Convertible Notes Payable

9 Months Ended

Sep. 30, 2013

Convertible Notes Payable and Long-Term Borrowings [Abstract]

CONVERTIBLE NOTES PAYABLE

10. CONVERTIBLE NOTES PAYABLE

On February 9, 2011, the Company entered into a Securities Purchase Agreement with individual investors relating to a private placement transaction by the Company (the “Private Placement”) of 6,669,627 units. Each unit consisted of a $1.15 principal amount 8% Senior Convertible Note (the “Notes”) and a Common Stock Purchase Warrant (the “Warrants”) to purchase one share of the Company’s common stock at an exercise price of $1.40 per share.

As a result of the Private Placement, the Company sold $7,670,071 worth of Notes convertible into 6,669,627 shares of common stock. The Notes are payable 24 months from February 9, 2011 with an interest rate of 8% per annum payable semiannually in arrears. The Company placed in escrow an amount of the proceeds of the Private Placement equal to one semi-annual interest payment on the Notes to secure prompt interest payments. Until such time as 75% of the Notes are converted into shares of Common Stock, if such escrow is depleted in order to make interest payments, the Company will replenish such escrow amount. At the option of the holder, the Notes may be converted into Common Stock at a price of $1.15 per share, which is subject to customary weighted average and stock based anti-dilution protection. The issuance of the Notes was not registered under the Securities Act as such issuance was exempt from registration under Section 4(2) of the Securities Act of 1933 (“Securities Act”) and Regulation D.

The Notes contain customary events of default and affirmative and negative covenants of the Company, including negative covenants which restrict the Company’s ability to do the following (among other things) without the consent of the investors: (i) incur, or permit to exist, any indebtedness for borrowed money in excess of (A) US$3,000,000 during the twelve (12) month period beginning on February 9, 2011, or (B) US$5,000,000 during the two-year period beginning on February 9, 2011 and ending on February 9, 2013 (the maturity date of the Notes), except in the ordinary course of the Company’s business; (ii) lend or advance money, credit or property to or invest in (by capital contribution, loan, purchase or otherwise) any person or entity in excess of US$1,000,000 except: (A) investments in United States Government obligations, certificates of deposit of any banking institution with combined capital and surplus of at least $200,000,000; (B) accounts receivable arising out of sales in the ordinary course of business; and (C) inter-company loans between and among the Company and its subsidiaries; (iii) pay dividends or make any other distribution on shares of the capital stock of the Company; (iv) create, assume or permit to exist, any lien on any of the Company’s property or assets now owned or hereafter acquired, subject to existing liens and certain exceptions; (v) assume guarantees, subject to certain exceptions; (vi) engage in “sale-leaseback” transactions, subject to certain exceptions; (vii) make capital expenditures in excess of US$5,000,000 in any fiscal year, subject to certain exceptions; and (viii) materially alter the Company’s business.

In connection with the issuance of the Notes, we entered into a Registration Rights Agreement (the “Registration Rights Agreement”) with the investors which sets forth the rights of the investors to have the shares of common stock underlying the Notes and Warrants registered with the SEC for public resale. Pursuant to the Registration Rights Agreement, we agreed to file, no later than April 11, 2011, a registration statement to register the shares underlying the Notes and the Warrants and to have such registration statement effective no later than September 18, 2011. If the registration statement was not filed by April 11, 2011 (the “Filing Failure”), was not effective by September 18, 2011 (the “Effectiveness Failure”) or if, after the effective date, sales of securities included in the registration statement cannot be made (including, without limitation, because of a failure to keep the registration statement effective, to disclose such information as is necessary for sales to be made pursuant to the registration statement, to register a sufficient number of shares of Common Stock or to maintain the listing of the Common Stock) (a “Maintenance Failure”) then, as liquidated damages (and in complete satisfaction and to the exclusion of any claims or remedies inuring to any holder of the securities) the Company is required to pay an amount in cash equal to 1% of the aggregate purchase price paid by the Investors on each of the following dates: (i) 20 days following the date of a Filing Failure; (ii) 30 days following the initial day of a Maintenance Failure; (iii) on every thirtieth day thereafter (pro-rated for periods totaling less than thirty days) until such failure is cured; (iv) on every thirtieth day after the day of an Effectiveness Failure and thereafter (pro rated for periods totaling less than thirty days) until such Effectiveness Failure is cured; (v) on every thirtieth day after the initial day of a Maintenance Failure and thereafter (pro rated for periods totaling less than thirty days) until such Maintenance Failure is cured. The payments to be made by the Company are limited to a maximum of 6% of the aggregate amount paid by the Investors ($460,204). The registration statement was not declared effective by December 31, 2011, as such an Effectiveness Failure occurred and the Company accrued the full $460,204. The Company will continue to assess the likelihood of payments under this arrangement.

The warrants issued as a component of the units were valued using the Black-Scholes method using the following assumptions: (1) life of warrants of 3 years, (2) annualized volatility of 100%, (3) fair value of stock as of grant date of $1.15, (4) exercise price of $1.40, (5) annual dividend rate of 0%, and (6) discount rate of 1.34%. Such calculation resulted in a warrant value of $4,470,536.

The proceeds of the Private Placement offering were allocated to the Notes and warrants based on their relative fair values on a weighted average basis, with the resulting allocated value of the warrants of $2,824,350 being classified to additional paid in capital. Such discount to the Notes is being amortized over their expected life.

The beneficial conversion feature associated with the issuance of the above Notes, amounted to $2,824,350, which has also been recorded as a discount to the convertible notes payable and is being amortized over the life of the Notes. As of September 30, 2013, the discount to the convertible notes was fully amortized.  The Notes do not contain any embedded derivatives which require liability classification.

As of February 10, 2013, the Company was in default on the Notes due to failure to pay the investors in full the $7,670,071 principal and accrued interest on February 9, 2013.  Subsequently, the Company has released $229,018 from investor relations escrow to pay the accrued interest of $68,178 and principal of $160,839 to investors.  The Company and the investor representative reached an Amendment to Promissory Notes (“Amendment”) on August 23, 2013 (see Form 8-K filed by Company on August 29, 2013) and developed a repayment schedule of the remaining principle balance over the next two years.  No interest was to be accrued if the Company makes the payments on time.  However, the first repayment of $1 million due on September 30 was delayed due to practical difficulty of conversion RMB funds to U.S. Dollars due to China’s foreign exchange control.  The Company is in oral discussions with Euro-Pacific Capital, Inc, the investor representatives, to determine a revised repayment schedule.

According to the Amendment, if the Company fails to make the agreed payment and does not cure within 45 days, interest on the then outstanding principal balance shall accrue at 8% per annum retroactively from the then missed payment date. The interest is approximately $50,000 per month. In addition, another 500,000 shares shall be immediately issued to Note holders.

According to the Amendment, if the Company fails to make the first payment of $1,000,000 on or before September 30, 2013, the registration delay payments in $460, 206 shall become due immediately. The Company has fully accrued such payable as of September 30, 2013.

As required by the Amendment, the Company has released 500,000 make-good shares to Note holders by September 30, 2013. At the request of the investor representative, such shares have not been transferred to Note holders’ individual accounts due to a review for acceptability.

As of September 30, 2013, the book value of the Notes amounted to $7,509,232. There is no further unamortized discount remaining as of September 30, 2013.