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Derivative Financial Instruments
9 Months Ended
Sep. 30, 2011
Derivative Financial Instruments [Abstract] 
Derivative Financial Instruments

NOTE M — DERIVATIVE FINANCIAL INSTRUMENTS

As more fully discussed in NOTE O, (i) on October 11, 2010, we entered into the Series G Convertible Preferred Stock and Warrant Financing Transaction and the Series G Convertible Preferred Stock and Warrant Settlement Transactions, which gave rise to our recognition and classification of derivative financial instruments, (ii) in April 2011 certain investors redeemed Series G Preferred Stock for cash of $757,500, and (iii) on April 14, 2011 the remaining outstanding shares of Series G Preferred Stock were modified and an additional 525,000 warrants were issued in connection with the modification.

The following tables summarize the components of our derivative liabilities as of September 30, 2011 and December 31, 2010:

 

     September 30,
2011		      December 31,
2010		  

Derivative liabilities:

      

Compound embedded derivative

    $ 3,335,136      $ 4,075,344  

Warrant derivative

      2,768,771        2,287,800  
  

 

 

     

 

 

  

Total derivative liabilities

    $ 6,103,907      $ 6,363,144  
  

 

 

     

 

 

  

 

     September 30,
2011		      December 31,
2010		  

Common shares linked to derivative liabilities:

      

Compound embedded derivative

      2,940,000        3,360,000  

Warrant derivative

      2,325,000        1,800,000  
  

 

 

     

 

 

  

Total common shares linked to derivative liabilities

      5,265,000        5,160,000  
  

 

 

     

 

 

  

The following table summarizes the changes in fair values of our derivative liabilities, which are reflected in income, during the three and nine-months ended September 30, 2011 and 2010:

 

     Three Months Ended      Nine Months Ended  
     September 30,      September 30,  
     2011      2010      2011      2010  

Derivative (expense) income:

            

Compound embedded derivative

    $ 1,185,555       $ —         $ 740,208       $ —     

Warrant derivative

      564,454         —           425,179         —     
  

 

 

     

 

 

     

 

 

     

 

 

  

Total derivative (expense) income

    $ 1,750,009       $ —         $ 1,165,387       $ —     
  

 

 

     

 

 

     

 

 

     

 

 

  

The Series G Convertible Preferred Stock included certain terms and features that both possessed all of the conditions of derivative financial instruments and were not clearly and closely related to the host preferred contract in terms of economic risks and characteristics. These terms and features consist of the embedded conversion option and the related down-round anti-dilution protection provision, the Company's redemption privilege and the holder's redemption privilege. Each of the redemption features also embodies the redemption premium payments. Current accounting principles that are provided in ASC 815 do not permit an issuer to account separately for individual derivative terms and features that require bifurcation and liability classification. Rather, such terms and features must be bundled together and fair valued as a single, compound embedded derivative. We have selected the Monte Carlo Simulations valuation technique to fair value the compound embedded derivative because we believe that this technique is reflective of all significant assumption types, and ranges of assumption inputs, that market participants would likely consider in transactions involving such types of derivatives. Such assumptions include, among other inputs, interest risk assumptions, credit risk assumptions and redemption behaviors in addition to traditional inputs for option models such as market trading volatility and risk free rates.

The Monte Carlo Simulations technique is a level-three valuation technique because it requires the development of significant internal assumptions in addition to observable market indicators. Significant assumptions and results arising from the Monte Carlo Simulations process are as follows at September 30, 2011 and December 31, 2010:

 

     September 30,     December 31  
     2011     2010  

Quoted market price of our common stock

    $ 2.46      $ 2.78   

Contractual conversion rate

    $ 1.78      $ 1.78   

Implied expected term (years)

      0.70        0.81   

Market volatility:

     

Range of volatilities

      69.73%-125.36 %      57.69%-73.28 % 

Equivalent volatility

      104.27 %      61.59 % 

Market-risk adjusted interest rate:

     

Range of rates

      12.0%-32.00 %      8.0%-33.09 % 

Equivalent market-risk adjusted interest rate

      14.46 %      13.55 % 

Credit-risk adjusted yield rate:

     

Range of rates

      3.21%-4.85 %      3.46%-4.81 % 

Equivalent credit-risk adjusted yield rate

      3.20 %      3.54 % 

Risk-free rates using yields on zero coupon US Treasury Security rates:

     

Range of rates

      0.13%-0.42 %      0.29%-1.02 % 

 

The following table reflects the issuances of compound embedded derivatives and changes in fair value inputs and assumptions related to the compound embedded derivatives during the nine-months ended September 30, 2011.

 

     Amount  

Balance at January 1, 2011

    $ 4,075,344  

Issuances

      —     

Expirations from redemptions of host contracts reflected in income

      (676,718 ) 

Changes in fair value inputs and assumptions reflected in income

      (63,490 ) 
  

 

 

  

Balance at September 30, 2011

    $ 3,335,136  
  

 

 

  

Fair value adjustments associated with redeemed Series G Preferred shares were recorded through the respective dates of redemption and amounted to expense of $52,052. Upon the redemption of the Series G Preferred shares for cash at par value discussed in the introductory paragraph and Note O, the compound embedded derivative option associated with the redeemed shares expired and was written off to income in the amount of $676,718. The fair value of the compound embedded derivative is significantly influenced by our trading market price, the price volatility in trading and the interest components of the Monte Carlo Simulation technique. To illustrate, during the period from December 31, 2010 and September 30, 2011, the quoted market price of our common stock decreased from $2.78 to $2.46. That decrease largely caused the decrease in fair value during that period.

In addition to the Series G Convertible Preferred Stock, we also issued warrants to acquire 1,800,000 of our common shares. On April 14, 2011, we issued the investors additional warrants to acquire 525,000 shares of common stock as consideration for the modification described in NOTE O. These warrants required liability classification as derivative financial instruments because certain down-round anti-dilution protection features included in the warrant agreements are not consistent with the concept of equity. We applied the Trinomial Lattice valuation technique in estimating the fair value of the warrants because we believe that this technique is most appropriate and reflects all of the assumptions that market participants would likely consider in transactions involving the warrants, including the potential incremental value associated with the down-round anti-dilution protections.

The Trinomial Lattice technique is a level-three valuation technique because it requires the development of significant internal assumptions in addition to observable market indicators. Significant assumptions utilized in the Trinomial Lattice process are as follows for April 14, 2011, September 30, 2011 and December 31, 2010:

 

     April 14,     September 30,     December 31  
     2011     2011     2010  

Quoted market price of our common stock

    $ 3.36      $ 2.46      $ 2.78   

Contractual exercise rate

    $ 2.75      $ 2.50-$2.75      $ 2.50   

Effective anti-dilution adjusted exercise price

    $ 2.59      $ 2.49-$2.74      $ 2.46   

Term (years)

      3.00        2.03-2.54        2.78   

Range of market volatilities

      59.51%-73.01 %      68.9%-129.5 %      57.64%-74.21 % 

Range of risk-free rates using yields on US Treasury Securities

      0.07%-1.27 %      0.02%-0.43 %      0.12%-1.02 % 

The following table reflects the issuances of derivative warrants and changes in fair value inputs and assumptions related to the derivative warrants during the nine-months ended September 30, 2011.

 

     Amount  

Balance at January 1, 2011

    $ 2,287,800  

Issuances of Modification Warrants on April 14, 2011

      906,150  

Exercises

      —     

Changes in fair value inputs and assumptions reflected in income

      (425,179 ) 
  

 

 

  

Balance at September 30, 2011

    $ 2,768,771  
  

 

 

  

 

The fair value of the warrant derivative is significantly influenced by our trading market price, the price volatility in trading and the risk free interest components of the Trinomial Lattice technique.