11. DERIVATIVE LIABILITY

9 Months Ended

Sep. 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 September 30, 2014, the Company had outstanding unsecured 7% convertible notes for $500,000 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 $3,830,034 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 200%; (iii) risk free rate of 0.78%, (iv) stock price of $0.05, (v) per share conversion price of $0.007, and (vi) expected term of 8 months to one year, as the Company estimates that these notes will be converted by June 25, 2015 to September 30, 2015.

As of September 30, 2014, the Company had outstanding unsecured 6% convertible notes for $350,000 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 $2,277,951 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 200%; (iii) risk free rate of 0.78%, (iv) stock price of $0.08-0.11, (v) per share conversion price of $0.007, and (vi) expected term of 1.9-1.96 years.

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.  

	Fair Value Measurements Using Inputs						Carrying Amount at September 30,
Financial Instruments	Level 1		Level 2		Level 3		2014
Liabilities:
Derivative Instruments - Warrants	$	-	$	6,107,985	$	-	$	6,107,985
Total	$	-	$	6,107,985	$	-	$	6,107,985

For the nine months ended September 30, 2014, the Company recorded a non-cash gain of $3,216,015 related to the “change in fair value of derivative” expense related to its 6% and 7% convertible notes.