Note 6. Convertible Debentures and Derivative Liability

9 Months Ended

Sep. 30, 2017

Notes

Note 6. Convertible Debentures and Derivative Liability

Note 6. Convertible Debentures and Derivative Liability

Pursuant to a Private Placement Memorandum dated February 14, 2014 (the "Private Placement"), the Company offered up to a maximum of $3,000,000 of Collateralized Convertible Senior Debentures in three tranches of $1,000,000 each, to accredited or institutional investors. The Offering was conducted contingent on the deposit into Escrow of the purchase price for all of the Debentures offered in the principal amount of $3,000,000. The Debentures, once issued, bore interest at 4% per annum after 180 days, mature six years from the date of issuance, and are secured by a lien on the Company’s Mississippi property. On March 31, 2014, the First Closing occurred when subscriptions in the amount of $3,000,000 were received in Escrow and accepted by the Company. The Escrow Agent released $1,000,000 to the Company and the Company issued First Tranche Debentures in the aggregate principal amount of $1,000,000.   

On December 31, 2014, investors who had purchased $950,000 of First Tranche Debentures consented to Amendment I to the Private Placement, which amended certain terms and conditions, including the conversion terms of the First Tranche Debentures. The remaining First Tranche Debenture in the amount of $50,000 remains as originally issued with no conversion rights. Thus, the First Tranche Debentures can be converted into a total of 3,166,666 shares of common stock.

On December 31, 2014, the Second Closing occurred when investors representing $850,000 of Second Tranche Debentures consented to Amendment II to the Private Placement, which amended certain terms and conditions, including those relating to issuance and conversion of the Second and Third Tranche Debentures, as well as the period of time within which to perform the Third Tranche Closing Obligations, as amended.  The Escrow Agent released $850,000 to the Company and the Company issued Second Tranche Debentures in the aggregate principal amount of $850,000. Thus, the Second Tranche Debentures can be converted into a total of 1,888,889 shares of common stock. The Escrow Agent refunded $300,000 to those investors who did not consent to Amendment II.

The Company did not meet the closing obligations for the Third Tranche Debentures as of June 30, 2015, as was required pursuant to the terms of the Private Placement, as amended. Therefore, the remaining $850,000 being held in escrow for the purchase of the Third Tranche Debentures was returned to the investors in July 2015.

For purposes of determining the proper accounting treatment and valuation of the instruments, the Company applied the provisions set forth in ASC Topic 820, "Fair Value in Financial Instruments" and ASC Topic 815, "Accounting for Derivative Instruments and Hedging Activities." Since the Notes issued have derivative features, the embedded derivatives should be bundled and valued as a single, compound embedded derivative, bifurcated from the debt host and treated as a liability. In addition, the valuation is required to be conducted for each reporting period the instrument is in existence.

The Company's stock was not trading from approximately September 4, 2014, when its stock registration was revoked, through approximately October 26, 2015, when its' stock began to trade again. The Company engaged an independent valuation expert to determine the fair value of its shares of common stock for each quarter beginning with the quarter ended September 30, 2014. For periods from September 30, 2014 through September 30, 2015, the fair value of the common stock was estimated by adjusting the most recent market price by changes in the underlying market cap due to changes in the value of net assets and applying a discount for lack of marketability inasmuch as the stock was not trading. After the stock began to trade again on or about October 26, 2015, the closing price of the stock was used in the valuation beginning with the quarter ending December 31, 2015 through this most recent valuation at September 30, 2017. Monte Carlo models were developed to value the derivative liability within the Notes using a historical volatility rate, based on comparable companies, of 132% at September 30, 2017 and 179% at December 31, 2016, and using discount bond rates based on the expected remaining term of each instrument ranging from 6.35% to 6.78% at September 30, 2017 and 5.26% at December 31, 2016. In addition, the September 30, 2017 valuation included that the conversion requirements for Tranche I Debentures, exclusive of price, were met as of September 30, 2017 and continue to be met at September 30, 2017, while conversion requirements for Tranche II Debentures were expected to be met by October 24, 2017.

The estimated fair value for the derivative liability relating to each Debenture at the balance sheet dates is as follows:

	September 30, 2017	December  31, 2016
Tranche 1	$ 668,654	$ 1,008,068
Tranche 2	600,944	1,022,221
Derivative Liability	$ 1,269,598	$ 2,030,289

At the initial valuation date of each Tranche, a portion of the derivative liability was allocated to the Convertible Debentures as debt discount, with the remainder being recorded as other income/expense. At March 31, 2014, the initial valuation of the First Tranche Debentures, $1,000,000, was allocated to debt discount and, at December 31, 2014, the initial valuation of the Second Tranche Debentures, $850,000, was allocated to debt discount. The debt discount is subsequently amortized to expense using an effective interest methodology. Amortization of debt discount amounted to $98,947 and $48,146 for Convertible Debentures and $3,415 and $1,659 for the non-convertible Debenture for the nine months ended September 30, 2017 and 2016, respectively.

The interest payment on the Tranche 1 and Tranche 2 Debentures for the calendar year 2015, in the amount of $57,233, was due March 1, 2016. The interest payment on the Tranche 1 and Tranche 2 Debentures for the calendar year 2016, in the amount of $74,000, was due March 1, 2017. The Company failed to make these interest payments and, therefore, is in default under the terms of the Debentures.

On October 25, 2016, certain Debenture holders filed a Complaint against the Company in the United States District Court for the District of Delaware for monies due and owing pursuant to the Tranche 1 and Tranche 2 Collateralized Convertible Senior Debentures issued on March 31, 2014 and December 31, 2014. The plaintiffs are seeking $1.4 million, plus interest from January 1, 2015, together with costs and fees. See Part II: Item 1: Legal Proceedings-Edson R. Arneault, Kathleen Devlin and James Devlin, J. Steven Emerson, Emerson Partners, J. Steven Emerson Roth IRA, Steven Rothstein, and Barry Stark and Irene Stark v. Diamondhead Casino Corporation (In the United States District Court for the District of Delaware (C.A. No. 1:16-cv-00989-LPS).