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Risk Factor Disclosure Mark Shuman Special Counsel SEC, Division of Corporation Finance Risk Factor Disclosure Item 503(c) of Regulation S-K generally requires disclosure of the most significant factors that make the offering risky: • Concise and organized logically; • Explain how the risk affects the issuer or the securities; Risk Factor Disclosure (cont’d) • Presented under a sub-caption that adequately describes the risk; • Immediately follow the summary section; • Location referenced by page number on the cover. Risk Factors Should Avoid • Legalistic or overly complex presentations; • Vague "boilerplate" explanations that are imprecise; Risk Factors Should Avoid (cont’d) • Complex information copied directly from legal documents; • Repetitive disclosure that does not inform. Risk Factors Fall into Three Categories Industry Risk • Will acquire properties with significant environmental issues; • Seasonal demand, uncertain supply of raw materials. Risk Factors --Three Categories (cont’d) Company Risk • Specific owned properties require environmental clean-up; • Issuer has decided not to obtain insurance coverage. Risk Factors --Three Categories (cont’d) Investment Risk • No prior market; • Debt being offered is subordinate to current and future debt. Example of Industry Risk All of our key customers are telecommunications companies. If the telecommunications industry continues to experience significant economic downturn, our sales could be adversely impacted. Example of Industry Risk (cont’d) A significant portion of our revenues is generated from sales of our products and services to various telecommunications companies. During the last twelve to eighteen months, the telecommunications industry has endured a significant economic downturn. Telecommunications service providers have typically reduced planned capital spending, have reduced staff, and sought bankruptcy proceedings and/or ceased operations. Example of Industry Risk (cont’d) Consequently, the spending cutback of these organizations has affected the Company through reduced product orders. The decline in product orders negatively impacted our revenues,resulting in significant operating losses and negative cash flows. If the telecommunications industry experiences further economic downturns, this could negatively impact our sales and revenue generation, and consequently have a material adverse effect on our business, financial condition and results of operations. Example of Company Risk We may be unable to protect our proprietary rights, permitting competitors to duplicate our products and services, which could negatively impact our business and operations. Example of Company Risk (cont’d) We hold no patents on any of our technology. If we are unable to license any technology or products that we may need in the future, our business and operations may be materially and adversely impacted. However, we do not consider any of these licenses to be critical to our operations. We have made a consistent effort to minimize the ability of competitors to duplicate our software technology utilized in our products. Example of Company Risk (cont’d) However, there remains the possibility of duplication of our products, and competing products have already been introduced. Any such duplication by our competitors could negatively impact on our business and operations. We may be unable to protect our proprietary rights, permitting competitors to duplicate our products and services, which could negatively impact our business and operations. Example of Securities Risk Our common stock may be delisted from Nasdaq and if this occurs you may have difficulty converting your investment into cash efficiently. Example of Securities Risk (cont’d) The National Association of Securities Dealers, Inc. has established certain standards for the continued listing of a security on the Nasdaq National Market and the Nasdaq SmallCap Market. The standards for continued listing on either market require, among other things, that the minimum bid price for the listed securities be at least $1.00 per share. Example of Securities Risk (cont’d) Our Common Stock has traded below $1.00 since January 29, 2002, and on March 13, 2002, we received notice from Nasdaq stating that our Common Stock has not met the $1.00 continuing listing standard for a period of 30 consecutive trading days. There can be no assurance that we will continue to satisfy the requirements for maintaining a Nasdaq National Market or SmallCap listing. Example of Securities Risk (cont’d) If our common stock were to be excluded from Nasdaq, the prices of our common stock and the ability of holders to sell such stock would be adversely affected, and we would be required to comply with the initial listing requirements to be relisted on Nasdaq. Combination Risk – Issuer and Security We do not anticipate the payment of dividends. We have never declared or paid cash dividends on our common stock. We currently anticipate that we will retain all available funds for use in the operation of our business. Thus, we do not anticipate paying any cash dividends on our common stock in the foreseeable future. Sample Comment Currently, it appears you are including more than one risk factor under one subheading. For example, is the second paragraph under "Recent Operating Results" a significant risk factor of this offering that needs to stand alone under an explanatory subheading? Other examples of "bundled" risk factors include . . . In order to give the proper prominence to each risk you present, we suggest you assign each risk its own descriptive subheading. Another Sample Comment Provide the information investors need to assess the magnitude of the risk. For example, in the second risk factor on page 4, you state that increases in short-term interest rates could have a material adverse effect on XYZ Bank's profitability. Explain why. Are a substantial percentage of XYZ's interest-earning assets in long-term investments that pay fixed rates while the interest you pay to your depositors fluctuates? If so, what percentage of your interest-earning assets are in long-term investments? Risks Associated with Blank Check Offerings. What Is a Blank Check Offering? A blank check company: • Is a development stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and • Is issuing penny stock What Risks Are Associated with Blank Check Offerings? • Investors don’t have a business plan or history to evaluate; • Investors don’t know the business to be entered; • Investors don’t know the terms on which a business is acquired or entered; What Risks Are Associated with Blank Check Offerings? (cont’d) • Investor reliance upon management is pronounced; • Investors may be mislead about prospects. What is Required in a Blank Check Offering? • With limited exceptions, all securities issued in connection with an offering by a blank check company and the gross proceeds from the offering shall be deposited promptly into an escrow account; • Securities held in the escrow or trust account are to be held for the sole benefit of the purchasers; What is Required in a Blank Check Offering? (cont’d) • Upon acquisition of a business, amended disclosure is required and investors have a specified period to evaluate the proposed company and whether they wish to continue as investors; • If an acquisition has not occurred by a date 18 months after the effective date of the initial registration statement, funds held in the escrow or trust account shall be returned. Liquidity and Going Concern Problems In the past we have experienced significant losses and negative cash flows from operations. If these trends continue in the future, it could adversely affect our financial condition. Liquidity and Going Concern Problems (cont’d) We have incurred significant losses and negative cash flows from operations in the past. For the fiscal years ended March 31, 2001 and 2002, we experienced net losses of $16,676,666 and $6,929,379, respectively, and negative cash flows from operations of $7,086,246 and $5,026,038, respectively. These results have had a negative impact on our financial condition. Liquidity and Going Concern Problems (cont’d) There can be no assurance that our business will become profitable in the future and that additional losses and negative cash flows from operations will not be incurred.If these trends continue in the future, it could have a material adverse affect on our financial condition. Final Paragraph from Report of Independent Public Accountant The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company's recurring losses from operations and its difficulty in generating sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt about its ability to continue as a going concern. Final Paragraph from Report of Independent Public Accountant Management's plans concerning these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. MD&A Disclosure By Distressed Issuer Our consolidated financial statements have been prepared on the basis that we will continue as a going concern, which contemplates the realization and satisfaction of liabilities and commitments in the normal course of business. At March 31, 2002, we had an accumulated deficit of $37,094,424 and working capital of $5,040,922. We also realized net losses of $6,929,379 for the year ended March 31, 2002 and $16,676,666 for the year ended March 31, 2001. Our existing working capital might not be sufficient to sustain our operations. MD&A Disclosure By Distressed Issuer (cont’d) Our financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or to amounts and classification of liabilities that may be necessary should we be unable to continue as a going concern. More MD&A Disclosure By Distressed Issuer The decline in product orders negatively impacted our revenues, resulting insignificant operating losses and negative cash flows. As a result, it is imperative for us to be successful in increasing our revenue, reducing costs,and/or securing additional funding in fiscal 2003 in order to continue operating as a going concern. MD&A Disclosure By Distressed Issuer— The Problem Quantified We believe that a minimum of $2,000,000 in additional capital will be needed in order to fund the Company's planned operations through June 2003. We plan to seek equity financing to provide funding for operations but the current market for equity financing is very weak. If we are not successful in raising additional equity capital to generate sufficient cash flows to meet our obligations as they come due, we plan to continue to reduce our overhead expenses by the reduction of headcount and other available measures. MD&A Disclosure By Distressed Issuer— The Problem Quantified (cont’d) We may also explore the possibility of mergers and acquisitions. If we are not successful in increasing our revenue, reducing our expenses or raising additional equity capital to generate sufficient cash flows to meet our obligations as they come due, we may not be able to continue as a going concern. The Plan to Address the Problem Our plans to overcome this condition includes refocusing our sales efforts to include penetrating additional markets with our enterprise infrastructure security products, reducing expenses and raising additional equity capital. On February 14, 2002, we received $3,480,000 from the issuance of new shares in a private placement of 4,000,000 shares of Common Stock. The Plan to Address the Problem (cont’d) We have restructured and reorganized to reduce our operating expenses by the layoff of 8 employees in July 2002 which reduced the Company's overhead expenses by approximately $575,000 in annual salaries and employee benefits. The Plan to Address the Problem (cont’d) The Company has refocused its sales effort to emphasize the selling of its software products and reengineered its hardware products in an effort to increase gross margins. The Company has begun to establish alternate channels that will open opportunities in the future to sell our products without the overhead expenses associated with headcount. The Plan to Address the Problem (cont’d) We can not assure that our sales efforts or expense reduction programs will be successful, or that additional financing will be available to us, or, if available, that the terms will be satisfactory to us. The Plan to Address the Problem (cont’d) If we are not successful in increasing our revenue, reducing our expenses or raising additional equity capital, to generate sufficient cash flows to meet our obligations as they come due, we may not be able to continue as a going concern. Dealing With Issuers Under Investigation • Issuer may or may not know about the investigation; • Inquiry-investigation process typically is not disclosed; Dealing With Issuers Under Investigation (cont’d) • Disclosure and Enforcement operations are by different persons; • Disclosure concerns—issuer has the disclosure obligation. When Issuer Is Aware of Enforcement Interest All persons who are responsible for the accuracy and adequacy of the disclosure in the registration statement are urged to be certain that all information required for investors to make an informed investment decision is provided. Since ABC and its management are in possession of all facts with respect to the matter under investigation they are responsible for the accuracy and adequacy of the disclosures made. When Issuer is Aware of Enforcement Interest (cont’d) In the event that ABC requests acceleration of the effective date of the pending registration statement, ABC should furnish a letter at the time of such request which acknowledges the following: When Issuer is Aware of Enforcement Interest (cont’d) The disclosure in the filing is is the responsibility of ABC. ABC represents to the Commission that should the Commission or the staff acting pursuant to delegated authority, declare the filing effective, it does not foreclose the Commission from taking any action with respect to the filing and ABC represents that it will not assert this action as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States. When Issuer is Aware of Enforcement Interest (cont’d) ABC further acknowledges, that the action of the Commission or the staff, acting pursuant to delegated authority, in declaring the filing effective does not relieve ABC from its full responsibility for the adequacy and accuracy of the disclosures in the filing.
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