11. DERIVATIVE LIABILITY

6 Months Ended

Jun. 30, 2014

Notes to Financial Statements

DERIVATIVE LIABILITY

In April 2008, the FASB issued a pronouncement that provides guidance on determining what types of instruments or embedded features in an instrument held by a reporting entity can be considered indexed to its own stock for the purpose of evaluating the first criteria of the scope exception in the pronouncement on accounting for derivatives. This pronouncement was effective for financial statements issued for fiscal years beginning after December 15, 2008. The adoption of these requirements can affect the accounting for warrants and many convertible instruments with provisions that protect holders from a decline in the stock price (or “down-round” provisions). For example, warrants or conversion features with such provisions are no longer recorded in equity. Down-round provisions reduce the exercise price of a warrant or convertible instrument if a company either issues equity shares for a price that is lower than the exercise price of those instruments or issues new warrants or convertible instruments that have a lower exercise price.

As of December 31, 2013, the Company had outstanding 7% convertible notes for $1,850,000 that the Company determined were a derivative liability due to the “reset” clause associated with the note’s conversion price. The Company had valued the derivative liability of these notes at $9,324,000 using the Black-Scholes-Merton option pricing model. 

As of June 30, 2014, the Company had outstanding 7% convertible notes for $625,000 that the Company determined were a derivative liability due to the “reset” clause associated with the note’s conversion price. The Company valued the derivative liability of these notes at $2,473,849 using the Black-Scholes-Merton option pricing model, which approximates the Monte Carlo and other binomial valuation techniques, with the following assumptions (i) dividend yield of 0%; (ii) expected volatility of 177%; (iii) risk free rate of 0.03%, (iv) stock price of $0.11, (v) per share conversion price of $0.025, and (vi) expected term of 11 months, as the Company estimates that these notes will be converted by December 31, 2014.

The risk-free rate of return reflects the interest rate for the United States Treasury Note with similar time-to-maturity to that of the warrants.  

				Carrying
	Fair Value Measurements Using Inputs			Amount at
Financial Instruments	Level 1	Level 2	Level 3	June 30, 2014
Liabilities:
Derivative Instruments - Warrants	$                         -	$            2,473,849	$                         -	$                    2,473,849
Total	$                         -	$            2,473,849	$                         -	$                    2,473,849

For the six months ended June 30, 2014, the Company recorded a non-cash loss of $13,310,855 related to the “change in fair value of derivative” expense, all of which was related to its 7% convertible notes.