10-Q 1 d627160d10q.htm 10-Q 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

Commission File Number 001-34689

 

 

CEREPLAST, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Nevada   91-2154289

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

2213 Killion Avenue

Seymour, Indiana

  47274
(Address of Principal Executive Office)   (Zip Code)

(812) 220-5400

(Registrant’s Telephone Number, Including Area Code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed 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  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 or Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨    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  ¨    No  x

The number of shares of common stock outstanding as of November 11, 2013 is 994,949,093

 

 

 


Table of Contents

CEREPLAST, INC.

FORM 10-Q

TABLE OF CONTENTS

 

     Page  
PART I—FINANCIAL INFORMATION   

Item 1. FINANCIAL STATEMENTS

     3   

CONSOLIDATED BALANCE SHEETS AT SEPTEMBER 30, 2013 AND DECEMBER 31, 2012

     3   

CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2013 AND 2012

     4   

CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2013 AND 2012

     5   

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

     6   

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     20   

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     28   

Item 4. CONTROLS AND PROCEDURES

     28   

PART II—OTHER INFORMATION

  

Item 1. LEGAL PROCEEDINGS

     30   

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     30   

Item 3. DEFAULTS UPON SENIOR SECURITIES

     30   

Item 4. MINE SAFETY DISCLOSURES

     30   

Item 5. OTHER INFORMATION

     30   

Item 6. EXHIBITS

     31   

SIGNATURES

     32   

Exhibit 31.1

  

Exhibit 31.2

  

Exhibit 32.1

  

Exhibit 32.2

  

EX-101 INSTANCE DOCUMENT

  

EX-101 SCHEMA DOCUMENT

  

EX-101 CALCULATION LINKBASE DOCUMENT

  

EX-101 LABELS LINKBASE DOCUMENT

  

EX-101 PRESENTATION LINKBASE DOCUMENT

  

EX-101 DEFINITION LINKBASE DOCUMENT

  

Unless otherwise indicated or unless the context requires otherwise, all references in this report to “we,” “us,” “our,” “Cereplast” or the “Company” shall refer to Cereplast, Inc.

 

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Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

CEREPLAST, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except shares data)

 

     September 30, 2013     December 31, 2012  
     (Unaudited)        

ASSETS

    

Current Assets

    

Cash

   $ 233      $ 183   

Accounts Receivable, Net

     1,021        149   

Inventory, Net

     5,722        6,941   

Prepaid Expenses and Other Current Assets

     199        227   
  

 

 

   

 

 

 

Total Current Assets

     7,175        7,500   
  

 

 

   

 

 

 

Property and Equipment

    

Property and Equipment

     11,152        11,601   

Accumulated Depreciation and Amortization

     (4,660     (4,004
  

 

 

   

 

 

 

Property and Equipment, Net

     6,492        7,597   
  

 

 

   

 

 

 

Other Assets

    

Restricted Cash

     —         43   

Deferred Loan Costs

     350        750   

Intangible Assets, Net

     239        245   

Deposits

     48        47   
  

 

 

   

 

 

 

Total Other Assets

     637        1,085   
  

 

 

   

 

 

 

Total Assets

   $ 14,304      $ 16,182   
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ DEFICIT

    

Current Liabilities

    

Accounts Payable

   $ 920      $ 803   

Accrued Expenses

     3,386        3,663   

Capital Leases, Current Portion

     97        85   

Loan Payable, Current Portion

     6,224        5,978   

Convertible Subordinated Notes, Current Portion

     1,122        891   

Derivative Liability

     15,142        3,189   

Preferred Stock, $0.001 par value; 5,000,000 shares authorized, 490 and 92 shares issued and outstanding at September 30, 2013 and December 31, 2012, respectively

     2,213        500   
  

 

 

   

 

 

 

Total Current Liabilities

     29,104        15,109   
  

 

 

   

 

 

 

Long-Term Liabilities

    

Loan Payable

     —          923   

Convertible Subordinated Notes

     7,500        10,000   

Capital Leases, Long-Term

     120        173   
  

 

 

   

 

 

 

Total Long-Term Liabilities

     7,620        11,096   
  

 

 

   

 

 

 

Total Liabilities

     36,724        26,205   
  

 

 

   

 

 

 

Shareholders’ Deficit

    

Common Stock, $0.001 par value; 2,000,000,000 shares authorized; 810,757,671 and 63,463,659 shares issued and outstanding at September 30, 2013 and December 31, 2012, respectively

     811        63   

Common Stock Subscribed, not issued

     1,358        —    

Additional Paid in Capital

     96,416        76,919   

Accumulated Deficit

     (121,136     (87,097

Accumulated Other Comprehensive Income

     127        88   
  

 

 

   

 

 

 

Total Shareholders’ Deficit

     (22,424     (10,027

Noncontrolling Interests

     4        4   
  

 

 

   

 

 

 

Total Shareholders’ Deficit

     (22,420     (10,023
  

 

 

   

 

 

 

Total Liabilities and Shareholders’ Deficit

   $ 14,304      $ 16,182   
  

 

 

   

 

 

 

See accompanying notes to unaudited consolidated financial statements.

 

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Table of Contents

CEREPLAST, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME

(unaudited, in thousands, except per share data)

 

     Three Months Ended     Nine Months Ended  
     September 30, 2013     September 30, 2012     September 30, 2013     September 30, 2012  

GROSS SALES

   $ 438      $ 481      $ 2,135      $ 786   

Sales Discounts, Returns and Allowances

     (2     (4     (3     (16
  

 

 

   

 

 

   

 

 

   

 

 

 

NET SALES

     436        477        2,132        770   

COST OF GOOD SOLD

     382        473        1,880        861   
  

 

 

   

 

 

   

 

 

   

 

 

 

GROSS PROFIT (LOSS)

     54        4        252        (91

OPERATING EXPENSES:

        

Research and Development

     75        115        295        371   

Selling, General and Administrative

     1,134        6,847        3,796        10,518   

Impairment of Long-Lived Assets

     547        —         547       —    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Operating Expenses

     1,756        6,962        4,638        10,889   
  

 

 

   

 

 

   

 

 

   

 

 

 

OPERATING LOSS

     (1,702     (6,958     (4,386     (10,980

Debt Extinguishment

     (1,065           (2,821     (427

Change in Derivative Liabilities

     (2,392     47        (21,629     (52

Interest and Other Income

     —         —         —         18   

Interest Expense

     (2,112     (3,057     (5,203     (4,834
  

 

 

   

 

 

   

 

 

   

 

 

 

LOSS BEFORE PROVISION FOR INCOME TAXES

     (7,271     (9,968     (34,039     (16,275

Provision for Income Taxes

     —         —         —         —    
  

 

 

   

 

 

   

 

 

   

 

 

 

NET LOSS

     (7,271     (9,968     (34,039     (16,275

Gain (Loss) on Foreign Currency Translation

     89       (95     39       26   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Comprehensive Loss

   $ (7,182   $ (10,063   $ (34,000   $ (16,249
  

 

 

   

 

 

   

 

 

   

 

 

 

NET LOSS PER SHARE - BASIC AND DILUTED

   $ (0.01   $ (0.40   $ (0.07   $ (0.77
  

 

 

   

 

 

   

 

 

   

 

 

 

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, BASIC AND DILUTED

     731,817,081        24,739,449        482,042,209        21,242,115   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to unaudited consolidated financial statements.

 

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CEREPLAST, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands, except shares data)

 

     Nine Months Ended  
     September 30, 2013     September 30, 2012  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net Loss

   $ (34,039   $ (16,275

Adjustment to Reconcile Net Loss to Net Cash Used in Operating Activities

    

Depreciation and Amortization

     665        536   

Allowance for Doubtful Accounts

     3        5,082   

Common Stock Issued for Services, Salaries and Wages

     171        160   

Amortization of Loan Discount

     4,230        3,223   

Extinguishment of Convertible Debt

     2,821        368   

Loss on Derivative Liabilities

     21,629        52   

Impairment of Long-Lived Assets

     547        —    

Changes in Operating Assets and Liabilities

    

Accounts Receivable

     (875     537   

Deferred Loan Costs

     400        458   

Inventory

     1,219        814   

Prepaid Expenses and Other Current Assets

     28        (171

Restricted Cash

     43        —    

Accounts Payable

     116        659   

Accrued Expenses

     749        288   
  

 

 

   

 

 

 

NET CASH USED IN OPERATING ACTIVITIES

     (2,293     (4,269
  

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Purchase of Property, Equipment, and Intangibles

     (3     (180

Proceeds from Sale of Equipment

     —         15   
  

 

 

   

 

 

 

NET CASH USED IN INVESTING ACTIVITIES

     (3     (165
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Payments on Capital Leases

     (41     (50

Payments made on Notes Payable

     (63     (603

Proceeds from Convertible Notes, Net of Issuance Costs

     63        600  

Proceeds from Issuance of Preferred Stock

     2,750        400   

Proceeds from Issuance of Common Stock and Subscriptions, Net of Issuance Costs

     (23     400  
  

 

 

   

 

 

 

NET CASH PROVIDED BY FINANCING ACTIVITIES

     2,686        747  
  

 

 

   

 

 

 

FOREIGN CURRENCY TRANSLATION

     (340     (16
  

 

 

   

 

 

 

NET INCREASE (DECREASE) IN CASH

     50        (3,703

CASH, BEGINNING OF PERIOD

     183        3,940   
  

 

 

   

 

 

 

CASH, END OF PERIOD

   $ 233      $ 237   
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

    

Cash Paid During the Year For:

    

Interest

   $ 960      $ 460   

Income Taxes

   $ —       $ —    

SUPPLEMENTAL DISCLOSURE OF NON-CASH TRANSACTIONS

    

During the nine months ended September 30, 2013, the Company issued 63,548,299 shares valued at $342 for a settlement agreement. The Company also issued 3,200,000 shares valued at $86 for services rendered and $60 of expense related to vesting of employee stock options for the same period. During the nine months ended September 30, 2012, the Company issued 84,478 shares valued at $88 to employees for service rendered during the period, 50,000 shares valued at $11 to a vendor for services rendered during the period and 9,587 shares valued at $10 for a settlement agreement. The Company also recognized $51 of expense related to vesting of employee stock options for the same period.

See accompanying notes to unaudited consolidated financial statements.

 

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2013

(Unaudited)

1. ORGANIZATION AND LINE OF BUSINESS

Organization

We were incorporated on September 29, 2001 in the State of Nevada under the name Biocorp North America Inc. On March 18, 2005, we filed an amendment to our certificate of incorporation to change our name to Cereplast, Inc.

Line of Business

We have developed and is commercializing proprietary bio-based resins through two complementary product families: Cereplast Compostables® resins which are compostable, renewable, ecologically sound substitutes for petroleum-based plastics, and Cereplast Sustainables™ resins (including the Cereplast Hybrid Resins product line), which replaces up to 90% of the petroleum-based content of traditional plastics with materials from renewable resources. Our resins can be converted into finished products using conventional manufacturing equipment without significant additional capital investment by downstream converters.

The demand for non-petroleum based, clean and renewable sources for materials, such as bioplastics, and the demand for compostable/biodegradable products are being driven globally by a variety of factors, including fossil fuel price volatility, energy security and environmental concerns. These factors have led to increased spending on clean and renewable products by corporations and individuals as well as legislative initiatives at national, state and local level.

We are a full-service resin solution provider uniquely positioned to capitalize on the rapidly increasing demand for sustainable and environmentally friendly alternatives to traditional plastic products.

We primarily conduct our operations through two product families:

 

    Cereplast Compostables® resins are compostable and bio-based, ecologically sound substitutes for petroleum-based plastics targeting primarily compostable bags, single-use food service products and packaging applications. We offer 13 commercial grades of Compostable resins in this product line. These resins are compatible with existing manufacturing processes and equipment making them a ready substitute for traditional petroleum-based resins. We commercially introduced our Compostable line in November 2006.

 

    Cereplast Sustainables™ resins are partially or fully bio-based, ecologically sound substitutes for fully petroleum-based plastics targeting primarily durable goods, packaging applications. We offer six commercial grades of Sustainable resins in this product line. These resins are compatible with existing manufacturing processes and equipment, making them a ready substitute for traditional petroleum-based resins. We commercially introduced our Sustainable line in late 2007 under the name “Cereplast Hybrid Resins®.”

 

    Cereplast Hybrid Resins® products replace up to 55% of the petroleum content in conventional plastics with bio-based materials such as industrial starches sourced from plants. The Hybrid resins line is designed to offer similar properties to traditional polyolefins such as impact strength and heat deflection temperature, and is compatible with existing converter processes and equipment. The Cereplast Hybrid Resins® line provides a viable alternative for brand owners and converters looking to partially replace petroleum-based resins in durable goods applications. Hybrid resins address this need in a wide range of markets, including automotive, consumer goods, consumer electronics, medical, packaging, and construction. We commercially introduced our first grade of Hybrid resin, Hybrid 150, at the end of 2007. We currently offer four commercial grades in this product line.

 

    Cereplast Algae Plastic® resins. In October of 2009 we announced that we have been developing a new technology to transform algae into bioplastics and intend to launch a new resin family containing algae-based materials that will complement our existing line of resins. The first commercial product with Cereplast Algae Plastic® resin is now being produced and sold as part of our Sustainables resin family. We believe that it is important to enhance research on non-food crops as we expect a surge in demand in bioplastics in future years, thus potentially creating pressure on food crops. Algae are the first non-food crop project that we have introduced and our R&D department is contemplating the development of additional non-food crop based materials in future years. In March 2013 the Company announced the incorporation of a wholly owned subsidiary Algaeplast, Inc. This new company will serve as vehicle to develop additional research on algae based plastic with the ultimate scope to create 100% algae based polymers.

Our patent portfolio is currently comprised of six patents in the United States (“U.S.”), one Mexican patent, and eight pending patent applications in the U.S. and abroad. Our trademark portfolio is currently comprised of approximately 45 registered marks and 21 pending applications in the U.S. and abroad.

 

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2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Consolidation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”). The unaudited consolidated financial statements include the financial condition and results of operations of our wholly-owned subsidiary, Cereplast International, S.A., a Luxembourg company organized during the year ended December 31, 2008, for the purpose of conducting sales operations in Europe. Intercompany balances and transactions have been eliminated in consolidation. The results of operations for interim periods are not necessarily indicative of the results that may be expected for a full year. These financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the accompanying financial statements. Significant estimates made in preparing these financial statements include the estimate of useful lives of property and equipment, the deferred tax valuation allowance and the fair value of stock options. Actual results could differ from those estimates.

Cash

We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. At various times throughout the year, we may have exceeded federally insured limits. At September 30, 2013 and December 31, 2012, balances in our cash accounts did not exceed federally insured limits of $0.25 million. We have not experienced any losses in such accounts and we do not believe we are exposed to any significant credit risk on cash and cash equivalents.

Concentration of Credit Risk

We had no unrestricted cash at September 30, 2013. We had unrestricted cash totaling $0.2 million at December 31, 2012. The unrestricted cash and cash equivalents are held for working capital purposes. We do not enter into investments for trading or speculative purposes. Some of the securities in which we invest, however, may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, debt securities and certificates of deposit. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. We actively monitor changes in interest rates.

Going Concern

We have incurred a net loss of $34.0 million for the nine months ended September 30, 2013, and $30.2 million for the year ended December 31, 2012, and have an accumulated deficit of $121.1 million as of September 30, 2013. Based on our operating plan, our existing working capital will not be sufficient to meet the cash requirements to fund our planned operating expenses, capital expenditures and working capital requirements through December 31, 2013 without additional sources of cash. This raises substantial doubt about our ability to continue as a going concern.

Our plan to address the shortfall of working capital is to generate additional cash through a combination of refinancing existing credit facilities, incremental product sales and raising additional capital through debt and equity financings. We are confident that we will be able to deliver on our plans, however, there are no assurances that we will be able to obtain any sources of financing on acceptable terms, or at all.

If we cannot obtain sufficient additional financing in the short-term, we may be forced to curtail or cease operations or file for bankruptcy. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should we be forced to take such actions.

Fair Value of Financial Instruments

The carrying amounts of our financial instruments as of September 30, 2013 and December 31, 2012, which include cash, accounts receivable, unbilled receivable, accounts payable, accrued expenses, loans payable and convertible subordinated notes approximate their fair values due to the short-term nature of these instruments.

 

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Accounts Receivable

We maintain an allowance for doubtful accounts for estimated losses that may arise if any of our customers are unable to make required payments. Management performs a quantitative and qualitative review of the receivables past due from customers on a monthly basis. Quantitative factors include customer’s past due balance, prior payment history, recent sales activity and days sales outstanding. Qualitative factors include macroeconomic environment, current product demand, estimated inventory levels and customer’s financial position. For our accounts receivable balances that have been fully reserved, we may have access to repossess unsold products held at customer locations as recourse for payment defaults. The fair market value of these products are considered as potential recovery in estimating net losses from uncollectible accounts. We record an allowance against uncollectible items for each customer after all reasonable means of collection have been exhausted, and the potential for recovery is considered remote. The allowance for doubtful accounts was approximately $0 and $15.0 million as of September 30, 2013 and December 31, 2012, respectively.

Inventory

Inventories are stated at the lower of cost (first-in, first-out basis) or market, and consist primarily of raw materials used in the manufacturing of bioplastic resins, finished bioplastic resins and finished goods. Inventories are reviewed for excess and obsolescence and a reserve is established accordingly. As of September 30, 2013 and December 31, 2012, inventories consisted of the following (in thousands):

 

     September 30, 2013     December 31, 2012  
     (Unaudited)        

Raw Materials

   $ 1,961      $ 1,950   

Bioplastic Resins

     3,853        5,082   

Finished Goods

     41        42   

Packaging Materials

     66        66   

WIP

     —         —    

Obsolescence Reserve

     (199     (199
  

 

 

   

 

 

 

Inventory, net

   $ 5,722      $ 6,941   
  

 

 

   

 

 

 

Property and Equipment

Property and equipment are stated at cost, and depreciation is computed on the straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are between five and seven years. Repairs and maintenance expenditures are charged to expense as incurred. During the three months ended September 30, 2013, we recorded in an impairment of $0.5 million on our Building in Italy to adjust its net book value to equal the carrying value of its related mortgage to reflect our current dispute with the seller, as disclosed in Note 4. Property and Equipment consist of the following (in thousands):

 

     September 30, 2013     December 31, 2012  
     (Unaudited)        

Equipment

   $ 5,732      $ 5,732   

Building

     3,835        4,218   

Construction In Progress

     1,189        1,255   

Auto

     12        12   

Furniture and Fixtures

     297        297   

Leasehold Improvements

     87        87   
  

 

 

   

 

 

 
     11,152        11,601   

Accumulated Depreciation

     (4,660     (4,004
  

 

 

   

 

 

 

Property and Equipment, Net

   $ 6,492      $ 7,597   
  

 

 

   

 

 

 

Intangible Assets

Intangible assets are stated at cost and consist primarily of patents and trademarks. Amortization is computed on the straight-line method over the estimated life of these assets, estimated to be between five and fifteen years. Intangible assets consist of the following (in thousands):

 

     September 30, 2013     December 31, 2012  
     (Unaudited)        

Intangible Assets

   $ 296      $ 294   

Accumulated Amortization

     (57     (49
  

 

 

   

 

 

 

Intangible Assets, Net

   $ 239      $ 245   
  

 

 

   

 

 

 

 

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Deferred Income Taxes

Deferred income taxes are provided using the liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of the changes in tax laws and rates of the date of enactment.

The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the statement of income.

Revenue Recognition

We recognize revenue at the time of shipment of products, when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the price to the customer is fixed or determinable; and (iv) collection of the sales price is probable.

Certain of our product sales are made to distributors under agreements with generally the same terms of sale and credit as all other customer agreements. Revenue from product sales to our customers, including our customers who are distributors, is recognized upon shipment provided the above noted fundamental criteria of revenue recognition are met. The sale of products to our customers who are distributors is not contingent upon the distributor selling the product to the end-user, and our current agreements with distributors do not have any rights of return.

Impairment of Long-Lived Assets

We evaluate long-lived assets for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. Factors we consider include:

 

    Significant changes in the operational performance or manner of use of acquired assets or the strategy for our overall business,

 

    Significant negative market conditions or economic trends, and

 

    Significant technological changes or legal factors which may render the asset obsolete.

We evaluate long-lived assets based upon an estimate of future undiscounted cash flows. Recoverability of these assets is measured by comparing the carrying value to the future net undiscounted cash flows expected to be generated by the asset. An impairment loss is recognized when the carrying value exceeds the undiscounted future cash flows estimated to result from the use and eventual disposition of the asset. Future net undiscounted cash flows include estimates of future revenues and expenses which are based on projected growth rates. We continually use judgment when applying these impairment rules to determine the timing of the impairment tests, the undiscounted cash flows used to assess impairments and the fair value of a potentially impaired asset. The reasonableness of our judgment could significantly affect the carrying value of our long-lived assets.

During fiscal year 2012, and continuing through the third quarter of fiscal 2013, we experienced a significant decline in sales volume due to liquidity and sales resource constraints, which we believe to be temporary. Our reduced production volume has not changed the manner in which we use our equipment, nor its physical condition. Our current estimate of future net undiscounted cash flows indicates that the carrying value of our long-lived assets is recoverable and therefore no impairment is recorded for equipment.

During the third quarter of 2013, Cereplast Italia is in default with its mortgage payable related to our building in Italy. We have recorded an impairment of $0.5 million to adjust the carrying value of our building to equal the outstanding value of its related mortgage to reflect our potential loss exposure based on this default.

Derivative Financial Instruments

Our derivative financial instruments consist of embedded and free-standing derivatives related primarily to the convertibles notes. The embedded derivatives include the conversion features, and liquidated damages clauses in the registration rights agreement. The accounting treatment of derivative financial instruments requires that we record the derivatives and related warrants at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. The recorded value of all derivatives at September 30, 2013 totaled approximately $15.1 million. Any change in fair value of these instruments will be recorded as non-operating, non-cash income or expense at each reporting date. If the fair value of the derivatives is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives is lower at the subsequent balance sheet date, the Company will record non-operating, non-cash income. At September 30, 2013, derivatives were valued primarily using the Black-Scholes Option Pricing Model.

 

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Comparative Figures

Certain of the prior year figures have been reclassified to conform to the presentation adopted in the current year.

3. CAPITAL STOCK

Capital Stock Issued

During the nine months ended September 30, 2013, we issued shares of common stock as follows:

 

    We issued 317,251,420 shares of common stock valued at $8.7 million, pursuant to exchange agreements.

 

    We issued 361,294,293 shares of common stock valued at $12.5 million, in connection with the conversion of 141 shares of Series A Preferred Stock.

 

    We issued 63,548,299 shares of common stock valued at approximately $342,000 pursuant to settlement agreements.

 

    We issued 2,000,000 shares of common stock valued at approximately $60,000 in stock-based compensation.

 

    We issued 3,000,000 shares of common stock valued at approximately $83,700 for consultant fees.

 

    We issued 200,000 shares of common stock valued at approximately $2,000 for lender fees.

We have issued 184.2 million shares of common stock since September 30, 2013, as follows:

 

    176.7 million shares of common stock pursuant to conversion of our Series A Preferred Stock.

 

    7.5 million shares of common stock valued at approximately $97,500 for consultant fees.

Valuation Assumptions for Stock Options

During the year ended December 31, 2011, we granted options to our employees to purchase an aggregate of 300,000 shares of our common stock, with estimated total grant-date fair values of $0.7 million. We estimate that stock-based compensation for awards not expected to be exercised is $0.2 million. During the nine months ended September 30, 2013 and September 30, 2012, we recorded stock-based compensation related to stock options of $60,000 and $51,000, respectively. The grant date fair value was estimated at the date of grant using the Black-Scholes option pricing model, assuming no dividends and the following assumptions:

 

     January 14, 2011  

Average risk-free interest rate

     2.29

Average expected life (in years)

     6.0   

Volatility

     41.9

 

    Expected Volatility: The fair values of stock based payments were valued using a volatility factor based on our historical stock prices.

 

    Expected Term: We elected to use the “simplified method” as discussed in SAB No. 107 to develop the estimate of the expected term.

 

    Expected Dividend: We have not paid any dividends and do not anticipate paying dividends in the foreseeable future.

 

    Risk-Free Interest Rate: We base the risk-free interest rate used on the implied yield currently available on U.S. Treasury zero-coupon issues with remaining term equivalent to the expected term of the options.

 

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Stock Option Activity

Under the 2004 Employee Stock Option Plan adopted by our board of directors (the “Plan”), our board of directors may issue incentive and non-qualified stock options to our employees. Options granted under the Plan generally expire at the end of five or ten years and vest in accordance with a vesting schedule determined by our board of directors, usually over three years from the grant date. As of September 30, 2013, we have 34,375 shares available for future grants under the Plan. We settle stock option exercises with newly issued shares of our common stock (in thousands except, per share data):

 

     2013      2012  
     Shares     Weighted
Average
Exercise Price
     Shares      Weighted
Average
Exercise Price
 

Outstanding—January 1

     204      $ 5.62         373       $ 8.65   

Granted at fair value

     —         —          —           —     

Exercised

     —          —           —           —     

Cancelled/forfeited

     (200 )     —           —           —     
  

 

 

      

 

 

    

Outstanding—September 30

     4        22.40         373         8.65   
  

 

 

      

 

 

    

Options exercisable at September 30

     4      $ 22.40         193       $ 11.77   
  

 

 

      

 

 

    

The following table summarizes information about stock options as of September 30, 2013, (in thousands, except per share data):

 

     Options Outstanding      Options Exercisable  

Range of Exercise Prices

   Shares      Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contract
Life
     Aggregate
Intrinsic
Value
     Shares      Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contract
Life
     Aggregate
Intrinsic
Value
 

$5.32—$22.40

     4       $ 22.40         1.42       $ —           4       $ 22.40         1.42       $ —     

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing stock price of $0.01 at September 30, 2013 which would have been received by the option holders had all option holders exercised their options as of that date.

Preferred Stock

On August 24, 2012, we entered into a Stock Purchase Agreement (“SPA”) with Ironridge Technology Co., a division of Ironridge Global IV, Ltd, for the sale of up to $5 million in shares of convertible redeemable Series A Preferred Stock (“Series A Preferred Stock”). The closing of the transactions contemplates the fulfillment of certain closing conditions. The initial closing with respect to the sale of 30 shares of Series A Preferred Stock occurred on August 24, 2012.

On August 24, 2012, we filed a Certificate of Designation of Preferences, Rights and Limitations of Series A Preferred Stock (“Certificate of Designation”) with the Secretary of State of Nevada. The Certificate of Designation provides that the Series A Preferred Stock ranks senior with respect to dividend and rights upon liquidation to the Company’s common stock and junior to all existing and future indebtedness. Except as otherwise required by law, the Series A Preferred Stock shall have no voting rights. The Certificate of Designation provides for the payment of cumulative dividends at a rate of 2.5% per annum when and if declared by the Board of Directors in its sole discretion. Dividends and any Embedded Derivative Liability (as defined in the Certificate of Designation) may be paid in cash or free trading shares of the Company as provided in the Certificate of Designation.

Unless we have received the approval of the holders of a majority of the Series A Preferred Stock then outstanding, we shall not (i) alter or change adversely the powers, preferences or rights of the holders of the Series A Preferred Stock or alter or amend the Certificate of Designation; (ii) authorize or create any class of stock ranking senior as to distribution of dividends senior to the Series A Preferred Stock; (iii) amend its certificate of incorporation in breach of any provisions of the Certificate of Designation; increase the authorized number of Series A Preferred Stock; (iv) liquidate, or wind-up the business and affaires of the Corporation or effect any Deemed Liquidation Event, as defined in the Certificate of Designation.

Upon any liquidation, dissolution or winding up of the Company, after payment or provision for payment of debts and other liabilities of the Company, the holders of Series A Preferred Stock shall be entitled to receive, pari passu with any distribution to the holders of Common Stock of the Company, an amount equal to $10,000 per share of Series A Preferred Stock plus any accrued and unpaid dividends.

Upon or after 18 years after the Issuance Date, the Corporation will have the right to redeem 100% of the Series A Preferred Stock at a price of $10,000 per share plus any accrued and unpaid dividends (the “Corporation Redemption Price”). We are also permitted to redeem the Series A Preferred Stock at any time after issuance as provided in the Certificate of Designation. The Certificate of Designation also provides for mandatory redemption if the Company determines to liquidate, dissolve or wind-up its business and affects or effect any Deemed Liquidation Event as such term is defined in the Certificate of Designation.

 

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The Series A Preferred Stock may be converted into shares of common stock of the Company at the option of the Company or the holder. In the event of a conversion by the holder at a price per share equal to the sum of (a) the Corporation Redemption Price plus the Embedded Derivative Liability (as defined in the Certificate of Designation) less any dividends paid, multiplied by (b) the number of shares being converted, divided by (c) the conversion price of $0.25. On February 27, 2013, the holder elected to convert 50 shares of Series A Preferred Stock into shares of common stock. In accordance with the formula discussed above, 50 shares of Series A Preferred Stock converted into 190,888,889 shares of common stock. On June 17, 2013, the holder elected to convert 42 shares of Series A Preferred Stock into shares of common stock. In accordance with the formula discussed above, 42 shares of Series A Preferred Stock converted into 115,631,700 shares of common stock. On September 4, 2013, the holder elected to convert 49 shares of Series A Preferred Stock into shares of common stock. In accordance with the formula discussed above, 49 shares of Series A Preferred Stock converted into 134,821,492 shares of common stock. As of September 30, 2013, we issued 54,000,000 shares of common stock, while the remaining 80,821,492 shares were subscribed to the holder. In connection with the conversion, the Derivative Liability related to the 141 shares of Series A Preferred Stock, with a total value at the conversion date of $12.3 million, was reclassified into equity as a component of the common stock issued and subscribed. We estimated the fair value of the Series A Preferred Stock Embedded Derivative Liability and Series A Preferred Stock conversion option was $6.7 million and $30,000, respectively, at September 30, 2013. We estimated the fair value of the Embedded Derivative Liability using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   September 30, 2013  

Expected life

     0.6 years   

Expected volatility

     270.2

Dividends

     None   

Risk-free interest rate

     0.04

We estimated the fair value of the conversion option using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   September 30, 2013  

Expected life

     0.3 years   

Expected volatility

     125.0

Dividends

     None   

Risk-free interest rate

     0.02

4. LOANS PAYABLE AND CONVERTIBLE SUBORDINATED NOTES

Venture Loan Payable

On December 21, 2010, we entered into a Venture Loan and Security Agreement (the “Loan Agreement”) with Compass Horizon Funding Company, LLC (the “Lender” or “Horizon”). The Loan Agreement provides for a total loan commitment of $5.0 million (“the Loan”) comprising of Loan A and Loan B, each in the amount of $2.5 million. Loan A was funded at closing on December 21, 2010 and matures 39 months after the date of advance. Loan B was funded on February 17, 2011 and also matures 39 months after the date of advance. We are obligated to pay interest per annum equal to the greater of (a) 12% or (b) 12% plus the difference between (i) the one month LIBOR Rate in effect on the date preceding the funding of such loan by five business days and (ii) .30%. We are required to make interest only payments for the first nine months of each loan and equal payments of principal over the final thirty months of each loan. We granted a security interest in all of our assets to the Lender.

In connection with Loan Agreements, we issued a seven year warrant to the Lender to purchase 140,000 shares of our common stock at an exercise price of $4.40. The relative fair value of the warrants was $0.2 million and is being recorded as interest expense over the term of the Loan. We estimated the fair value of the warrants using the Black-Scholes option pricing model using the following assumptions:

 

     December 22, 2010  

Assumptions:

  

Expected Life

     7 years   

Expected volatility

     39.9

Dividends

     None   

Risk-free interest rate

     2.74

Also in connection with the Loan Agreement, we incurred $0.4 million of debt issue costs which were deferred and are being amortized to interest expense over the term of the loan.

On June 29, 2012, we amended the Loan Agreement (the “Amendment”) to change the Maturity Date to the earlier to occur of (i) August 1, 2014, or (ii) the date of acceleration of a Loan following an event of default or the date of prepayment of the Loan. In addition, the definition of Scheduled Payments was amended. The definition of Events of Default was expanded to include the failure to pay certain late fees and amendment fees, which were agreed upon among the parties.

 

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In connection with the Amendment, we issued a warrant to Horizon representing the right to purchase 225,000 shares of our common stock at an exercise price of $0.01 per share (the “New Warrant”). In addition, we issued a restated and amended warrant to purchase 140,000 shares of the Company’s common stock at an exercise price of $0.26 (the “Amended Warrant”). The relative fair value of the New Warrant was $117,000. The difference between the fair value of the Amended Warrant immediately before and after the modification was $32,000. These amounts were recorded as a debt discount and are being recorded as interest expense over the remaining term of the loan. We estimated the fair value of the New and Amended Warrants using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   May 1, 2012  

Expected life

     7 years   

Expected volatility

     88.2

Dividends

     None   

Risk-free interest rate

     1.35

Convertible Subordinated Notes

On May 24, 2011, we issued $12.5 million in aggregate principal amount of 7% Senior Subordinated Convertible Notes due June 1, 2016 (the “Notes”). The Notes were issued pursuant to an indenture (the “Indenture”), entered into between us and Wells Fargo Bank, National Association, as trustee, on May 24, 2011. In connection with the issuance of the Notes, we entered into a Waiver to our Venture Loan and Security Agreement with Horizon, dated May 18, 2011 pursuant to which Horizon provided its consent to the offering of the Notes and waived any restrictions in the Loan Agreement.

The Notes are senior subordinated unsecured obligations which will rank subordinate in right to payment to all of our existing and future senior secured indebtedness and bear interest at a rate of 7% per annum payable semi-annually in arrears on June 1 and December 1 of each year, commencing on December 1, 2011. The Notes mature on June 1, 2016, with an early repurchase date of June 15, 2014 at the option of the purchaser. The Notes are convertible into shares of our common stock in accordance with the terms of the Notes and the Indenture, at the initial conversion rate of 172.4138 shares of our common stock per $1,000 principal amount of Notes, equivalent to a conversion price of approximately $5.80 per share, subject to adjustment. If the Notes are converted into shares of our common stock prior to June 2, 2014, an interest make-whole payment will be due based on the conversion date up until June 2, 2014. Upon a non-stock change in control, additional shares of our common stock may need to be issued upon conversion, with a maximum additional shares of 25.606 per $1,000 in principal amount of Notes being issuable thereunder, for a total maximum of 198.0198 shares per $1,000 Note. Certain customary anti-dilution provisions included in the Indenture and/or the Notes could adjust the conversion rate.

The conversion feature within the Notes is not considered to be a beneficial conversion feature within the meaning of Accounting Standards Codification (“ASC”) 470, Debt, and therefore all of the gross proceeds from the Notes have been classified as long term debt. In connection with the issue of the Notes, we incurred approximately $1.3 million of debt issue costs which were deferred and are being amortized to interest expense over the term to the early repurchase date of June 15, 2014.

Also in connection with the issuance of the Notes, we entered into a Securities Purchase Agreement dated May 18, 2011 pursuant to which we agreed to prepare and file a registration statement with the Securities and Exchange Commission (the “SEC”) registering the resale of the Notes and the shares of common stock underlying the Notes. The registration statement was declared effective on August 10, 2011.

On June 1, 2012, we entered into an Exchange Agreement and a Forbearance Agreement with certain of the holders of our Notes. Pursuant to the terms of the Exchange Agreement, certain of the holders agreed to exchange the Notes for shares at an exchange rate of one share of our common stock for each $1.00 amount of the Notes exchanged.

Pursuant to the terms of the Forbearance Agreement, certain of the holders agreed to forbear from exercising their rights to require us to pay accrued interest on June 1, 2012 until the earlier of December 1, 2012 or our failure to meet certain milestones. In addition, pursuant to the terms of the Forbearance Agreement, we agreed to amend the conversion rate of the Notes as set forth in the Indenture to provide for an effective conversion rate of $1.00.

On January 25, 2013, we entered into an Exchange Agreement with IBC Funds, LLC (“IBC Funds”) in connection with Purchase Agreements between IBC Funds and certain Noteholders, to purchase up to $2.0 million of Notes through November 2013. Total purchases by IBC Funds in the nine months ended September 30, 2013 were $2.5 million.

At September 30, 2013 the Notes were convertible into 7,500,000 shares of our common stock.

 

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Short-Term Convertible Notes

The total amount of Short-Term Convertible Notes Payable as of September 30, 2013 was $2.1 million, offset by discounts totalling $977,000. The total amount of Short-Term Convertible Notes Payable as of December 31, 2012 was $1.3 million, offset by discounts totalling $451,000. These Notes are comprised of the following:

 

    From June 1, 2012 through January 17, 2013, we issued Convertible Promissory Notes to Asher Enterprises, Inc. (the “Asher Notes”) with a remaining principal amount of $213,000 and bearing 8% annual interest. The Asher Notes have maturity dates between September 13, 2013 and October 17, 2013 with repayment options from 100% to 135% of the principal amount beginning 90 days from each issuance date. The holder has the option to convert the principal and accrued interest into shares of our Company stock at a conversion price calculated as 70% of the average of the five lowest trading prices for our common stock during the 90 days prior to the conversion date. Proceeds from the Asher Notes were used to fund Company operations.

 

    On June 26, 2012, we issued a Promissory Note to JMJ Financial (the “JMJ Note”) of up to $1.1 million, which bears 0% interest if repaid at maturity. The JMJ Note has a maturity date of 180 days from the effective date of each funding. The principal amount due to JMJ Financial (“JMJ”) was prorated based on the consideration actually paid by JMJ, plus an approximate 10% Original Issue Discount (“OID”) that is prorated based on the consideration actually paid by JMJ as well as any other interest or fees. In addition, we will issue 100% warrant coverage for each amount funded under the JMJ Note. In addition, JMJ has the right, at any time at its election, to convert all or part of the outstanding and unpaid principal and any other fees, into shares of fully paid and non-assessable shares of our common stock. The conversion price is a variable calculation of 80% of the average of the three lowest closing prices for our common stock during the 20 days prior to the conversion date. We are only required to repay the amount funded and we are not required to repay any unfunded portion of the JMJ Note.

 

    The consideration received as through September 30, 2013 is $400,000, in exchange for a principal amount of $440,000 and issuance of 1,886,792 warrants (“the JMJ Warrants”) with an exercise price of $0.21, which may be reset if securities are issued for less than $0.21. For financial accounting purposes, the JMJ Warrants and conversion feature embedded in the JMJ Note were considered derivatives. The fair values of the JMJ Warrants and JMJ Note conversion features were estimated at inception and recorded as a debt discount and is being recorded to interest expense over the life of the JMJ Note. The derivatives will be valued at each reporting date and the change in estimated fair value will result in a gain or loss recorded in the statement of operations. The estimated grant date fair value of the JMJ Warrants and JMJ Note conversion were $198,113 and $187,195, respectively. We estimated the fair value of the JMJ Warrants and JMJ Note conversion features using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   June 26, 2012     August 9, 2012  

Expected life

     4 years        4 years   

Expected volatility

     95.4     97.7

Dividends

     None        None   

Risk-free interest rate

     0.59     0.66

 

    The estimated fair value of the JMJ Warrants and JMJ Note conversion features was $1.2 million and $153,393, respectively, at September 30, 2013. We estimated the fair value of the JMJ Warrants and JMJ Note conversion feature at September 30, 2013 using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   September 30, 2013  

Expected life

     2.7 years   

Expected volatility

     180.7

Dividends

     None   

Risk-free interest rate

     0.63

 

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    On October 15, 2012, we entered into an Exchange Agreement (the “Exchange Agreement”) with Magna Group LLC (“Magna”), pursuant to which we agreed to issue to Magna convertible notes (the “Magna Notes”), in the aggregate principal amount of up to $4.6 million, in exchange for an equal amount of participation interests in certain secured promissory notes (the “Secured Notes”) issued by us to Horizon to be acquired by Magna. Pursuant to a participation purchase agreement dated as of October 15, 2012 (the “Magna Purchase Agreement”), Magna agreed to acquire, in tranches through on or around February 15, 2013, participation interests in the Secured Notes from Horizon up to the maximum amount of the principal outstanding, together with accrued interest and fees. The total issuances in 2012 were $1.0 million under the Exchange Agreement, pursuant to which we issued a Magna Note in exchange for a participation interest in a Secured Note. The Magna Notes bear interest at the rate of 6% per annum and mature 12 months after the date of issuance. The Magna Notes are convertible at the option of the holder at a conversion price equal to 75% of the average of the three lowest volume weighted average prices during the ten consecutive trading day period immediately prior to the date of conversion. The Magna Notes contain standard default provisions and provisions for adjustment of the conversion price in the event of subsequent equity sales. For financial accounting purposes, the conversion feature embedded in the Magna Notes were considered derivatives. The fair values of the Magna Notes conversion features were estimated at inception and recorded as a debt discount and is being recorded to interest expense over the life of the Magna Notes. The derivatives will be valued at each reporting date and the change in estimated fair value will result in a gain or loss recorded in the statement of operations. The estimated fair value of the Magna Notes conversion were $198,113. We estimated the fair value of the Magna Notes conversion feature using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   October 15, 2012     November 8, 2012  

Expected life

     1 year        1 year   

Expected volatility

     155.6     125.9

Dividends

     None        None   

Risk-free interest rate

     0.19     0.20

 

    The estimated fair value of the Magna Notes conversion features was $35,000 at September 30, 2013. We estimated the fair value of the Magna Notes conversion feature at September 30, 2013 using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   September 30, 2013  

Expected life

     0.3 years   

Expected volatility

     125.0

Dividends

     None   

Risk-free interest rate

     0.02

 

    On October 15, 2012, we entered into a Note Purchase Agreement (the “Hanover Purchase Agreement”) with Hanover Holding I, LLC (“Hanover”), pursuant to which Hanover agreed to purchase from us, and we agreed to sell to Hanover (subject to the terms and conditions set forth therein), an aggregate of $0.8 million of convertible promissory notes (the “Hanover Notes”). Subject to the terms and conditions set forth in the Hanover Purchase Agreement, the Hanover Notes will be sold in tranches of $100,000 through on or around February 15, 2013. The total issuances in 2012 were $0.3 million under the Hanover Purchase Agreement. The Hanover Notes bear interest at the rate of 12% per annum and mature eight months after issuance. The Hanover Notes are convertible at the option of the holder at a price equal to 75% of the average of the three lowest volume weighted average prices during the ten consecutive trading day period immediately prior to the date of conversion. The Hanover Notes contain standard default provisions and provisions for adjustment for the conversion price in the event of subsequent equity sales. For financial accounting purposes, the conversion feature embedded in the Hanover Notes were considered derivatives. The fair values of the Hanover Notes conversion features were estimated at inception and recorded as a debt discount and is being recorded to interest expense over the life of the Hanover Notes. The derivatives will be valued at each reporting date and the change in estimated fair value will result in a gain or loss recorded in the statement of operations. The estimated fair value of the Hanover Notes conversion were $204,498. We estimated the fair value of the Hanover Notes conversion feature using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   October 15, 2012     November 8, 2012     November 8, 2012  

Expected life

     0.7 years        0.7 years        0.7 years   

Expected volatility

     133.3     138.0     163.9

Dividends

     None        None        None   

Risk-free interest rate

     0.15     0.15     0.10

 

    The estimated fair value of the Hanover Notes conversion features was $152,000 at September 30, 2013. We estimated the fair value of the Hanover Notes conversion feature at September 30, 2013 using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   September 30, 2013  

Expected life

     0.3 years   

Expected volatility

     125.0

Dividends

     None   

Risk-free interest rate

     0.02

 

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    On January 28, 2013, we entered into an Exchange Agreement (the “Exchange Agreement”) with IBC Funds LLC (“IBC”), pursuant to which we agreed to issue to IBC convertible notes (the “IBC Notes”), in the aggregate principal amount of up to $2.0 million, in exchange for an equal amount of participation interests in certain subordinated convertible debentures (the “Subordinated Notes”). Pursuant to various note purchase agreements dated as of January 25, 2013 (the “IBC Purchase Agreement”), IBC agreed to acquire, in tranches through on or around November 28, 2013, participation interests in the Subordinated Notes up to $2.0 million. The total issuances in 2013 were $2.0 million under the Exchange Agreement, pursuant to which we issued an IBC Note in exchange for a participation interest in a Subordinated Notes. The IBC Notes bear interest at the rate of 8% per annum and mature 9 months after the date of issuance. The IBC Notes are convertible at the option of the holder at a conversion price equal to 65% of the three lowest bid price during the ten consecutive trading day period immediately prior to the date of conversion. The IBC Notes contain standard default provisions and provisions for adjustment of the conversion price in the event of subsequent equity sales. We are in default under the Exchange Agreement on the conversion of our outstanding promissory note with IBC on April 23, 2013 as there are no available shares to complete IBC’s request to convert the debt into non restricted stock. For financial accounting purposes, the conversion features embedded in the IBC Notes were considered derivatives. The fair values of the IBC Notes conversion features were estimated at inception and recorded as a debt discount and is being recorded to interest expense over the life of the IBC Notes. The derivatives will be valued at each reporting date and the change in estimated fair value will result in a gain or loss recorded in the statement of operations. The estimated fair value of the IBC Notes conversion feature were $2.8 million. We estimated the fair value of the IBC Notes conversion feature using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   January 28, 2013     February 8, 2013  

Expected life

     1 year        1 year   

Expected volatility

     226.5     247.4

Dividends

     None        None   

Risk-free interest rate

     0.16     0.14

 

    The estimated fair value of the IBC Notes conversion features was $182,000 at September 30, 2013. We estimated the fair value of the IBC Notes conversion feature at September 30, 2013 using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   September 30, 2013  

Expected life

     0.9 years   

Expected volatility

     270.2

Dividends

     None   

Risk-free interest rate

     0.10

 

    On March 8, 2013, we entered into an Exchange Agreement (the “Exchange Agreement”) with Ironridge Global IV, Ltd. (“Ironridge”), pursuant to which we agreed to issue to Ironridge convertible notes (the “Ironridge Notes”), in the aggregate principal amount of up to $4.0 million, in exchange for an equal amount of participation interests in certain secured promissory notes (the “Secured Notes”) issued by us to Horizon to be acquired by Ironridge. Pursuant to a participation purchase agreement dated as of March 8, 2013 (the “Ironridge Purchase Agreement”), Ironridge agreed to acquire, in tranches through on or around June 1, 2014, participation interests in the Secured Notes from Horizon up to the maximum amount of the principal outstanding, together with accrued interest and fees. The total issuances in 2013 were $250,000 under the Exchange Agreement, pursuant to which we issued an Ironridge Note in exchange for a participation interest in a Secured Note. The Ironridge Notes do not bear interest and mature 12 months after the date of issuance. The Ironridge Notes are convertible at the option of the holder at a conversion price equal to 70% of the closing bid price on the trading day prior to the date of conversion, subject to certain conversion price limitations. For financial accounting purposes, the conversion feature embedded in the Ironridge Note was considered a derivative. The fair values of the Ironridge Notes conversion features were estimated at inception and recorded as a debt discount and is being recorded to interest expense over the life of the Ironridge Notes. The derivatives will be valued at each reporting date and the change in estimated fair value will result in a gain or loss recorded in the statement of operations. The estimated fair value of the Ironridge Notes conversion feature was $588,095. We estimated the fair value of the Ironridge Notes conversion feature using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   March 8, 2013  

Expected life

     1 year   

Expected volatility

     249.0

Dividends

     None   

Risk-free interest rate

     0.15

 

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    The estimated fair value of the Ironridge Notes conversion features was $1.8 million at September 30, 2013. We estimated the fair value of the Ironridge Notes conversion feature at September 30, 2013 using the Black-Scholes option pricing model using the following assumptions:

 

Assumptions:

   September 30, 2013  

Expected life

     0.7 years   

Expected volatility

     214.6

Dividends

     None   

Risk-free interest rate

     0.10

Mortgage Payable

Effective October 24, 2011, Cereplast Italia S.p.A (“Cereplast Italia”), our wholly owned subsidiary, completed its acquisition of an industrial plant and the real estate on which the industrial plant is located in Cannara, Italy. The Deed of Sale between Cereplast Italia and Societa Regionale Per Lo Sviluppo Economico Dell’Umbria — Sviluppumbria S.p.A, provided for an aggregate purchase price of approximately $6.5 million. The acquisition had previously been secured by a mortgage loan with Banca Monte Dei Paschi Di Sienna S.p.A for the principal of $4.5 million.

Effective October 25, 2012, Cereplast Italia renegotiated the terms of the acquisition of the industrial plant located in Cannara, Italy with Societa Regionale Per Lo Sviluppo Economico Dell’Umbria — Sviluppumbria S.p.A In connection with our renegotiation, the sale of the land was rescinded and Cereplast Italia retained the existing building, reducing the value of the purchase price to approximately $4.2 million. In exchange, Cereplast Italia rescinded the Mortgage loan with Banca Monte Dei Paschi Di Sienna S.p.A for the principal of $4.5 million in paying a limited rescission fee and cancelled all credit facility. Sviluppumbria S.p.A accepted to carry over a Note secured by the building, in amount of $3.2 million with an annual interest rate of 5.5%, until a new lender is secured. During that period of time Cereplast Italia agreed to negotiate the refurbishment of the building by a third party at no cost. Svilluppumprbia requested Cereplast Italia to represent a plan of development to occur within a longer period of time.

In July 2013, Cereplast Italia was unable to secure a new lender to repay the Note owed to Sviluppumbria S.p.A and is in default. However, during the refurbishment due diligence process, Cereplast Italia identified significant undisclosed environmental issues and requested additional time to clarify the situation. We are continuing an ongoing discussion to explore mutually acceptable alternatives with Sviluppumbria S.p.A. Potential resolutions include, but are not limited to, a revised payment plan with significant financial concessions. If we are unable to reach an agreement with Sviluppumbria S.p.A,,Cereplast Italia may abandon the property and pursue recovery of its full investment.

5. FAIR VALUE MEASUREMENTS

We have certain financial instruments that are measured at fair value on a recurring basis. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A three-tier fair value hierarchy has been established which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). These tiers include:

 

    Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets;

 

    Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and

 

    Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

 

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We measure certain financial instruments at fair value on a recurring basis. Assets and liabilities measured at fair value on a recurring basis are as follows at September 30, 2013 (in thousands):

 

     Total      Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 

Assets

           

None

   $ —         $ —        $ —        $ —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets measured at fair value

   $ —        $ —        $ —        $ —    

Liabilities

           

Derivative liability (1)

   $ 15,142       $ —         $ —         $ 15,142   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities measured at fair value

   $ 15,142       $ —         $ —         $ 15,142   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) See Note 4 for additional discussion.

The table below presents our assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at September 30, 2013. We classify financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model.

 

(in thousands)

   Derivative
Liability
 

Balance at December 31, 2012

   $ 3,189   

Total gains or losses (realized and unrealized)

  

Included in net loss

     21,629   

Valuation adjustment

     (9,676

Purchases, issuances, and settlements, net

     —    

Transfers to Level 3

     —    
  

 

 

 

Balance at September 30, 2013

   $ 15,142   
  

 

 

 

6. LEASES

We currently operate out of our manufacturing facility in Seymour, IN. The lease underlying this facility is summarized below:

 

    Indiana Facility — The Seymour facility consists of approximately 105,000 square feet used as a manufacturing and distribution facility for our products. The lease commenced in January 2008, with a ten year term expiring in January 2018. Our current monthly rent is $25,000.

7. MAJOR CUSTOMERS AND FOREIGN SALES

The following customers accounted for 10% or more of net revenue in the periods presented:

 

     Three Months Ended Sept 30,     Nine Months Ended Sept 30,  
     2013     2012     2013     2012  

Customer A

     —          80.3     —          49.8

Customer B

     —          14.5     —          18.0

Customer C

     —          —          —          10.5

Customer D

     22.6     —          31.0     —     

Customer E

     18.7     —          19.8     —     

Customer F

     15.9     —          —          —     

Our net sales were made up of sales to customers in the following geographic regions (in thousands):

 

     Three Months Ended September 30,  
     2013     2012  

North America

   $ 139         31.9   $ 94         19.7

International

          

Italy

     297         68.1     383         80.3
  

 

 

    

 

 

   

 

 

    

 

 

 

Net sales

   $ 436         100.0   $ 477         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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     Nine Months Ended September 30,  
     2013     2012  

North America

   $ 203         9.5   $ 338         44.0

International

          

Italy

     1,887         88.5     389         50.6

Germany

     21         1.0     14         1.8

India

     21         1.0     —           —     

Other

     —          —          29         3.6
  

 

 

    

 

 

   

 

 

    

 

 

 

Net sales

   $ 2,132         100.0   $ 770         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

8. INCOME TAX

We are subject to U.S. and California income tax. Subject to limited statutory exceptions, we are no longer subject to federal, state and local or non-U.S. income tax examinations by tax authorities for years before 2006. We are not presently liable for any income taxes nor are we undergoing any tax examinations by the Internal Revenue Service. No Deferred Tax Assets or Deferred Tax Liabilities are included in our balance sheets at September 30, 2013 or December 31, 2012.

Our policy is to recognize interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expenses.

9. COMMON STOCK WARRANTS

In connection with the registered direct offering of 3,125,000 Units effective November 2011, we issued warrants to purchase 2,343,750 of our common stock. The per share exercise price of the warrants is $2.20. The warrants are exercisable at any time on or after the date that is 180 days after the initial issuance on the date of closing and will expire on a date that is five years from the date of closing.

In connection with the issue of 2,596,500 shares of common stock to accredited investors pursuant to the Securities Purchase Agreement entered into on January 26, 2011, we issued warrants to purchase 649,128 shares of the Company’s common stock. The warrants have an exercise price of $6.35 per share and are exercisable for a period of five years commencing August 1, 2011.

In connection with the issue of 1,000,000 shares of common stock pursuant to a Subscription Agreement entered into on April 30, 2012, we issued a warrant to purchase 100,000 shares of our common stock for offering costs. The warrants have an exercise price of $0.50 per share and are exercisable for a period of seven years.

In connection with the Amendment with Compass Horizon Funding Company, LLC, we issued a warrant representing the right to purchase 225,000 shares of our common stock at an exercise price of $0.01 per share. In addition, we issued a restated and amended warrant to purchase 140,000 shares of the Company’s common stock at an exercise price of $0.26.

In connection with our JMJ Note, we issued a warrant to purchase 1,886,792 shares of our common stock. The warrants had an initial exercise price of $0.21 per share and are exercisable for a period of four years. The warrants also contained a reset provision that was triggered upon conversion of debts during the fourth quarter of 2012 and again during the first quarter of 2013. As a result, the number of warrants issued increased to 30,769,231 and the exercise price decreased to $0.013 in connection with the JMJ Note as of December 31, 2012 and 64,102,564 warrants with an exercise price of $0.0062 as of September 30, 2013.

A summary of warrant activity for the period ending September 30, is as follows (in thousands except per share data):

 

     2013      2012  
     Number of
Warrants
     Weighted
Average
Exercise Price
     Number of
Warrants
     Weighted
Average
Exercise Price
 

Outstanding—January 1,

     35,313       $ 0.41         4,219       $ 5.09   

Issued

     33,333         0.006         —           —     

Exercised

     —           —           —           —     
  

 

 

       

 

 

    

Outstanding—September 30,

     68,646         0.22         4,219         5.09   
  

 

 

       

 

 

    

Warrants exercisable at end of period

     68,646       $ 0.22         4,219       $ 5.09   
  

 

 

       

 

 

    

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENTS

This Form 10-Q may contain forward-looking statements, as that term is used in federal securities laws, about our financial condition, results of operations and business. These statements include, among others, statements concerning the potential benefits that we may experience from our business activities and certain transactions we contemplate or have completed; and statements of our expectations, beliefs, future plans and strategies, anticipated developments and other matters that are not historical facts. These statements may be made expressly in this Form 10-Q. You can find many of these statements by looking for words such as believes, expects, anticipates, estimates, “opines, or similar expressions used in this Form 10-Q. These forward-looking statements are subject to numerous assumptions, risks and uncertainties that may cause our actual results to be materially different from any future results expressed or implied by us in those statements. The most important facts that could prevent us from achieving our stated goals include, but are not limited to, the following:

 

    inability to raise sufficient additional capital to finance operations;

 

    potential fluctuation in quarterly results;

 

    worsening economic conditions affecting the economic health of our clients;

 

    uncertain global economic conditions

 

    failure to earn profits;

 

    inadequate capital to expand our business, inability to raise additional capital or financing to implement our business plans;

 

    decline in demand for our products and services;

 

    inability to source raw materials in sufficient quantities to support growth in customer demand;

 

    rapid and significant changes in markets and other factors, including national, state and local legislation, that encourage use of bioplastics;

 

    failure to commercialize new grades of resin being pursued in our technical / market development “pipeline;”

 

    competitor actions that curtail our market share, negatively affect pricing or limit sales growth;

 

    litigation with or legal claims and allegations by outside parties;

 

    insufficient revenues to cover operating costs;

There can be no assurance that we will be profitable. We may not be able to successfully manage or market our products, attract or retain qualified executives and technology personnel or obtain additional customers for our products. Our products may become obsolete, government regulation may hinder our business, additional dilution in outstanding stock ownership may be incurred due to the issuance of more shares, warrants and stock options, or the exercise of outstanding warrants and stock options, and other risks inherent in our business.

Because forward-looking statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the forward-looking statements. We caution you not to place undue reliance on these statements, which speak only as of the date of this Form 10-Q. The cautionary statements contained or referred to in this section should be considered in connection with any subsequent written or oral forward-looking statements that our company or persons acting on our behalf may issue. We do not undertake any obligation to review or confirm analysts’ expectations or estimates or to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this Form 10-Q, or to reflect the occurrence of unanticipated events.

OVERVIEW

General

We have developed and are commercializing proprietary bio-based resins through two complementary product families: (1) Cereplast Compostables® resins, which are compostable and bio-based, ecologically sound substitutes for traditional petroleum-based non-compostable plastics, and (2) Cereplast Sustainables™ resins, which replace up to 90% of the petroleum-based content of traditional plastics with materials from renewable resources. Our resins aim to be competitively priced compared to fully petroleum-based plastic resins and can be converted into finished products using conventional manufacturing equipment without significant additional capital investment by downstream converters.

 

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The demand for non-petroleum based, clean and renewable sources for materials, such as bioplastics, and the demand for compostable/biodegradable products, is each being driven globally by a variety of factors, including environmental concerns, new stringent regulations on compostable material, fossil fuel price volatility and energy security. These factors have led to increased spending on clean and sustainable products by corporations and individuals as well as legislative initiatives at the local and state level.

We are a full-service resin solution provider uniquely positioned to capitalize on the rapidly increasing demand for sustainable and environmentally friendly alternatives to traditional plastic products.

We primarily conduct our operations through two product families:

 

    Cereplast Compostables® resins are compostable and bio-based, ecologically sound substitutes for petroleum-based plastics targeting primarily compostable bags, single-use food service products and packaging applications. We offer 13 commercial grades of Compostable resins in this product line. These resins are compatible with existing manufacturing processes and equipment making them a ready substitute for traditional petroleum-based resins. We commercially introduced our Compostable line in November 2006.

 

    Cereplast Sustainables™ resins are partially or fully bio-based, ecologically sound substitutes for fully petroleum-based plastics targeting primarily durable goods, packaging applications. We offer six commercial grades of Sustainable resins in this product line. These resins are compatible with existing manufacturing processes and equipment, making them a ready substitute for traditional petroleum-based resins. We commercially introduced our Sustainable line in late 2007 under the name “Cereplast Hybrid Resins®.”

 

    Cereplast Hybrid Resins® products replace up to 55% of the petroleum content in conventional plastics with bio-based materials such as industrial starches sourced from plants. The Hybrid resins line is designed to offer similar properties to traditional polyolefins such as impact strength and heat deflection temperature, and is compatible with existing converter processes and equipment. The Cereplast Hybrid Resins® line provides a viable alternative for brand owners and converters looking to partially replace petroleum-based resins in durable goods applications. Hybrid resins address this need in a wide range of markets, including automotive, consumer goods, consumer electronics, medical, packaging, and construction. We commercially introduced our first grade of Hybrid resin, Hybrid 150, at the end of 2007. We currently offer four commercial grades in this product line.

 

    Cereplast Algae Plastic® resins. In October of 2009 we announced that we have been developing a new technology to transform algae into bioplastics and intend to launch a new resin family containing algae-based materials that will complement our existing line of resins. The first commercial product with Cereplast Algae Plastic® resin is now being produced and sold as part of our Sustainables resin family. We believe that it is important to enhance research on non-food crops as we expect a surge in demand in bioplastics in future years, thus potentially creating pressure on food crops. Algae are the first non-food crop project that we have introduced and our R&D department is contemplating the development of additional non-food crop based materials in future years. In March 2013 the Company announced the incorporation of a wholly owned subsidiary Algaeplast, Inc. This new company will serve as vehicle to develop additional research on algae based plastic with the ultimate scope to create 100% algae based polymers.

Our patent portfolio is currently comprised of six patents in the United States (“U.S.”), one Mexican patent, and eight pending patent applications in the U.S. and abroad. Our trademark portfolio is currently comprised of approximately 45 registered marks and 21 pending applications in the U.S. and abroad.

Trends and Uncertainties that May Impact Future Results of Operations

Global Market and Economic Conditions. Recent global market and economic conditions have been unprecedented and challenging with tighter credit conditions and slower growth. These conditions, combined with volatile oil prices, declining business and consumer confidence and increased unemployment have contributed to continued volatility of unprecedented levels.

As a result of these market conditions, the cost and availability of credit has been, and may continue to be, adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally, and the strength of counterparties specifically, has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers and to developing companies, such as ours. Continued turbulence in the U.S. and international markets and economies may adversely affect our liquidity and financial condition and the liquidity and financial condition of our customers. If these market conditions continue, they may limit our ability, and the ability of our customers, to timely replace maturing liabilities and access the capital markets to meet liquidity needs, resulting in an adverse effect on our financial condition and results of operations.

 

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Sales. We record sales at the time that we ship our products, provided that evidence of an arrangement exists, title and risk of loss have passed to the customer, fees are fixed or determinable and collection of the related receivable is reasonably assured. We record sales net of sales discounts and allowances. Beginning in 2011, we provided price incentives to several customers that entered into significant supply contract for their initial purchase commitments to assist in commercial launch activities. In the future, we may offer these incentives on a selective basis as we continue to grow our customer base. The amount of these incentives in future periods will be a function of the growth of our customer base and the particular commercialization.

Operating Expenses. Operating expenses consist principally of salaries (both cash and non-cash equity-based compensation), professional fees (including legal, accounting, patent-related, government compliance), marketing, sales commissions, rent and research and development. Salaries include all cash and non-cash compensation and related costs for all principal selling, general and administrative functions. During recent periods we have made grants of equity awards, including shares of restricted stock and stock options, to attract directors and members of senior management, which have resulted in non-cash compensation expense for the periods reported. We expect that non-cash compensation expense attributed to equity-based awards may increase in future periods as the result of future equity-based incentive compensation awards granted to attract and retain talented employees as we continue to grow our business. In addition, we expect to experience increases in our research and development expenses as we continue to develop new products and formulations, as well as increases in marketing and promotional expenses as we seek to increase our customer base.

CRITICAL ACCOUNTING POLICIES AND USE OF ESTIMATES

Our discussion and analysis of our financial condition and results of operations are based upon our unaudited financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We monitor our estimates on an ongoing basis for changes in facts and circumstances, and material changes in these estimates could occur in the future. Changes in estimates are recorded in the period in which they become known. We base our estimates on historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from our estimates if past experience or other assumptions do not turn out to be substantially accurate.

Revenue Recognition

We recognize revenue at the time of shipment of products, when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the price to the customer is fixed or determinable; and (iv) collection of the sales price is probable.

Certain of our product sales are made to distributors under agreements with generally the same terms of sale and credit as all other customer agreements. Revenue from product sales to our customers, including our customers who are distributors, is recognized upon shipment provided the above noted fundamental criteria of revenue recognition are met. The sale of products to our customers who are distributors is not contingent upon the distributor selling the product to the end-user, and our current agreements with distributors do not have any rights of return.

Stock-Based Compensation

Compensation cost for all stock-based awards is measured at fair value on the date of grant and recognized over the service period for awards expected to vest. The fair value of stock options is determined using the Black-Scholes valuation model. Such value is recognized as expense over the service period, net of estimated forfeitures, using the straight-line method. Adjustments to this expense are made periodically to recognize actual rates of forfeiture, which vary significantly from estimates.

Accounts Receivable

We maintain an allowance for doubtful accounts for estimated losses that may arise if any of our customers are unable to make required payments. Management performs a quantitative and qualitative review of the receivables past due from customers on a monthly basis. Quantitative factors include customer’s past due balance, prior payment history, recent sales activity and days sales outstanding. Qualitative factors include macroeconomic environment, current product demand, estimated inventory levels and customer’s financial position. For our accounts receivable balance which have been fully reserved, we may have access to repossess unsold products held at customer locations as recourse for payment defaults. The fair market value of these products are considered as potential recovery in estimating net losses from uncollectible accounts. On July 27, 2012, we entered into a Settlement Agreement with Colortec S.r.l. (“Colortec”) to resolve a dispute regarding unfair competition within the Italian market and our claims on outstanding accounts receivable balances. In exchange for renouncing our claim on outstanding accounts receivable from Colortec, we were granted access to recover unused containers of our products held by Colortec, valued at approximately $1.5 million. We have eliminated the outstanding accounts receivable balance due from Colortec in exchange for the value of inventory we recovered. We record an allowance against uncollectible items for each customer after all reasonable means of collection have been exhausted, and the potential for recovery is considered remote.

 

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Inventories

Inventories are stated at the lower of cost (first-in, first-out basis) or market, and consist primarily of raw materials used in the manufacturing of bioplastic resins, finished bioplastic resins and finished goods. Inventories are assessed for recoverability through an ongoing review of inventory levels in relation to foreseeable demand, which is typically six to twelve months. We consider any quantities in excess of three years of inventory to be excessive due to the shelf life of our products. A significant qualitative factor used in our evaluation is the fact that polypropylene is a core ingredient to our bioplastic resin products. Polypropylene is a multi-billion dollar commodity market within the plastics industry, which provides us an active marketplace to monetize potential excess or obsolete inventory. Our foreseeable demand, which is based upon all available information, including sales forecasts, new product marketing plans and product life cycles, indicates that our current inventory on hand represents approximately 12-18 months of inventory. When the inventory on hand exceeds the foreseeable demand, we write down the value of those inventories which, at the time of our review, we expect to be unable to sell or return to the vendor. The amount of the inventory write down is the excess of historical cost over estimated realizable value. Once established, these write downs are considered permanent adjustments to the cost basis of the excess inventory.

Intangibles

Intangibles are stated at cost and consist primarily of patents and trademarks. Amortization is computed on the straight-line method over the estimated life of these assets, estimated to be between five and fifteen years.

Property and Equipment

Property and equipment are stated at cost, and depreciation is computed on the straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are between three and seven years. Repairs and maintenance expenditures are charged to expense as incurred. Assets under construction are not depreciated until placed into service.

Impairment of Long-Lived Assets

We evaluate long-lived assets for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. Factors we consider include:

 

    Significant changes in the operational performance or manner of use of acquired assets or the strategy for our overall business,

 

    Significant negative market conditions or economic trends, and

 

    Significant technological changes or legal factors which may render the asset obsolete.

We evaluate long-lived assets based upon an estimate of future undiscounted cash flows. Recoverability of these assets is measured by comparing the carrying value to the future net undiscounted cash flows expected to be generated by the asset. An impairment loss is recognized when the carrying value exceeds the undiscounted future cash flows estimated to result from the use and eventual disposition of the asset. Future net undiscounted cash flows include estimates of future revenues and expenses which are based on projected growth rates. We continually use judgment when applying these impairment rules to determine the timing of the impairment tests, the undiscounted cash flows used to assess impairments and the fair value of a potentially impaired asset. The reasonableness of our judgment could significantly affect the carrying value of our long-lived assets.

During fiscal year 2012, and continuing through the second quarter of fiscal 2013, we experienced a significant decline in sales volume due to liquidity and sales resource constraints, which we believe to be temporary. Our reduced production volume has not changed the manner in which we use our equipment, nor its physical condition. Our current estimate of future net undiscounted cash flows indicates that the carrying value of our long-lived assets is recoverable and therefore no impairment is recorded for equipment.

During the third quarter of 2013, Cereplast Italia is in default with its mortgage payable related to our building in Italy. We have recorded an impairment of $0.5 million to adjust the carrying value of our building to equal the outstanding value of its related mortgage to reflect our potential loss exposure based on this default.

Deferred Income Taxes

Deferred income taxes are provided using the liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases.

The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

 

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Derivative Financial Instruments

Our derivative financial instruments consist of embedded and free-standing derivatives related primarily to the convertibles notes. The embedded derivatives include the conversion features, and liquidated damages clauses in the registration rights agreement. The accounting treatment of derivative financial instruments requires that we record the derivatives and related warrants at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. The recorded value of all derivatives at September 30, 2013 totaled approximately $15.1 million. Any change in fair value of these instruments will be recorded as non-operating, non-cash income or expense at each reporting date. If the fair value of the derivatives is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives is lower at the subsequent balance sheet date, the Company will record non-operating, non-cash income. At September 30, 2013, derivatives were valued primarily using the Black-Scholes Option Pricing Model.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2013 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2012

Sales

Net sales for the three months ended September 30, 2013 were approximately $0.4 million, compared to $0.5 million in the same period in 2012. Sales are essentially flat when comparing the third quarter of 2013 to the third quarter of 2012, with both periods impacted by summer seasonality in our European markets.

Cost of Sales

Cost of sales is comprised of variable costs associated with our product revenues. Cost of sales for the three months ended September 30, 2013 was approximately $0.4 million, compared to $0.5 million for the same period in 2012.

Gross Profit (Loss)

Gross profit (loss) for the three months ended September 30, 2013 was approximately $0.1 million, compared to $4,000 for the same period in 2012. The increase in gross profit was attributable to a slight decrease in the cost of our products.

Research and Development Expenses

Research and development expenses for the three months ended September 30, 2013 were $0.1 million, compared to approximately $0.1 million for the same period in 2012. Research and development expenses decreased slightly due to our cost containment effort to preserve working capital.

Selling, General and Administrative Expenses and Impairment of Long-Lived Assets

Selling, general and administrative expenses and impairment of long-lived assets for the three months ended September 30, 2013 were $1.7 million, compared to $6.8 million for the same period in 2012. Our decrease in sales, general and administrative expenses was primarily due to bad debt expense of $5.1 million recorded in the third quarter of 2012. In addition, our sales, general and administrative expenses decreased due to reduced headcount and a reduction in fixed production overhead costs classified as selling, general and administrative expense due to an extended period of abnormally low production volume. Impairment of long-lived assets reflect an adjustment to the carrying value of our facility in Italy.

Other Income and Expense, Net

Other income and expense, net for the three months ended September 30, 2013 was a net expense of $5.6 million, as compared to a net expense of $3.0 million in the same period in 2012. The increase in expense was due to a loss on debt extinguishment in addition to expense recorded as a result of the change in our derivative liability related to our warrants, short term convertible debt and preferred stock agreements partially offset by a decrease in interest expense.

Net Loss

Net loss for the three months ended September 30, 2013 was $7.3 million, as compared to $10.0 million in the same period in 2012. The decrease in net loss was primarily driven by a decrease in selling, general and administrative expense related to bad debt expense recorded in the third quarter of 2012 partially offset by an increase in Other Expense related to our financing transactions. As discussed above, Other Income and Expense, net was unfavorably impacted by losses on derivative liabilities and losses on extinguishment of debt.

 

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RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2013 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2012

Sales

Net sales for the nine months ended September 30, 2013 were approximately $2.1 million, compared to $0.8 million in the same period in 2012. Sales increased from the prior year due to growing demand in our European markets primarily due to anticipated legislation in Italy banning traditional plastic bags.

Cost of Sales

Cost of sales is comprised of variable costs associated with our product revenues. Cost of sales for the nine months ended September 30, 2013 was approximately $1.9 million, compared to $0.9 million for the same period in 2012. The increase in cost of sales is due to an increase in our sales.

Gross Profit (Loss)

Gross profit (loss) for the nine months ended September 30, 2013 was approximately $0.3 million, compared to ($91,000) for the same period in 2012. The increase in gross profit was attributable to our increase in sales, as stated above.

Research and Development Expenses

Research and development expenses for the nine months ended September 30, 2013 were $0.3 million, compared to approximately $0.4 million for the same period in 2012. Research and development expenses have slightly decreased due to our cost containment effort to preserve working capital.

Selling, General and Administrative Expenses and Impairment of Long-Lived Assets

Selling, general and administrative expenses and impairment of long-lived assets for the nine months ended September 30, 2013 were $4.3 million, compared to $10.5 million for the same period in 2012. Our decrease in sales, general and administrative expenses was primarily due to bad debt expense of $5.1 million recorded in the third quarter of 2012. In addition, our sales, general and administrative expenses decreased due to reduced headcount and a reduction in fixed production overhead costs classified as selling, general and administrative expense due to an extended period of abnormally low production volume. Impairment of long-lived assets reflect an adjustment to the carrying value of our facility in Italy.

Other Income and Expense, Net

Other income and expense, net for the nine months ended September 30, 2013 was a net expense of $29.7 million, as compared to a net expense of $5.3 million in the same period in 2012. The increase in expense was primarily a result of the change in our derivative liability related to our warrants, short term convertible debt and preferred stock agreements. In addition, we recorded $2.8 million in debt extinguishment costs related to the exchange of certain of our term loan and convertible notes.

Net Loss

Net loss for the nine months ended September 30, 2013 was $34.0 million, as compared to $16.3 million in the same period in 2012. The increase in net loss was primarily driven by an increase in Other Expense related to our financing transactions. As discussed above, Other Income and Expense, net was unfavorably impacted by losses on derivative liabilities totaling $21.6 million. The increase in net loss was partially offset by a decrease in bad debt expense recorded in the first nine months of 2013 compared to the first nine months of 2012.

LIQUIDITY AND CAPITAL RESOURCES

We require working capital to fund our operations, including payments to finance our research and development and expand sales and marketing, to purchase equipment, service indebtedness, satisfy lease obligations and execute on our business plan and growth strategy.

We had net unrestricted cash of $0.2 million at both September 30, 2013 and at December 31, 2012.

Cash used in operating activities during the nine months ended September 30, 2013 was $2.3 million, compared to $4.3 million during the same period in the 2012. The decrease in cash used in operations was primarily a result of lower operating expense and cash proceeds from increased resin sales.

Cash used in investing activities during the nine months ended September 30, 2013 was $3,000 compared to cash used in investing activities of approximately $0.2 million during the same period in 2012.

 

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Cash provided by financing activities during the nine months ended September 30, 2013 was $2.7 million compared to cash provided by in financing activities of $0.7 million during the same period in 2012. The increase was primarily attributed to proceeds received from issuance of preferred stock.

We have incurred a net loss of $34.0 million for the nine months ended September 30, 2013, and $30.2 million for the year ended December 31, 2012, and have an accumulated deficit of $121.1 million as of September 30, 2013. Based on our operating plan, our existing working capital will not be sufficient to meet the cash requirements to fund our planned operating expenses, capital expenditures and working capital requirements through December 31, 2013 without additional sources of cash. This raises substantial doubt about our ability to continue as a going concern.

Our plan to address the shortfall of working capital is to generate additional cash through a combination of refinancing existing credit facilities, incremental product sales and raising additional capital through debt and equity financings. We are confident that we will be able to deliver on our plans, however, there are no assurances that we will be able to obtain any sources of financing on acceptable terms, or at all.

If we cannot obtain sufficient additional financing in the short-term, we may be forced to curtail or cease operations or file for bankruptcy. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should we be forced to take such actions.

Loans Payable and Long Term Debt

Venture Loan Payable

On December 21, 2010, we entered into a Venture Loan and Security Agreement (the “Loan Agreement”) with Compass Horizon Funding Company, LLC (the “Lender” or “Horizon”). The Loan Agreement provides for a total loan commitment of $5.0 million comprising of Loan A and Loan B, each in the amount of $2.5 million. Loan A was funded at closing on December 21, 2010 and matures 39 months after the date of advance. Loan B was funded on February 17, 2011 and also matures 39 months after the date of advance. We are obligated to pay interest per annum equal to the greater of (a) 12% or (b) 12% plus the difference between (i) the one month LIBOR Rate in effect on the date preceding the funding of such loan by five business days and (ii) .30%. We are required to make interest only payments for the first nine months of each loan and equal payments of principal over the final thirty months of each loan. In connection with the loan, we issued a seven year warrant to the Lender to purchase 140,000 shares of our common stock at an exercise price of $4.40. We granted a security interest in all of our assets to the Lender.

Effective November 27, 2012, we entered into a Second Amendment (the “Amendment”) to the Loan Agreement. Pursuant to the Amendment, Horizon agreed to extend additional loans to us in the form of Loan C in the amount of $150,000 and Loan D in the amount of $250,000. The Amendment provides for a maturity date of April 4, 2013 and an annual rate of interest of 15% for Loans C and D.

The Amendment also amends other portions of the Loan Agreement to include Loans C and D and sets forth the terms governing repayment, interest rate and use of proceeds and conditions to funding such loans.

Convertible Subordinated Notes

On May 24, 2011, we issued $12.5 million in aggregate principal amount of 7% Senior Subordinated Convertible Notes due June 1, 2016 (the “Notes”). The Notes were issued pursuant to an indenture (the “Indenture”), entered into between us and Wells Fargo Bank, National Association, as trustee, on May 24, 2011. In connection with the issuance of the Notes, we entered into a Waiver to our Venture Loan and Security Agreement with Horizon, dated May 18, 2011 pursuant to which Horizon provided its consent to the offering of the Notes and waived any restrictions in the Loan Agreement.

The Notes are senior subordinated unsecured obligations which will rank subordinate in right to payment to all of our existing and future senior secured indebtedness and bear interest at a rate of 7% per annum payable semi-annually in arrears on June 1 and December 1 of each year, commencing on December 1, 2011. The Notes mature on June 1, 2016, with an early repurchase date of June 15, 2014 at the option of the purchaser. The Notes are convertible into shares of our common stock in accordance with the terms of the Notes and the Indenture, at the initial conversion rate of 172.4138 shares of our common stock per $1,000 principal amount of Notes, equivalent to a conversion price of approximately $5.80 per share, subject to adjustment. If the Notes are converted into shares of our common stock prior to June 2, 2014, an interest make-whole payment will be due based on the conversion date up until June 2, 2014. Upon a non-stock change in control, additional shares of our common stock may need to be issued upon conversion, with a maximum additional shares of 25.606 per $1,000 in principal amount of Notes being issuable thereunder, for a total maximum of 198.0198 shares per $1,000 Note. Certain customary anti-dilution provisions included in the Indenture and/or the Notes could adjust the conversion rate.

 

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The conversion feature within the Notes is not considered to be a beneficial conversion feature within the meaning of Accounting Standards Codification (“ASC”) 470, Debt, and therefore all of the gross proceeds from the Notes have been classified as long term debt. In connection with the issue of the Notes, we incurred approximately $1.3 million of debt issue costs which were deferred and are being amortized to interest expense over the term to the early repurchase date of June 15, 2014.

Also in connection with the issuance of the Notes, we entered into a Securities Purchase Agreement dated May 18, 2011 pursuant to which we agreed to prepare and file a registration statement with the Securities and Exchange Commission (the “SEC”) registering the resale of the Notes and the shares of common stock underlying the Notes. The registration statement was declared effective on August 10, 2011.

On June 1, 2012, we entered into an Exchange Agreement and a Forbearance Agreement with certain of the holders of our Notes. Pursuant to the terms of the Exchange Agreement, certain of the holders agreed to exchange the Notes for shares at an exchange rate of one share of our common stock for each $1.00 amount of the Notes exchanged.

On January 3, 2013, we received a Notice of Event of Default from Wells Fargo Bank, National Association, the Trustee under the Indenture. The Notice was triggered by our failure to pay on December 1, 2012 pursuant to the terms of the Forbearance Agreements dated as of May 31, 2012 entered into with the holders of the Notes, interest in the amount of $332,500 that was due on June 1, 2012 (the “June 2012 Interest Payment”) and interest in the amount of $332,500 due on December 1, 2012 (the “December 2012 Interest Payment”). On January 25, 2013, the Holders of the Notes entered into a payment agreement with IBC Funds, LLC (“IBC”) pursuant to which IBC agreed to purchase up to $2,000,000 of the principal amount of the Notes in tranches. In connection with the execution of the payment agreement, the Holders agreed to waive the Event of Default and forebear from exercising any of their rights and remedies under the Indenture in connection with our failure to make the June 2012 and December 2012 Interest Payments until the earlier of December 31, 2013 or the date IBC has failed to make payments as set forth in the Payment Agreement.

On January 25, 2013, we entered into an Exchange Agreement with IBC in connection with Purchase Agreements between IBC and certain Noteholders, to purchase up to $2.0 million of Notes through November 2013. Total purchases by IBC in the nine months ended September 30, 2013 were $1.8 million.

At September 30, 2013 the Notes were convertible into 7,500,000 shares of our common stock.

Mortgage Payable

Effective October 24, 2011, Cereplast Italia S.p.A (“Cereplast Italia”), our wholly owned subsidiary, completed its acquisition of an industrial plant and the real estate on which the industrial plant is located in Cannara, Italy. The Deed of Sale between Cereplast Italia and Societa Regionale Per Lo Sviluppo Economico Dell’Umbria — Sviluppumbria S.p.A, provided for an aggregate purchase price of approximately $6.5 million. The acquisition had previously been secured by a mortgage loan with Banca Monte Dei Paschi Di Sienna S.p.A for the principal of $4.5 million.

Effective October 25, 2012, Cereplast Italia renegotiated the terms of the acquisition of the industrial plant located in Cannara, Italy with Societa Regionale Per Lo Sviluppo Economico Dell’Umbria — Sviluppumbria S.p.A In connection with our renegotiation, the sale of the land was rescinded and Cereplast Italia retained the existing building, reducing the value of the purchase price to approximately $4.2 million. In exchange, Cereplast Italia rescinded the Mortgage loan with Banca Monte Dei Paschi Di Sienna S.p.A for the principal of $4.5 million in paying a limited rescission fee and cancelled all credit facility. Sviluppumbria S.p.A accepted to carry over a Note secured by the building, in amount of $3.2 million with an annual interest rate of 5.5%, until a new lender is secured. During that period of time Cereplast Italia agreed to negotiate the refurbishment of the building by a third party at no cost. Svilluppumprbia requested Cereplast Italia to represent a plan of development to occur within a longer period of time.

In July 2013, Cereplast Italia was unable to secure a new lender to repay the Note owed to Sviluppumbria S.p.A and is in default. However, during the refurbishment due diligence process, Cereplast Italia identified significant undisclosed environmental issues and requested additional time to clarify the situation. We are continuing an ongoing discussion to explore mutually acceptable alternatives with Sviluppumbria S.p.A. Potential resolutions include, but are not limited to, a revised payment plan with significant financial concessions. If we are unable to reach an agreement with Sviluppumbria S.p.A,,Cereplast Italia may abandon the property and pursue recovery of its full investment.

Preferred Stock

On August 24, 2012, we entered into a Stock Purchase Agreement (“SPA”) with Ironridge Technology Co., a division of Ironridge Global IV, Ltd, for the sale of up to $5 million in shares of convertible redeemable Series A Preferred Stock (“Series A Preferred Stock”). The closing of the transactions contemplates the fulfillment of certain closing conditions. The initial closing with respect to the sale of 30 shares of Series A Preferred Stock occurred on August 24, 2012.

 

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On August 24, 2012, we filed a Certificate of Designation of Preferences, Rights and Limitations of Series A Preferred Stock (“Certificate of Designation”) with the Secretary of State of Nevada. The Certificate of Designation provides that the Series A Preferred Stock ranks senior with respect to dividend and rights upon liquidation to the Company’s common stock and junior to all existing and future indebtedness. Except as otherwise required by law, the Series A Preferred Stock shall have no voting rights. The Certificate of Designation provides for the payment of cumulative dividends at a rate of 2.5% per annum when and if declared by the Board of Directors in its sole discretion. Dividends and any Embedded Derivative Liability (as defined in the Certificate of Designation) may be paid in cash or free trading shares of the Company as provided in the Certificate of Designation.

Unless we have received the approval of the holders of a majority of the Series A Preferred Stock then outstanding, we shall not (i) alter or change adversely the powers, preferences or rights of the holders of the Series A Preferred Stock or alter or amend the Certificate of Designation; (ii) authorize or create any class of stock ranking senior as to distribution of dividends senior to the Series A Preferred Stock; (iii) amend its certificate of incorporation in breach of any provisions of the Certificate of Designation; increase the authorized number of Series A Preferred Stock; (iv) liquidate, or wind-up the business and affaires of the Corporation or effect any Deemed Liquidation Event, as defined in the Certificate of Designation.

Upon any liquidation, dissolution or winding up of the Company, after payment or provision for payment of debts and other liabilities of the Company, the holders of Series A Preferred Stock shall be entitled to receive, pari passu with any distribution to the holders of Common Stock of the Company, an amount equal to $10,000 per share of Series A Preferred Stock plus any accrued and unpaid dividends.

Upon or after 18 years after the Issuance Date, the Corporation will have the right to redeem 100% of the Series A Preferred Stock at a price of $10,000 per share plus any accrued and unpaid dividends (the “Corporation Redemption Price”). We are also permitted to redeem the Series A Preferred Stock at any time after issuance as provided in the Certificate of Designation. The Certificate of Designation also provides for mandatory redemption if the Company determines to liquidate, dissolve or wind-up its business and affects or effect any Deemed Liquidation Event as such term is defined in the Certificate of Designation.

The Series A Preferred Stock may be converted into share of common stock of the Company at the option of the Company or the holder. In the event of a conversion by the holder at a price per share equal to the sum of (a) the Corporation Redemption Price plus the Embedded Derivative Liability (as defined in the Certificate of Designation) less any dividends paid, multiplied by (b) the number of shares being converted, divided by (c) the conversion price of $0.25. On February 27, 2013, the holder elected to convert 50 shares of Series A Preferred Stock into shares of common stock. In accordance with the formula discussed above, 50 shares of Series A Preferred Stock converted into 190,888,889 shares of common stock. On June 17, 2013, the holder elected to convert 42 shares of Series A Preferred Stock into shares of common stock. In accordance with the formula discussed above, 42 shares of Series A Preferred Stock converted into 115,631,700 shares of common stock. On September 4, 2013, the holder elected to convert 49 shares of Series A Preferred Stock into shares of common stock. In accordance with the formula discussed above, 49 shares of Series A Preferred Stock converted into 134,821,492 shares of common stock. As of September 30, 2013, we issued 54,000,000 shares of common stock, while the remaining 80,821,492 shares were subscribed to the holder. In connection with the conversion, the Derivative Liability related to the 141 shares of Series A Preferred Stock, with a total value at the conversion date of $12.3 million, was reclassified into equity as a component of the common stock issued and subscribed.

OFF-BALANCE SHEET ARRANGEMENTS

We do not have any relationships with unconsolidated entities or financial partnerships such as entities often referred to as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance-sheet arrangements or for other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to a number of market risks in the ordinary course of business. These risks, which include interest rate risk, foreign currency exchange risk and commodity price risk, arise in the normal course of business rather than from trading. We have examined our exposures to these risks and concluded that none of our exposures in these areas is material to fair values, cash flows or earnings. We regularly review these risks to determine if we should enter into active strategies, such as hedging, to help manage the risks. At the present time, we do not have any hedging programs in place and we are not trading in any financial or derivative instruments.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Under the supervision and participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as such term is defined under Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

 

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Based upon this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that as of September 30, 2013, due to material weaknesses existing in our internal controls as of December 31, 2012 (described below), which have not been fully remediated as of September 30, 2013, our disclosure controls and procedures were ineffective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is: (i) recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms, and (ii) accumulated and communicated to our management, including our chief executive officer and chief financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

A material weakness is a deficiency or a combination of deficiencies in ICFR such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. Material weaknesses would permit information required to be disclosed by us in the reports that we file or submit to not be recorded, processed, summarized and reported, within the time period specified in the Securities Exchange Commission’s rules and forms.

As a result of our assessment and based on the criteria in the COSO framework, management has concluded that, as of December 31, 2012, our ICFR was not effective due to the existence of the following material weakness:

Inadequate Reviews to Ensure Complex Accounting Transactions and Foreign Subsidiary Balances are Accurately Recorded in Accordance with U.S. Generally Accepted Accounting Principles (“GAAP”): Due to our liquidity situation, we did not have adequate staffing of adequately trained accounting personnel with appropriate expertise in U.S. GAAP to ensure that certain complex material and non-routine transactions are properly reflected in our financial statements. Consequently, we may not anticipate and identify accounting issues, or other risks critical to financial reporting, that could materially impact the consolidated financial statements.

Remediation Activities. We will begin to implement remediation steps outlined below to eliminate the material weakness identified.

Inadequate Reviews to Ensure Complex Accounting Transactions and Foreign Subsidiary Balances are Accurately Recorded in Accordance with U.S. GAAP: We have engaged a consulting firm to provide review and analysis for complex transactions and technical accounting research to ensure transactions are properly recorded in compliance with U.S. GAAP. In addition, we are seeking to hire additional staff with greater knowledge of U.S. GAAP both in the U.S. and our foreign operations as well as engaging selected third parties to improve the accuracy of our financial reporting.

Changes in Internal Control Over Financial Reporting

During the quarter ended September 30, 2013, management continued to implement the steps outlined above under “Remediation Activities” to improve the quality of its ICFR.

 

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PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are subject to various claims and contingencies in the ordinary course of business, including those related to litigation, business transactions and others. When we are aware of a claim or potential claim, we assess the likelihood of any loss or exposure. If it is probable that a loss will result and the amount of the loss can be reasonably estimated, we will record a liability for the loss. In addition to the estimated loss, the recorded liability includes probable and estimable legal costs associated with the claim or potential claim. There is no assurance that such matters will not materially and adversely affect our business, financial position and results of operations or cash flows.

On May 6, 2013, Continental Grand LP, a Delaware company filed a lawsuit in the Superior Court of California against the Company for unlawful detainer of a property located in El Segundo, California. The action seeks termination of our lease. A Settlement is currently being negotiated out-of-court by the parties.

On May 8, 2013, the Company filed in the United States of New York, Southern District of New York a lawsuit against Magna Group LLC and Hanover Holdings LLC for breach of contract, breach of the covenant of good faith and fair dealing. The action is seeking compensatory damages in an unspecified amount, plaintiff’s costs and attorneys’ fees, and unspecified equitable or injunctive relief.

ITEM 1A. RISK FACTORS

There are no material changes from the risk factors previously disclosed in the Registrant’s Form 10-K filed on April 14, 2013.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

None.

 

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ITEM 6. EXHIBITS

 

Exhibit

Number

  

Description

  31.1    Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  31.2    Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
  32.1    Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ***
  32.2    Certification of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002***
   101    XBRL (Extensible Business Reporting Language) The following materials from Cereplast Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013, formatted in Extensive Business Reporting Language (XBRL), (i) consolidated balance sheets, (ii) consolidated statements of operations and other comprehensive loss, (iii) consolidated statement of cash flows, and (iv) the notes to the consolidated financial statements.

 

*** In accordance with Item 601(b)(32)(ii) of Regulation S-K, this exhibit shall not be deemed “filed” for the purposes of Section 18 of the Exchange Act or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Exchange Act.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: November 14, 2013

 

  CEREPLAST, INC.
By:  

/s/ Frederic Scheer

 

Frederic Scheer

Chairman and Chief Executive Officer

(Principal Executive Officer)

 

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