for the loss on extinguishment and adjustments to fair value for the three and six months ended June 30, 2013 was a gain of $2,370,000 and $1,718,000, respectively.

 

During the three and six months ended June 30, 2013 certain holders of the 2011 Convertible Notes converted $300,000 of convertible note principal into 3,000,000 shares of common stock. The conversion resulted in the reclassification of $450,000 of the 2011 Convertible Notes at fair value being reclassified as a component of common stock in stockholders’ equity.

 

During the three and six months ended June 30, 2013 certain holders of the 2011 Warrants exercised warrants to purchase 20,335,524 and 29,085,523, respectively, shares of common stock pursuant to the cashless exercise provisions resulting in the issuance of 7,478,226 and 10,695,967, respectively, shares of the Company’s common stock.  The cashless exercise resulted in the reclassification of $1,159,125 and $2,002,674, respectively, in the exercise date fair value of the 2011 Warrants exercised as a component of common stock in stockholders’ equity.

 

2012 Convertible Notes and 2012 Warrants

 

Upon issuance of the 2012 Convertible Notes, the Company allocated the proceeds received to the Second Tranche Convertible Notes and 2012 Warrants on a relative fair value basis.  As a result of such allocation, the Company determined the initial carrying value of the Second Tranche Convertible Notes to be $417,000.  The debt discount in the amount of $583,000 (resulting from the allocation of proceeds) was being amortized to interest expense using the effective interest method over the expected term of the Convertible Notes. The carrying value of the 2011 Convertible Notes has been adjusted to fair value each reporting period.

 

The Company has accounted for the Amendment and Waiver Agreement as an extinguishment of debt at February 22, 2013.  The fair value of the 2012 Convertible Notes prior to the extinguishment was replaced by the fair value of the amended 2012 Convertible Notes, resulting in a fair value of $1,516,000 as of February 22, 2013. As of June 30, 2013, the 2012 Convertible Notes have been marked to fair value resulting in a derivative liability of $1,180,000.  In connection with the extinguishment of the debt as of February 22, 2013, the Company had amortized $55,000 of the debt discount and wrote off the remaining debt discount of $462,000.  The impact to other income (expense) for the loss on extinguishment and adjustments to fair value was a gain of $620,000 and $463,000 for the three and six months ended June 30, 2013, respectively.

 

As a result of the Amendment and Waiver Agreement the carrying value of the 2012 Warrants was adjusted at February 22, 2013 to reflect the revised terms.  As of June 30, 2013, the 2012 Warrants have been marked to fair value resulting in a derivative liability of $979,000. The impact to other income (expense) for the three and six months ended June 30, 2013 was a gain of $979,000 and $21,000, respectively.

 

Third Tranche Convertible Notes and Third Tranche Warrants

 

Upon issuance of the Third Tranche Convertible Notes in January 2013, the Company allocated the proceeds received to the Third Tranche Convertible Notes and Third Tranche Warrants on a relative fair value basis.  As a result of such allocation, the Company determined the initial carrying value of the Third Tranche Convertible Notes to be $142,000.  The Third Tranche Convertible Notes were immediately marked to fair value, resulting in a derivative liability in the amount of $394,000. The debt discount in the amount of $108,000 (resulting from the allocation of proceeds) was being amortized to interest expense using the effective interest method over the expected term of the Convertible Notes.

 

The Company has accounted for the Amendment and Waiver Agreement as an extinguishment of debt at February 22, 2013.  The fair value of the Third Tranche Convertible Notes prior to the extinguishment was replaced by the fair value of the amended Third Tranche Convertible Notes, resulting in a fair value of $386,000 as of February 22, 2013.  As of June 30, 2013, the Third Tranche Convertible Notes have been marked to fair value resulting in a derivative liability of $295,000.  In connection with the extinguishment of the debt as of February 22, 2013, the Company had amortized $2,000 of the debt discount and wrote off the remaining debt discount of $106,000.  The impact to other income (expense) was a gain of $187,000 and $101,000 for the three and six months ended June 30, 2013, respectively.

 

Upon issuance of the Third Tranche Warrants, the Company allocated $108,000 of the initial proceeds to the Third Tranche Warrants and immediately marked them to fair value resulting in a derivative liability of $300,000.  As of June 30, 2013, the Third Tranche Warrants have been canceled as per the terms of the Amendment and Waiver Agreement. The impact to other income (expense) for the three and six months ended June 30, 2013 was a gain of $187,000 and $101,000, respectively.