PDOS Platinum Studios Inc (CE)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

T            QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2011

¨            TRANSITION REPORT UNDER SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM __________ TO __________

COMMISSION FILE NUMBER: 333-145871

PLATINUM STUDIOS, INC.

(Name of registrant in its charter)

CALIFORNIA		20-5611551
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

2029 S. Westgate Ave., Los Angeles, CA 90025

 (Address of principal executive offices) (Zip Code)

Issuer’s telephone Number: (310) 807-8100

            Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o	Accelerated filer o
Non-accelerated filer o	Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

The number of shares of registrant’s common stock outstanding, as November 11, 2011 was 439,690,238.

 

 

PLATINUM STUDIOS, INC.

INDEX

 

 

PART I   – FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

PLATINUM STUDIOS, INC AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

		September 30, 2011				December 31, 2010
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	69,262			$	76,275
Accounts receivable			200,000				-
Prepaid expenses			46,549				100,940
Other current assets			1,017,557				438,799
Total current assets			1,333,368				616,014
Property and equipment, net			56,975				76,631
Investment in film library, net			295,919				9,449,207
Assets held for sale			12,000				12,000
Deposits and other			60,812				321,160
Total assets		$	1,759,074			$	10,475,012

 

(Continued)

 

 

PLATINUM STUDIOS, INC AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (continued)

		September 30, 2011				December 31, 2010
		(Unaudited)
LIABILITIES AND SHAREHOLDERS' DEFICIT
Current liabilities:
Accounts payable		$	1,257,540			$	1,195,673
Accrued expenses and other current liabilities			2,660,378				1,278,092
Deferred revenue			49,583				3,973,738
Short term notes payable			5,672,410				10,960,274
Related party payable			447,500				347,500
Related party notes payable, net of debt discount			662,286				1,279,018
Derivative liability			18,947,707				7,763,968
Accrued interest - related party notes payable			-				189,770
Capital leases payable			5,893				11,627
Total current liabilities			29,703,297				26,999,660
Commitments and contingencies
Shareholders' Deficit:
Common stock, $.0001 par value; 2,500,000,000 shares authorized; 413,234,555 and 310,345,811 issued and outstanding, respectively			41,323				31,035
Additional paid in capital			19,881,312				17,478,740
Accumulated deficit			(47,866,858	)			(34,034,423	)
Total shareholders' deficit			(27,944,223	)			(16,524,648	)
Total liabilities and shareholders' deficit		$	1,759,074			$	10,475,012

The accompanying footnotes are an integral part of these condensed consolidated financial statements.

 

PLATINUM STUDIOS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
Net revenue		$	4,943,963			$	150,645			$	10,469,444			$	2,248,693
Costs and expenses:
Cost of revenues			4,692,049				14,378				10,167,007				493,960
Operating expenses			1,009,398				650,260				2,276,343				2,251,495
Development costs			194,298				101,307				514,305				240,246
Total costs and expenses			5,895,745				765,945				12,957,655				2,985,701
Operating loss			(951,782	)			(615,300	)			(2,488,211	)			(737,008	)
Other income (expense):
Gain on disposition of assets			-				55,200				-				249,220
Gain (loss) on settlement of debt			(79,126	)			27,492				(245,695	)			109,949
Gain (Loss) on valuation of derivative liability			(1,282,318	)			525,000				(4,280,048	)			(245,000	)
Cost of Financing			(3,153,691	)			-				(3,153,691	)			-
Interest expense			(826,955	)			(121,279	)			(3,664,790	)			(1,079,444	)
Total other income (expense):			(5,342,090	)			486,413				(11,344,224	)			(965,275	)
Net loss		$	(6,293,872	)		$	(128,887	)		$	(13,832,435	)		$	(1,702,283	)
Net loss per share		$	(0.02	)		$	(0.00	)		$	(0.04	)		$	(0.01	)
Basic and diluted weighted average shares			376,150,663				289,778,706				339,050,861				282,777,651

The accompanying footnotes are an integral part of these condensed consolidated financial statements

 

 

PLATINUM STUDIOS, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ DEFICIT

(UNAUDITED)

Nine Months Ended September 30, 2011

		Common Stock Shares				Common  Stock Amount				Additional  Paid-In Capital				Accumulated Deficit				Total
Balance at December 31, 2010			310,345,811			$	31,035			$	17,478,740			$	(34,034,423	)		$	(16,524,648	)
Shares returned			(337,000	)			(34	)			34				-				-
Common stock issued for services.			41,323,534				4,132				894,146				-				898,278
Common stock issued for conversion of debt and accounts payable			20,929,736				2,093				503,257				-				505,350
Shares sold under equity credit line			40,972,474				4,097				1,005,135				-				1,009,232
Net Loss			-				-				-				(13,832,435	)			(13,832,435	)
Balance at September 30, 2011			413,234,555			$	41,323			$	19,881,312			$	(47,866,858	)		$	(27,944,223	)

The accompanying footnotes are an integral part of these condensed consolidated financial statements

 

 

PLATINUM STUDIOS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

( UNAUDITED)

 

		Nine Months Ended September 30,
		2011				2010
Supplemental disclosure of cash flow information:
Cash paid for interest		$	37,684			$	337,632
Non-cash investing and financing activities:
Fair value of note discount		$	3,750,000			$	-
Stock issued as payments of notes payable, accounts payable and accrued interest		$	809,248			$	53,773

The accompanying footnotes are an integral part of these condensed consolidated financial statements

 

PLATINUM STUDIOS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Nine months Ended September 30, 2011 and 2010

(UNAUDITED)

( 1 )

Description of business

Nature of operations – The Company controls a library consisting of more than 5,000 characters and is engaged principally as a comics-based entertainment company adapting characters and storylines for production in film, television, publishing and all other media.

 

Platinum Studios, LLC was formed and operated as a California limited liability company from its inception on November 20, 1996 through September 14, 2006. On September 15, 2006, Platinum Studios, LLC filed with the State of California to convert Platinum Studios, LLC into Platinum Studios, Inc., (“the Company”, “Platinum”) a California corporation. This change to the Company structure was made in preparation of a private placement memorandum and common stock offering in October, 2006.

 

On December 10, 2008, the Company purchased Long Distance Films, Inc. to facilitate the financing and production of the film currently titled “Dead of Night”. The Company’s license to the underlying rights of the “Dead of Nights” characters was due to expire unless principal photography commenced on a feature film by a certain date. The Company had previously licensed these rights to Long Distance Films, Inc. The Company then purchased Long Distance Films, Inc., with its production subsidiary, Dead of Night Productions, LLC in order to expedite and finalize the financing of the film with Standard Chartered Bank, whose outstanding debt balance was $4,916,665 as of September 30, 2011. Long Distance Films, Inc.’s only assets are investments in its subsidiaries related to the film production of “Dead of Night” and has no liabilities or equity other than 100 shares of common stock wholly owned by Platinum Studios, Inc. Long Distance Films, Inc was created for the sole purpose of producing “Dead of Night.” At the time of the acquisition, Long Distance Films, Inc. had no assets or liabilities and no consideration was paid by the Company for the acquisition and no value was assigned to the transaction, which would be eliminated in consolidation.

 

( 2 )

Authorized Shares

During August, 2011, the Board of Directors of the Company approved an increase in the number of authorized shares from 500,000 to 2,500,000. In October, 2011, the Company filed a Certificate of Amendment of Articles of Incorporation with the State of California to increase the authorized shares. The amendment to the Articles was approved by the required vote of shareholders in accordance with the California Corporations Code.

 

 

( 3 )

Basis of financial statement presentation and consolidation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with United States generally accepted accounting principles for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X, promulgated by the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and disclosures required by United States generally accepted accounting principles for complete financial statements. The consolidated financial statements include the financial condition and results of operations of its wholly-owned subsidiaries, Long Distance Films, Inc., Platinum Studios Productions, Inc. and Platinum Studios Entertainment, Inc. Intercompany balances and transactions have been eliminated in consolidation. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for interim periods are not necessarily indicative of the results that may be expected for the fiscal year. The condensed consolidated financial statements should be read in conjunction with the Company’s December 31, 2010 consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K (the “Annual Report”). All terms used but not defined elsewhere herein have the meanings ascribed to them in the Annual Report.

The balance sheet at December 31, 2010 has been derived from the audited consolidated financial statements at that date but does not include all the information and footnotes required by United States generally accepted accounting principles for complete financial statements.

( 4 )

Going concern

During the nine months ended September 30, 2011, the Company had a net loss of $13,832,435. At September, 2011, the Company had a working capital deficit of $9,422,222 (excluding its derivative liability) and a shareholders’ deficiency of $27,944,223. The Company is also delinquent in payment of $116,308 for payroll taxes as of September 30, 2011 and in default of certain of its short term notes payable including it $4,916,665 note payable to Standard Chartered Bank. These matters raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from this uncertainty. The Company intends to raise funds to finance operations until the Company achieves profitable operations. The Company’s capital requirements for the next 12 months will continue to be significant. If adequate funds are not available to satisfy either medium or long-term capital requirements, the Company’s operations and liquidity could be materially adversely affected and the Company could be forced to cut back its operations.

 

( 5 )

Summary of significant accounting policies

Revenue recognition - Revenue from the licensing of characters and storylines (“the properties”) owned by the Company are recognized in accordance with guidance of the Financial Accounting Standards Board (“FASB”) where revenue is recognized when the earnings process is complete. This is considered to have occurred when persuasive evidence of an agreement between the customer and the Company exists, when the properties are made available to the licensee and the Company has satisfied its obligations under the agreement, when the fee is fixed or determinable and when collection is reasonably assured.

 

The Company derives its licensing revenue primarily from the sale of options to purchase rights, the purchase of rights to properties and first look deals. For options that contain non-refundable minimum payment obligations, revenue is recognized ratably over the option period, provided all the criteria for revenue recognition have been met. Option fees that are applicable to the purchase price are deferred and recognized as revenue at the later of the expiration of the option period or in accordance with the terms of the purchase agreement. Revenue received under first look deals is recognized ratably over the first look period, which varies by contract provided all the criteria for revenue recognition under Staff Accounting Bulletin 104 have been met.

 

For licenses requiring material continuing involvement or performance based obligations, by the Company, the revenue is recognized as and when such obligations are fulfilled.

 

The Company records as deferred revenue any licensing fees collected in advance of obligations being fulfilled or if a licensee is not sufficiently creditworthy, the Company will record deferred revenue until payments are received.

 

License agreements typically include reversion rights which allow the Company to repurchase property rights which have not been used by the studio (the buyer) in production within a specified period of time as defined in the purchase agreement. The cost to repurchase the rights is generally based on the costs incurred by the studio to further develop the characters and story lines.

 

The Company recognizes revenue from television and film productions pursuant to FASB ASC Topic 926, Entertainment-Films . The following conditions must be met in order to recognize revenue under Topic 926: (i) persuasive evidence of a sale or licensing arrangement exists; (ii) the program is complete and has been delivered or is available for immediate and unconditional delivery; (iii) the license period of the arrangement has begun and the customer can begin its exploitation, exhibition or sale; (iv) the arrangement fee is fixed or determinable; and (v) collection of the arrangement fee is reasonably assured. Advance payments received from buyers or licensees are included in the condensed consolidated financial statements as a component of deferred revenue.

 

Use of estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Those estimates and assumptions include estimates for reserves of uncollectible accounts, analysis of impairments of recorded intangibles and investments in film library, accruals for potential liabilities, and assumptions made in valuing stock instruments issued for services and in valuing derivative liabilities.

 

Concentrations of risk - During the three and nine months and ended September 30, 2011 and 2010, the Company had customer revenues representing a concentration of the Company’s total revenues. For the three months ended September 30, 2011, one customer represented approximately 78% of total revenues. For the nine months ended September 30, 2011, three customers represented approximately 46%, 17% and 12% of total revenues. For the three months ended September 30, 2010, two customers represented approximately 66% and 13% of total revenues, respectively. For the nine months ended September 30, 2010, one customer represented approximately 91% of total revenues.

 

Derivative Instruments – The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the condensed consolidated statements of operations. For stock-based derivative financial instruments, the Company uses the Binomial option pricing model to value the derivative instruments at inception and on subsequent valuation dates. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.

 

Fair Value of Financial Instruments – Fair value measurements are determined by the Company's adoption of authoritative guidance issued by the FASB, with the exception of the application of the statement to non-recurring, non-financial assets and liabilities as permitted. The adoption of the authoritative guidance did not have a material impact on the Company's fair value measurements. Fair value is defined in the authoritative guidance as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy was established, which prioritizes the inputs used in measuring fair value into three broad levels as follows:

 

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs, other than the quoted prices in active markets, are observable either directly or indirectly.

Level 3—Unobservable inputs based on the Company's assumptions.

 

The Company is required to use observable market data if such data is available without undue cost and effort.

 

The following table presents certain investments and liabilities of the Company’s financial assets measured and recorded at fair value on the Company’s consolidated balance sheets on a recurring basis and their level within the fair value hierarchy as of September 30, 2011 and December 31, 2010:

		September 30, 2011 (unaudited)
		Level 1				Level 2				Level 3				Total
Fair value of convertible note conversion feature		$	-			$	-			$	7,540,494			$	7,540,494
Fair value of warrants			-				-				11,407,213				11,407,213
		$	-			$	-			$	18,947,707			$	18,947,707

		December 31, 2010
		Level 1				Level 2				Level 3				Total
Fair value of convertible note conversion feature		$	-			$	-			$	2,017,663			$	2,017,663
Fair value of warrants			-				-				5,746,305				5,746,305
		$	-			$	-			$	7,763,968			$	7,763,968

See Notes 8 and 9 for more information on these financial instruments.

 

Development costs - Development costs, primarily character development costs and design not associated with an identifiable revenue opportunity, are charged to operations as incurred. For the three months ended September 30, 2011 and 2010, development costs were $194,298 and $101,307, respectively. For the nine months ended September 30, 2011 and 2010, development costs were $514,305 and $240,246, respectively.

 

Net loss per share – Basic income per share is computed by dividing net income (loss) available to common stockholders by the weighted average number of shares of common stock outstanding during the periods, excluding shares subject to repurchase or forfeiture. Diluted income per share increases the shares outstanding for the assumption of the vesting of restricted stock and the exercise of dilutive stock options and warrants, using the treasury stock method, unless the effect is anti-dilutive. Since the Company incurred net losses for the nine months ended September 30, 2011 and 2010, any increase in the denominator would be anti-dilutive and therefore, the denominator is the same for basic and diluted weighted average shares.

 

The potentially dilutive securities consisted of the following as of September 30, 2011 and 2010:

 

 

		September 30, 2011				September 30, 2010
Warrants			1,005,426,136				41,958,600
Options			14,265,000				24,585,000
Convertible Notes			877,975,080				85,526,319
			1,897,666,216				152,069,919

 

Recently issued accounting pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. ASU No. 2011-4 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. The ASU is effective for interim and annual periods beginning after December 15, 2011. The Company will adopt the ASU as required. The ASU will affect the Company’s fair value disclosures, but will not affect the Company’s results of operations, financial condition or liquidity.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”. The ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive income or in two separate but consecutive statements. ASU No. 2011-5 is effective for interim and annual periods beginning after December 15, 2011. The Company will adopt the ASU as required. It will have no affect on the Company’s results of operations, financial condition or liquidity.

In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of goodwill impairment. This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount before performing the two step impairment review process. It also amends the examples of events or circumstances that would be considered in a goodwill impairment evaluation. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. The Company will adopt the ASU as required. It will have no affect on the Company’s results of operations, financial condition or liquidity.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

 

( 6 )

Investment in Film Library

 

As of September 30, 2011 and December 31, 2010, the investment in film library of $295,919 and $9,449,207, respectively, is related to the “Dead of Night” production, a completed film and is net of amortization of $9,153,288 and $0, respectively. The film was released theatrically in Italy on March 16, 2011 and in the United States on April 29, 2011. The majority of the remaining foreign territories were available for release upon the United States release date. During the nine months ended September 30, 2011, the Company recognized $10,207,479 of revenue upon the availability of the film in all of the territories and the theatrical release in the United States. The balance of the remaining ultimate revenues and unamortized costs of $295,919 should be principally amortized during the fourth quarter of 2011.

 

( 7 )

Short-term notes payable

 

Short-term notes payable consists of the following as of:

 

		September 30, 2011 (Unaudited)				December 31, 2010
Loans payable to various parties, including minority shareholders, unsecured, interest at 12% per annum, due on demand		$	450,039			$	482,085
Convertible note payable to a minority shareholder, unsecured, interest at 12% per annum, due on December 31, 2011. Note is convertible into Company's Common Stock at $0.048 per share.			102,853				161,023
Bank term loan, unsecured, interest at 7.5% per annum, payable in monthly installments of principal and interest			20,353				32,288
Standard Chartered Bank note payable of $13,365,000 loan secured by all rights in the sales agency agreement and the distribution agreement in connection with the film "Dead of Night". Company is currently in default. The interest rate is currently the default rate of Libor plus 8%.			4,916,665				9,799,878
Note payable to Omnilab Pty Ltd - 10% funded of gap investment of $4,850,000 for production "Dead of Night," to be recovered from gross receipts in North America. Interest rate of 4.09% per annum.			-				485,000
Convertible notes payable, unsecured, interest at 8% per annum, due from October 12, 2011 to May 8, 2012. Note is convertible into the Company's stock at 61% of the average of the lowest three trading days during the ten day trading period prior to conversion.			82,500				-
Convertible note payable, unsecured, interest at 9.875% (semi-annually), due from September 17, 2011 to October 8, 2011. Note is convertible into the Company's stock at lessor of 75% of the average of the last five trading days prior to conversion or closing price on the day prior to conversion, not to exceed $0.05. See Note 13.			100,000				-
Total		$	5,672,410			$	10,960,274

 

 

( 8 )

Notes Payable Initially issued to Related Party

 

Related party notes payable consist of the following as of:

		September 30, 2011 (Unaudited)				December 31, 2010
May 6, 2009 secured convertible notes payable		$	2,400,000			$	2,400,000
June 3, 2009 secured convertible notes payable			1,350,000				1,350,000
Related party notes payable			3,750,000				3,750,000
Less valuation discount			(3,087,714	)			(2,470,982	)
Total short-term notes payable		$	662,286			$	1,279,018

 

The Company entered into a Credit Agreement on May 6, 2009, with Mr. Rosenberg, its Chairman and Chief Executive Office, in connection with the issuance of two secured promissory notes. Two warrants were issued to Mr. Rosenberg in connection with the issuance of various promissory notes as of May 6, 2009 and June 3, 2009. The advances in 2009 increased Rosenberg’s security interest held in the Company’s assets to approximately $3,750,000. These transactions were:

 

May 6, 2009 Secured Debt - The May 6, 2009 secured debt has an aggregate principal amount of $2,400,000, is convertible into shares of the Company’s common stock at a conversion price of $0.048 and bears interest at the rate of eight percent per annum. The original principal amount of $2,400,000 is to be repaid upon the expiration of the notes on May 6, 2010. The Company may prepay the notes at any time. In connection with this debt the Company also issued ten-year warrants to purchase 25,000,000 shares of the Company’s common stock for $0.048 per share.

 

June 3, 2009 Secured Debt - The June 3, 2009 secured debt amounted to an aggregate principal amount of $1,350,000, is convertible into shares of the Company’s common stock at a conversion price of $0.038 and bears interest at the rate of eight percent per annum. The original principal amount of $1,350,000 is to be repaid upon the expiration of the notes on June 3, 2010 but may be prepaid at any time. In connection with this debt the Company also issued ten-year warrants to purchase 14,062,500 shares of the Company’s common stock for $0.038 per share.

 

First Modification of Secured Convertible Notes Payable – On October 22, 2010, the Company entered into a series of agreements with its CEO, Chairman, and a major shareholder to extend the due date of certain existing loans made by the CEO. Pursuant to the terms of the agreements, the new due date for the secured convertible notes payable totaling $2,400,000 was extended to May 6, 2011 and the new due date for the secured convertible notes payable totaling $1,350,000 was extended to June 3, 2011. The interest rate under these loans was increased from 8% to 10%, effective upon the original due date of May 6, 2010 and June 3, 2010, respectively.

 

In exchange for these due date extensions, the Company granted to the CEO:

1.

Two additional sets of warrants to purchase the Company’s common stock. The first set allowing for the exercise of up to 40,000,000 warrants to purchase shares of the Company’s common stock, at an exercise price of $0.11 per share, and the second set allowing for the acquisition of up to $3,750,000 in stock, also at an exercise price of $0.11 per share. Both sets (“New Warrants”) vested immediately and will expire on October 22, 2020; and

2.

As more fully described in the Intellectual Property Rights Assignment Agreement between the Company and Scott Rosenberg (included as an exhibit to the Company’s 8K filing, as amended, on December 28, 2010), 25% of gross revenues from those certain co-ownership rights assigned to Scott Rosenberg. A list of intellectual property that is excluded from this agreement is also in the exhibit to the 8K filing.

 

The notes and warrants were assigned in October, 2010 to Assignment & Collateral Holdings, LLC “(ACH)”, an entity managed at that time by a Director of the Company and Mr. Rosenberg, the CEO and Chairman of the Company.

 

Second Modification of Secured Convertible Notes Payable – In August, 2011, the Company entered into a series of agreements with ACH to extend the due date of certain existing loans originally made by the CEO. Pursuant to the terms of the agreements, the new due date for the secured convertible notes payable totaling $2,400,000 was extended to May 6, 2012 and the new due date for the secured convertible notes payable totaling $1,350,000 was extended to June 3, 2012.

In exchange for these due date extensions, the Company granted to ACH:

Two additional sets of warrants to purchase the Company’s common stock. The first set allowing for the exercise of up to 40,000,000 warrants to purchase shares of the Company’s common stock, at an exercise price of $0.11 per share, and the second set allowing for the acquisition of up to $3,750,000 in stock, also at an exercise price of $0.11 per share. Both sets (“New Warrants”) vested immediately and will expire on August 12, 2021.

The exercise price and the number of shares underlying the warrants are subject to anti-dilution adjustments from time to time if the Company issues common stock at below the exercise price at that time for the warrants. The dilutive issuances provisions of the warrants and convertible notes were triggered during the second quarter of 2011 due to issuances of common stock pursuant to the Dutchesss Opportunity Fund Agreement. As of June 30, 2011, the revised pricing on the warrants and conversions was set at $0.0121. The revised pricing was reduced further during the third quarter of 2011 due to conversions of debt by holders of convertible notes. As of September 30, 2011, the revised pricing on the warrants and conversion is now set at $0.0044 for the warrants that were issued originally and as part of the first debt modification.

 

The Company considered authoritative guidance and determined that the debt modification represented a substantial debt modification. As such the proper accounting treatment for the conversion price was reevaluated. FASB guidance indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument (or embedded feature), regardless of the probability or whether or not within the issuers’ control, means the instrument is not indexed to the issuers own stock. Accordingly, the embedded conversion feature of the notes and the conversion feature of the warrants resulted in a derivative liability being recorded by the Company when the Notes were modified and the New Warrants were granted (see Note 8). The Company determined the fair value at the second modification of the conversion feature of the Notes was $5,421,917 and the fair value of the New Warrants was $1,481,774 based on a binominal valuation model with the following assumptions: risk-free interest rate of 0.11% to 2.24%; dividend yield of 0%; volatility factor of 279%; and an expected life of 8 months to 10 years, resulting in total derivative at modification of $6,903,691. For financial statement purposes, $3,750,000 of this amount was allocated to debt discount (i.e. up to face amount of the Notes) and is being amortized over the term of the Notes. The balance of the derivative of $3,153,691 represents excess of the fair value of the derivatives over the face amount of the notes and has been recognized as Cost of Financing during the three and nine months ended September 30, 2011. For the three months ended September 30, 2011, $662,286 of discount amortization is included in interest expense. For the nine months ended September 30, 2011, $3,133,268 of discount amortization is included in interest expense, of which $2,470,982 was related to the first modification and $662,286 related to the second modification. At September 30, 2011, the unamortized balance of the discount is $3,087,717.

 

Due to the resignation of Mr. Rosenberg in May of 2011 as manager of ACH and the Director’s resignation as manager in September, 2011, the Company no longer considers ACH a related party.

 

( 9 )

Derivative Liabilities

 

In September 2008, the FASB issued authoritative guidance on determining whether an instrument (or embedded feature) is indexed to an entity’s own stock. Under the authoritative guidance, effective January 1, 2009, instruments which do not have fixed settlement provisions are deemed to be derivative instruments. The conversion feature of the Company’s secured convertible related party notes payable (described in Note 7), and the related warrants, do not have fixed settlement provisions because their conversion and exercise prices, respectively, may be lowered if the Company issues securities at lower prices in the future. In accordance with the FASB authoritative guidance, the conversion feature of the Notes was separated from the host contract (i.e., the Notes) and recognized as a derivative instrument. Both the conversion feature of the Notes and the related warrants have been characterized as derivative liabilities to be re-measured at the end of every reporting period with the change in value reported in the statement of operations.

The derivative liabilities were valued using a Binomial valuation model with the following assumptions:

 

 

						August 12,
		September 30,				2011				December 31,
		2011				(Modification)				2010
Conversion Feature:
Risk-free interest rate			0.13	%			0.11	%			0.21	%
Expected volatility			173	%			279	%			91.5	%
Expected life (in months)		8 to 9				9 to 10				4 to 5
Expected dividend yield			0	%			0	%			0	%
Warrants:
Risk-free interest rate		1.43 to 1.92		%			2.24	%		2.6 to 2.8		%
Expected volatility			173	%			279	%		91 to 92		%
Expected life (in years)		7.62 to 10					10			8.42 to 9.83
Expected dividend yield			0	%			0	%			0	%
Fair Value:
Conversion feature		$	7,540,494			$	5,421,917			$	2,017,663
Warrants			11,407,213				1,481,774				5,746,305
		$	18,947,707			$	6,903,691			$	7,763,968

 

The risk-free interest rate was based on rates established by the Federal Reserve Bank. The Company uses the historical volatility of its common stock. The expected life of the conversion feature of the notes was based on the term of the notes and the expected life of the warrants was determined by the expiration date of the warrants. The expected dividend yield was based on the fact that the Company has not paid dividends to common shareholders in the past and does not expect to pay dividends to common shareholders in the future.

As of September 30, 2011, August 12, 2011 and December 31, 2010, the fair value of the derivative liability was $18,947,707, $6,903,691 and $7,763,968, respectively. For the three and nine months ended September 30, 2011, the Company recorded a change in fair value of the derivative liabilities of ($1,282,318) and ($4,280,048), respectively.