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EX-32.1 - EXHIBIT 32.1 - VERTICAL COMPUTER SYSTEMS INCv378559_ex32-1.htm

 

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 March 31, 2014

 

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

 

For the transition period from _____ to _____

 

 

 

Commission file number 0-28685

 

 

 

VERTICAL COMPUTER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware 65-0393635
(State of incorporation) (I.R.S. Employer Identification No.)

 

101 West Renner Road, Suite 300

Richardson, TX 75082

(Address of principal executive offices)

 

(972) 437-5200

(Registrant’s Telephone Number)

 

 

 

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 of 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 the 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    ¨ (Do not check if a smaller  reporting company) 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

 

As of May 15, 2014, the issuer had 999,535,151 shares of common stock, par value $0.00001, issued and outstanding.

 

 
 

 

PART I

FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

 

   March 31,   December 31, 
   2014   2013 
Assets          
Current assets          
Cash  $423,957   $162,709 
Accounts receivable, net of allowance for bad debts of $55,847 and $83,326   1,002,528    562,831 
Prepaid expenses and other current assets   93,553    87,930 
Total current assets   1,520,038    813,470 
           
Property and equipment, net of accumulated depreciation of $1,030,214 and $1,028,102   21,215    22,596 
Intangible assets, net of accumulated amortization of $270,433 and $259,835   823,560    992,996 
Deposits and other   31,423    31,520 
           
Total assets  $2,396,236   $1,860,582 
           
Liabilities and Stockholder's Deficit          
Current liabilities:          
Accounts payable and accrued liabilities  $10,550,115   $9,763,921 
Accounts payable to related parties   23,594    23,594 
Bank overdraft   34,348    1,928 
Deferred revenue   2,366,264    2,317,989 
Derivative liability   258,599    263,340 
Convertible debenture   30,000    30,000 
Current portion - notes payable   3,010,593    3,006,561 
Current portion - notes payable to related parties   323,166    344,158 
Total current liabilities   16,596,679    15,751,491 
           
Non-current portion – notes payable   1,478,352    1,505,951 
           
Total liabilities   18,075,031    17,257,442 

 

See accompanying notes to the unaudited consolidated financial statements.

 

(Continued on next page)

 

2
 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

 

(Continued from previous page)

 

   March 31,   December 31, 
   2014   2013 
Series A 4% Convertible Cumulative  Preferred stock; $0.001 par value;          
250,000 shares authorized; 48,500 shares issued and outstanding   9,700,000    9,700,000 
Series B 10% Convertible Cumulative Preferred stock; $0.001 Par Value;          
375,000 shares authorized; 7,200 shares issued and outstanding   246    246 
Series C 4% Convertible Cumulative Preferred stock; $100.00 par value;          
200,000 shares authorized; 50,000 shares issued and outstanding   200,926    200,926 
Series D 15% Convertible Cumulative Preferred stock; $0.001 Par Value;          
300,000 shares authorized; 25,000 shares issued and outstanding   852    852 
    9,902,024    9,902,024 
           
Stockholders' Deficit          
Common Stock; $.00001 par value; 1,000,000,000 shares authorized          
 999,385,151 and  998,985,151 issued and outstanding as of March 31, 2014 and December 31, 2013   9,994    9,990 
Additional paid-in-capital   19,428,409    19,420,513 
Accumulated deficit   (46,094,978)   (45,691,721)
Accumulated other comprehensive income – foreign currency translation   (6,310)   (118,548)
           
Total Vertical Computer Systems, Inc. stockholders’ deficit   (26,662,885)   (26,379,766)
           
Noncontrolling interest   1,082,066    1,080,882 
Total stockholders’ deficit   (25,580,819)   (25,298,884)
           
Total liabilities and stockholders' deficit  $2,396,236   $1,860,582 

 

See accompanying notes to the unaudited consolidated financial statements.

 

3
 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

 

   Three Months Ended March 31, 
   2014   2013 
Revenues          
Licensing and software  $875,000   $- 
Software maintenance   1,026,363    1,085,879 
Cloud-based offering   109,916    119,068 
Consulting services   78,100    110,737 
Other   14,639    28,144 
Total revenues   2,104,018    1,343,828 
           
Cost of revenues   586,718    663,616 
           
Gross profit   1,517,300    680,212 
           
Operating expenses:          
Selling, general and administrative expenses   1,432,953    823,860 
Depreciation and amortization   11,919    14,098 
Bad debt expense   -    - 
Total operating expenses   1,444,872    837,958 
           
Operating income (loss)   72,428    (157,746)
           
Other income (expense):          
Impairment of software costs   (192,955)   - 
Interest income   8    7 
Gain on derivative liability   4,741    6,550 
Forbearance fees   (73,301)   - 
Interest expense   (213,522)   (146,051)
           
Net loss   (402,601)   (297,240)
           
Net income (loss) attributable to noncontrolling interest   (656)   12,742 
Net loss attributable to Vertical Computer Systems, Inc.   (403,257)   (284,498)
Dividends applicable to preferred stock   (147,000)   (147,000)
           
Net loss available to common stockholders  $(550,257)  $(431,498)
           
Basic and diluted loss per share  $(0.00)  $(0.00)
           
Basic and diluted weighted average of common shares outstanding   999,125,151    998,075,151 
           
Comprehensive loss          
Net loss  $(402,601)  $(297,240)
Translation adjustments   112,238    44,804 
Comprehensive loss   (290,363)   (252,436)
Comprehensive income (loss) attributable to noncontrolling interest   (656)   12,742 
Comprehensive loss attributable to Vertical Computer Systems, Inc.  $(291,019)  $(239,694)

 

See accompanying notes to the unaudited consolidated financial statements.

 

4
 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

(Unaudited)

 

           Additional       Other   Non-controlling     
   Common Stock   Paid-in   Accumulated   Comprehensive   Controlling     
   Shares   Amount   Capital   Deficit   Interest   Interest   Total 
Balances at December 31, 2013   998,985,151   $9,990   $19,420,513   $(45,691,721)  $(118,548)  $1,080,882   $(25,298,884)
                                    
Shares issued for stock compensation that was previously accrued   400,000    4    7,896    -    -    -    7,900 
                                    
Other comprehensive income translation adjustment   -    -    -    -    112,238    528    112,766 
                                    
Net  loss   -    -    -    (403,257)   -    656    (402,601)
                                    
Balances at  March 31, 2014   999,385,151   $9,994   $19,428,409   $(46,094,978)  $(6,310)  $1,082,066   $(25,580,819)

 

See accompanying notes to the unaudited consolidated financial statements.

 

5
 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

   Three Months Ended March 31, 
   2014   2013 
         
Cash flows from operating activities          
Net loss  $(402,601)  $(297,240)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:          
Depreciation and amortization   11,919    14,098 
Impairment of software development costs   192,955    - 
Gain on derivatives   (4,741)   (6,550)
Changes in operating assets and liabilities:          
Accounts receivable   (439,805)   41,012 
Prepaid expenses and other assets   (5,417)   (7,135)
Accounts payable and accrued liabilities   793,313    225,243 
Deferred revenue   48,275    (22,719)
Net cash provided by (used in) operating activities   193,898    (53,291)
           
Cash flow from investing activities:          
Software development   (33,200)   (5,873)
Purchase of property and equipment   -    (3,414)
Net cash used in investing activities   (33,200)   (9,287)
           
Cash flows from financing activities:          
Borrowings on notes payable   -    1,759,150 
Payments of notes payable   (23,644)   (1,419,907)
Payments of related party notes payable   (20,992)   (381,583)
Bank overdraft   32,419    (9,607)
Net cash used in financing activities   (12,217)   (51,947)
           
Effect of changes in exchange rates on cash   112,767    44,804 
Net change in cash and cash equivalents   261,248    (69,721)
Cash and cash equivalents, beginning of period   162,709    111,851 
Cash and cash equivalents, end of period  $423,957   $42,130 
           
Supplemental disclosures of cash flow information:          
Cash paid for interest  $89,989   $85,385 
           
Non-cash investing and financing activities:          
Common shares issued for accrued stock compensation  $7,900   $7,900 

 

See accompanying notes to unaudited consolidated financial statements.

 

6
 

 

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

Note 1. Organization, Basis of Presentation and Significant Accounting Policies

 

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”, the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the year ended December 31, 2013. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable). Vertical’s subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet, Inc.”), a wholly-owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc. (“Taladin"), OptVision Research, Inc. (“OptVision”), Vertical Healthcare Solutions, Inc., each a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. (“Priority Time”) a 90% owned subsidiary, and Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary, Vertical’s subsidiaries which are inactive include EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. (“PMI”) and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned subsidiary of Vertical. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the consolidated financial statements which would substantially duplicate the disclosure contained in the audited financial statements as reported in the 2013 annual report on Form 10-K have been omitted.

 

Earnings per share

 

Basic earnings per share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of shares of the Company’s common stock outstanding during the period. “Diluted earnings per share” reflects the potential dilution that could occur if our share-based awards and convertible securities were exercised or converted into common stock. The dilutive effect of our share-based awards is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. The dilutive effect of our convertible preferred stock and convertible debentures is computed using the if-converted method, which assumes conversion at the beginning of the year.

 

For the three months ended March 31, 2014 and 2013, common stock equivalents related to the convertible debentures, convertible debt and preferred stock and stock derivative liability were not included in the calculation of the diluted earnings per share as their effect would be anti-dilutive.

 

Reclassifications

 

Certain reclassifications have been made to the prior periods to conform to the current period presentation.

  

Capitalized Software Costs

 

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value. The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value.

 

During the three months ended March 31, 2014, the Company capitalized an aggregate of $33,200 related to software development and the Company recorded impairment of $192,955 on previously capitalized software development costs.

 

Recently Issued Accounting Pronouncements

 

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial position, operations or cash flows.

 

Note 2. Going Concern

 

The accompanying unaudited consolidated financial statements for the three months ended March 31, 2014 and 2013 have been prepared assuming that we will continue as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal course of business.

 

The carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement values. As of March 31, 2014, we had negative working capital of approximately $15.1 million and defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

 

7
 

 

Our management is continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations. The Company will require additional funds to pay down its liabilities, as well as finance its expansion plans consistent with anticipated changes in operations and infrastructure. However, there can be no assurance that the Company will be able to secure additional funds and that if such funds are available, whether the terms or conditions would be acceptable to the Company and whether the Company will be able to turn into a profitable position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.

 

Note 3. Notes Payable

 

The following table reflects our third party debt activity, including our convertible debt, for the three months ended March 31, 2014:

 

December 31, 2013  $4,542,512 
Repayments of third party notes   (23,644)
Effect of currency exchange   77 
March 31, 2014  $4,518,945 

 

On January 9, 2013, NOW Solutions completed a financing transaction in the aggregate amount of $1,759,150, which amount was utilized to pay off existing indebtedness of the Company and NOW Solutions to Tara Financial Services and Robert Farias, a former employee of the Company and all security interests granted to Tara Financial Services and Robert Farias were cancelled.

 

In connection with this financing, the Company and several of its subsidiaries entered into a loan agreement (the “Loan Agreement”), dated as of January 9, 2013 with Lakeshore Investment, LLC (“Lakeshore”) under which NOW Solutions issued a secured 10-year promissory note (the “Lakeshore Note”) bearing interest at 11% per annum to Lakeshore in the amount of $1,759,150. The Lakeshore Note contains provisions requiring additional principal reductions in the event sales by NOW Solutions exceed certain financial thresholds. Upon the payment of any prepayment principal amounts, the monthly installment payments shall be adjusted proportionately on an amortized pro rata basis.  The Lakeshore Note is currently payable in equal monthly installments of $22,987 until January 31, 2022.

 

The Lakeshore Note is secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. and the Company’s SiteFlash technology and cross-collateralized. Upon the aggregate principal payment of $290,000 toward the Lakeshore Note, the Company has the option to have Lakeshore release either the Priority Time collateral or the SiteFlash collateral. Upon payment of the aggregate principal $590,000 toward the Lakeshore Note, Lakeshore shall release either the Priority Time collateral or the SiteFlash collateral (whichever is remaining). Upon payment of the aggregate principal $890,000 toward the Lakeshore Note, Lakeshore shall release the SnAPPnet collateral and upon full payment of the Lakeshore Note, Lakeshore shall release the NOW Solutions collateral.

 

As additional consideration for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney’s fees and direct costs) from any litigation or settlement proceeds related to the SiteFlash technology to Lakeshore. In addition, until the Note is paid in full, NOW Solutions agreed to pay a Lakeshore royalty of 6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150.

 

Pursuant to the Loan Agreement, as amended, the Company also agreed to make certain principal payments toward the Lakeshore Note of (a) $90,000 by February 15, 2013, which was secured by 15% interest in the Company’s ownership of Priority Time and this payment was timely made to Lakeshore and (b) $600,000 by March 15, 2013, which was secured by 25% of the Company’s ownership interest in NOW Solutions and this payment was not made to Lakeshore. As of September 30, 2013, the common shares of NOW Solutions representing a 25% ownership interest in NOW Solutions were in Lakeshore’s possession, but Lakeshore had not taken action to transfer the shares in Lakeshore’s name due to forbearance agreements that have been entered into between March and August 2013. In connection with these forbearance agreements, the Company increased the 5% interest in Net Claim Proceeds to an 8% interest, paid a $100,000 transaction fee and made other payments including the issuance of 1,000,000 common shares valued at $47,000 and $5,000 weekly payments whereby such $5,000 payments are to be applied toward a bonus of 25% of NOW Solutions’ profits for the period that runs from March 15, 2013 through September 30, 2013. The aggregate forbearance fees paid to Lakeshore for the year ended December 31, 2013 were $327,867. The last forbearance agreement expired on September 30, 2013 and on October 1, 2013, Lakeshore became a 25% minority owner of NOW Solutions.  While there was an October 1, 2013 amendment to the Loan Agreement that the Company believed was in effect, whereby shares of common stock representing a 25% ownership interest of NOW Solutions (the “NOW shares”) in Lakeshore’s possession were to be returned to the Company, certain terms of the amendment were not fulfilled, resulting in the Company recognizing Lakeshore as the owner of the NOW Shares.  The Company is currently in discussions with Lakeshore to work out terms under which the Company can buy back the NOW Shares.

 

8
 

 

Note 4. Derivative liability and fair value measurements

 

Derivative liabilities

 

During 2008, one of our officers pledged 3,000,000 shares of common stock (through a company he controls) to secure the debt owed to a third party lender. In connection with the pledge of stock, we signed an agreement to replace these shares within one year. Subsequent to this agreement, 1,309,983 shares of this stock were sold to satisfy the debt owed to the lender.

 

In August 2013, an officer of the Company transferred 1,000,000 shares of common stock owned by him to our senior secured lenders in connection with an option and forbearance. In connection with the transfer of the stock, the Company signed an agreement to replace these shares. The initial fair value of these shares was determined to be $47,000 as of August 28, 2013.

 

In October 2013, one of our officers transferred 1,000,000 shares of common stock (through a company he controls) on behalf of the Company to a third party lender in consideration of a $100,000 loan made to the Company. In connection with the transfer of the stock, the Company signed an agreement to replace these shares. The initial fair value of these shares was determined to be $85,000 as of October 31, 2013.

 

In December 2013, a note payable secured by 1,000,000 shares of common stock pledged by an officer of the company (through a company he controls) to secure payment of a $50,000 loan by a third party lender to the Company became past due. In connection with the pledge of stock, we are obligated to replace these shares if the shares were transferred to the lender. This note is currently in default and therefore these shares have been classified as a derivative liability as of December 31, 2013.. As the Company does not have sufficient authorized stock to issue these shares, they were recorded as derivative liabilities. The initial fair value of these shares was determined to be $72,000 as of December 9, 2013.

 

These contractual commitments to replace all of the pledged shares was evaluated under FASB ASC 815-40, Derivatives and Hedging and was determined to have characteristics of a liability and therefore constituted a derivative liability under the above guidance. Each reporting period, this derivative liability is marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At March 31, 2014 and December 31, 2013, the aggregate fair value of the derivative liabilities was $258,599 and $263,340.

 

The aggregate change in the fair value of derivative liabilities was a gain of $4,741 and $6,550 for the three months ended March 31, 2014 and 2013, respectively.

 

The valuation of our embedded derivatives is determined by using the VCSY stock price at March 31, 2014. As such, our derivative liabilities have been classified as Level 1.

 

Fair value measurements

 

FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. FASB ASC 820 describes three levels of inputs that may be used to measure fair value:

 

Level 1 – Quoted prices in active markets for identical assets or liabilities.

 

Level 2 – Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

Level 3 – Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation.

 

If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level of input that is significant to the fair value measurement of the instrument.

 

9
 

 

The following table provides a summary of the fair value of our derivative liabilities as of March 31, 2014 and December 31, 2013:

 

   Fair value measurements on a recurring basis 
   Level 1   Level 2   Level 3 
As of March 31, 2014:            
Liabilities               
Stock derivative – 4,309,983 shares  $258,599   $-   $- 
                
As of December 31, 2013:               
Liabilities               
Stock derivative – 4,309,983 shares  $263,340   $-   $- 

  

The estimated fair value of short-term financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities and deferred revenue approximates their carrying value due to their short-term nature. The estimated fair value of our long-term borrowings approximates carrying value since the related rates of interest approximate current market rates.

 

Note 5. Common and Preferred Stock Transactions

 

During the three months ended March 31, 2014, 400,000 common shares previously granted to employees of the Company in 2012 vested. Stock compensation that was previously accrued totaling $7,900 was reclassified from accrued liabilities to stockholders’ equity associated with these shares vesting.

 

As of March 31, 2014, we have determined that we currently have (i) the following shares of common stock issued, and (ii) outstanding shares of preferred stock which are convertible into the shares of common stock indicated below and a contractual commitment to issue the shares of common stock indicated below:

 

 999,385,151   Common Stock Granted and Outstanding
 150,000   Common Stock Granted and Outstanding, but not vested
 4,309,983   Common Shares Company Is Obligated to Reimburse to officers of the Company for pledged shares sold and transferred on the Company’s behalf
 24,250,000   Common Shares convertible from Preferred Series A Stock (48,500 shares outstanding)
 27,274   Common Shares convertible from Preferred Series B Stock (7,200 shares outstanding)
 5,000,000   Common Shares convertible from Preferred Series C Stock (50,000 shares outstanding)
 94,700   Common Shares convertible from Preferred Series D Stock  (25,000 shares outstanding)
 1,033,217,108   Total Common Shares Outstanding and Accounted For/Reserved

 

In addition, the Company has $30,000 in an outstanding convertible debenture that had been issued to a third party.

 

Accordingly, given the fact that the Company currently has 1,000,000,000 shares of common stock authorized, the Company could exceed its authorized shares of common stock by approximately 33,600,000 shares if all of the financial instruments described in the table above were exercised or converted into shares of common stock (which does not include the shares that would be converted from the $30,000 outstanding debenture noted above).

 

We have evaluated our convertible cumulative preferred stock under the guidance set out in FASB ASC 470-20 and have accordingly classified these shares as temporary equity in the consolidated balance sheets.

 

10
 

 

Note 6. Stock Options, Warrants and Restricted Stock Awards

 

Stock Options and Warrants

 

There are currently no outstanding common stock options or warrants.

 

Restricted Stock

 

A summary of the activity of the restricted stock for the three months ended March 31, 2014 is shown below.

 

   Shares   Weighted
Average
Grant-Date
Fair Value
 
         
Non Vested Balance at December 31, 2013   550,000   $0.0186 
Granted   -    - 
Vested   (400,000)   0.0198 
Forfeited/Cancelled   -    - 
Non Vested Balance at March 31, 2014   150,000   $0.0155 

 

As of March 31, 2014, there was $191 of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of less than 3 years.

 

Note 7. Related Party Transactions

 

The following table reflects our related party debt activity for the three months ended March 31, 2014:

 

December 31, 2013  $344,158 
Repayments of related party notes   (20,992)
March 31, 2014  $323,166 

 

As of March 31, 2014 and December 31, 2013, the Company had accounts payable to two employees in an aggregate amount of $23,594. The payables are unsecured, non-interest bearing and due on demand.

 

Note 8. Legal Proceedings

 

We are involved in the following ongoing legal matters:

 

On November 18, 2009, we sued InfiniTek Corporation (“InfiniTek”) in the Texas State District Court in Fort Worth, Texas for breach of contract and other claims (the “Texas Action”) seeking equitable relief and unspecified damages when a dispute between the Company and InfiniTek was not resolved. All agreements with InfiniTek have been cancelled. On January 15, 2010, InfiniTek filed a counter-claim for non-payment of amounts billed. InfiniTek claimed it was owed $195,000 plus lost opportunity costs of not less than $220,000.

 

On April 7, 2010, we were served with a lawsuit filed by InfiniTek in the California Superior Court in Riverside, California seeking damages in excess of $76,303 for breach of contract and lost profit (the “California Action”). This lawsuit related to one of the causes of action and the same set of underlying facts, as those in the Texas legal action. On May 7, 2010, we filed a motion to dismiss this action. On July 14, 2010, the court denied our motion. On August 13, 2010, we filed an answer to InfiniTek’s complaint, including a denial and affirmative defenses.

 

On December 31, 2011, the Company and InfiniTek entered into a settlement agreement whereby the Texas Action and the California Action were both dismissed. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek shall transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and accrued liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500 in payments due under the settlement agreement as of November 16, 2012 and each party is alleging the other party is in breach of the settlement agreement. We are currently seeking to resolve all disputes with InfiniTek.

 

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On November 15, 2010, we filed a lawsuit in the Federal District Court for the Eastern District of Texas (the “Vertical Action”) against Interwoven, Inc. ("Interwoven"), LG Electronics MobileComm U.S.A., Inc., LG Electronics, Inc., Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (collectively, the "Defendants"). We sued the Defendants for patent infringement claims under United States Patent No. 6,826,744 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) and United States Patent No. 7,716,629 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) (collectively the “the Patents-in-Suit”), both of which are owned by the Company. We seek an award of monetary damages and other relief. The case is styled Vertical Computer Systems, Inc. v Interwoven, Inc., LG Electronics Mobilecomm U.S.A., Inc., No. 2:10-CV-00490.

 

On November 17, 2010, we were served with a lawsuit filed on October 14, 2010 by Interwoven in the United States District Court for the Northern District of California (the “Interwoven Action”). This lawsuit was instituted as a complaint for declaratory judgment, in which Interwoven requested that the court find that no valid and enforceable claim of either of the two patents referenced above has been infringed by Interwoven. The case is styled Interwoven, Inc. v Vertical Computer Systems, Inc. No. 3:10-CV-4645-RS.

 

On January 11, 2011, Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (“Samsung”) filed a lawsuit in the United States District Court for the Northern District of California seeking to consolidate its lawsuit with the Interwoven Action. This case is styled Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc., v. Vertical Computer Systems, Inc., No. 3:11-CV-00189-RS.

 

On May 2, 2011, the United States District Court for the Northern District of California denied Vertical’s renewed motion to transfer the Interwoven Action to the Eastern District of Texas and granted Vertical's motion to transfer the lawsuit filed by Samsung in the Northern District of California to the Eastern district in Texas. On May 11, 2011, the United States District Court for the Eastern District of Texas granted Interwoven’s motion to transfer the case to the Northern District of California with respect to Interwoven and denied Samsung’s motion to transfer its case to the Northern district.

 

On December 30, 2011, the United States District Court for the Northern District of California issued a claims construction order in the Interwoven Action concerning the terms found in the claims of the Patents-in-Suit.

 

On October 12, 2012, the United States Patent and Trademark Office (“USPTO”) issued an ex parte reexamination certificate of United States Patent No. 7,716,629.  In the ex parte reexamination certificate, Claims 21-36, 29, 30, and 32 were confirmed; Claims 1, 8, 11, 13, 28 and 31 were determined to be patentable as amended, Claims 2-6, 9, 10, 12, 14-17, 19 and 20, which were dependent on an amended claim, were determined to be patentable, and claims 7, 18 and 27 were not reexamined.

 

On October 25, 2012, the USPTO notified the Company of its intent to issue an ex parte reexamination certificate concerning the ex parte reexamination of United States Patent No. 6,826,744.  In the notice of intent to issue ex parte reexamination certificate, the USPTO notified that the prosecution on the merits is closed in this ex parte reexamination proceeding and indicated that Claims 6, 8, 19, 22, 30, 32, 41, 44, 50, 51 were confirmed; Claims 1 and 26 were cancelled; Claims 12-17, 20, 34-39, 42 and 43 are not subject to reexamination; newly presented Claims 54-57 are patentable and continuation of patent claims amended: 2-5, 7, 9-11, 18, 21, 23-25, 27-29, 31, 33, 40, 45-49, 52 and 53.

 

On January 4, 2013, the United States District Court for the Northern District of California in the Interwoven Action denied Interwoven’s motion for summary judgment for unenforceability and invalidity of the Patents-in-Suit in its entirety.

 

On July 17, 2013, the United States District Court for the Northern District of California in the Interwoven Action ruled on Interwoven’s motion for summary judgment with respect to infringement and damages concerning the Patents-in-Suit. The court denied Interwoven’s motion for summary judgment on the issue of direct infringement and granted summary judgment in favor of Interwoven with respect to infringement on the doctrine of equivalents and with respect to indirect infringement. The court also granted in part and denied in part Interwoven’s motion to exclude certain expert witness testimony.

 

On September 16, 2013, the United States District Court for the Eastern District of Texas issued a claims construction order in the Vertical Action concerning the terms found in the claims of the Patents-in-Suit. On December 12, the Company settled the patent infringement claim that the Company initiated in federal court against LG. Pursuant to the confidential settlement agreement, the Company has granted to LG a non-exclusive, fully paid-up license under the two patents (“Patents-in-Suit”) with any continuation patents of the Patents-in-Suit and any other continuation patents with the same priority claim as the Patents-in-Suit.

 

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On December 12, 2013, the Company settled its patent infringement claim against LG Electronics. Pursuant to the confidential settlement agreement, the Company granted to LG Electronics a non-exclusive, fully paid-up license under the Patents-in-Suit which were the subject of the legal proceeding. The litigation concerning the Patents-in-Suit with LG has been resolved.

 

On March 20, 2014, the Company settled the patent infringement claim that the Company initiated in federal court against Samsung. Pursuant to the confidential settlement agreement, the Company has granted to Samsung a non-exclusive, fully paid-up license under the Patents-in-Suit with any continuation patents of the Patents-in-Suit and any other patents with the same priority claim as the Patents-in-Suit. The litigation concerning the Patents-in-Suit with Samsung has been resolved.

 

On May 8, 2014, the Company settled the patent infringement claim that the Company initiated in federal court against Interwoven. Pursuant to the confidential settlement agreement, the Company has granted to Interwoven and its subsidiaries, affiliates and parent companies (which include Autonomy Corporation PLC and Hewlett-Packard Company, Inc.), a non-exclusive, fully paid-up license to the Patents-in-Suit with any continuation patents of the Patents-in-Suit and any other patents with the same priority claim as the Patents-in-Suit. The Interwoven Action has been resolved.

 

On July 8, 2011, we were served with a lawsuit in the Texas State District Court in Dallas, Texas by Clark Consulting Services, Inc. (“CCS”) for breach of contract and other claims.  CCS was seeking damages from us in excess of $133,750 plus attorney’s fees and interest.  On August 8, 2011, we filed an answer denying CCS’s claims and setting forth affirmative defenses.  In December 2011, the Company and CCS entered into a settlement agreement whereby the lawsuit was dismissed. Pursuant to the terms of the settlement agreement, the Company agreed to pay CCS $134,000, which was to be paid in installment payments. Due to the Company’s failure to make timely payments, an additional $60,000 was added to the outstanding balance. On October 26, 2012, we entered into an agreement under which we agreed to make monthly payments of $5,000 and pay the outstanding balance plus attorney’s fees and costs by February 1, 2013. As of December 31, 2012, the settlement amount of $149,000 has been included in accounts payable and accrued liabilities. During 2013, the parties entered into several agreements to extend the date by which the Company has to pay off the balance of the settlement amount whereby. Under these agreements, the Company agreed to make monthly payments of $10,000 (of which $2,500 of each payment would be applied as late fees) beginning in February 2013 through November 2013 until the outstanding balance has been paid. As of May 15, 2014, the outstanding settlement balance is $50,500.

 

On October 11 2012, Micro Focus (US), Inc. (“Micro Focus”) filed a lawsuit against NOW Solutions in the United States District Court for the southern division district of Maryland alleging breaches of its contractual obligations under an independent software agreement and copyright infringement. On January 28, 2013, NOW Solutions and Micro Focus entered into a settlement agreement whereby NOW Solutions agreed to pay Micro Focus $420,000, of which $70,000 in installment payments were made with the outstanding balance due on April 30, 2013. In connection with the settlement, the Company entered into a guaranty agreement with Micro Focus concerning NOW Solutions’ obligations under the promissory note. The Company did not make the $375,000 payment due to Micro Focus. On May 15, 2013, Vertical was served with a lawsuit in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning the guaranty by Vertical to Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. On July 3, 2013, NOW Solutions was served with a lawsuit for a confessed judgment in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. On January 15, 2014, the Company and NOW Solutions consented to a judgment in the amount of $350,000, plus $36,000 in accrued interest and attorney’s fees in the amount of $80,000, plus accrued interest at the rate of 10% per annum until paid. As of May 15, 2014, the Company has made payments in the amount of $250,000 to Micro Focus.

 

On February 4, 2014, Victor Weber filed a lawsuit against Vertical Mountain Reservoir Corporation (“MRC”), and Richard Wade in the District Court of Clark County, Nevada for failure to make payment of the outstanding balance due under a $275,000 promissory note issued by Vertical to Mr. Weber. The plaintiff seeks payment of the principal balance due under the note $275,000, default interest at the rate of 18% per annum, attorney’s fees and court costs, and punitive damages. On April 14, the Company and MRC filed an answer to Mr. Weber’s complaint. We are currently seeking to resolve this matter with Mr. Weber. Mr. Wade is the President and CEO of Vertical and the President of MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade is the trustee of the W5 Family Trust.

 

Note 9. Subsequent Events

 

In April 2014, the Company and a third party lender entered into a loan agreement under which the lender loaned Vertical $150,000. Pursuant to the loan agreement, Vertical issued a promissory note in the principal amount of $150,000 bearing interest at 12% per annum and due by May 15, 2014.  In connection with the loan, the company is obligated to pay a commitment fee of $14,500 and other payments totaling $43,500 owed to the lender under previous contractual obligations with the lender by May 15, 2014. All amounts due under this loan agreement have been repaid.

 

In May 2014, the Company and a third party lender entered into a loan agreement under which the lender loaned Vertical $81,282. Pursuant to the loan agreement, Vertical issued a promissory note in the principal amount of $81,282, bearing interest at 12% per annum and due by May 31, 2014.  In connection with the loan, the company is obligated to pay a commitment fee of $7,500 and other payments totaling $95,500 owed to the lender under previous contractual obligations with the lender by May 31, 2014.

 

During the period that runs from April 1, 2014 through May 15, 2014, 150,000 shares granted to a consultant of the Company in 2012, valued at $2,325, vested.

 

For subsequent events concerning parties we are involved in litigation with, please see “Legal Proceedings” under Note 8.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion is a summary of the key factors management considers necessary or useful in reviewing the Company’s results of operations, liquidity and capital resources. The following discussion and analysis should be read together with the accompanying Unaudited Consolidated Financial Statements, and the cautionary statements and risk factors included below in Item 1A of Part II of this Report.

 

Critical Accounting Policies

 

Capitalized Software Costs

 

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design.  Thereafter, all software development costs are capitalized until the point that the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value.  The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years.  The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value.  During the three months ended March 31, 2014 and 2013, $33,200 and $5,873 of internal costs were capitalized, respectively. During the three months ended March 31, 2014, $192,955 of capitalized software costs were written-off as impaired.

 

Revenue Recognition

 

Our revenue recognition policies are in accordance with standards on software revenue recognition, which include guidance on revenue arrangements with multiple deliverables and arrangements that include the right to use of software stored on another entity’s hardware.

 

In the case of non-software arrangements, we apply the guidance on revenue arrangements with multiple deliverables and wherein multiple elements are allocated to each element based on the element’s relative fair value. Revenue allocated to separate elements is recognized for each element in accordance with our accounting policies described below. If we cannot account for items included in a multiple-element arrangement as separate units of accounting, they are combined and accounted for as a single unit of accounting and generally recognized as the undelivered items or services are provided to the customer.

 

Consulting. We provide consulting services, primarily implementation and training services, to our clients using a time and materials pricing methodology. The Company prices its delivery of consulting services on a time and materials basis where the customer is either charged an agreed-upon daily rate plus out-of-pocket expenses or an hourly rate plus out-of-pocket expenses. In this case, the Company is paid fees and other amounts generally on a monthly basis or upon the completion of the deliverable service and recognizes revenue as the services are performed.

 

Software License. We sell concurrent perpetual software licenses to our customers. The license gives the customer the right to use the software without regard to a specific term. We recognize the license revenue upon execution of a contract and delivery of the software, provided the license fee is fixed and determinable, no significant production, modification or customization of the software is required and collection is considered probable by management. When the software license arrangement requires the Company to provide consulting services that are essential to the functionality of the software, the product license revenue is recognized upon the acceptance by the customer and consulting fees are recognized as services are performed.

 

Software licenses are generally sold as part of a multiple-element arrangement that may include maintenance and, under a separate agreement, consulting services. The consulting services are generally performed by the Company, but the customer may use a third-party to perform the consulting services. We consider these separate agreements as being negotiated as a package. The Company determines whether there is vendor specific objective evidence of fair value (‘‘VSOEFV’’) for each element identified in the arrangement, to determine whether the total arrangement fees can be allocated to each element. If VSOEFV exists for each element, the total arrangement fee is allocated based on the relative fair value of each element. In cases where there is not VSOEFV for each element, or if it is determined that services are essential to the functionality of the software being delivered, we initially defer revenue recognition of the software license fees until VSOEFV is established or the services are performed. However, if VSOEFV is determinable for all of the undelivered elements, and assuming the undelivered elements are not essential to the delivered elements, we will defer recognition of the full fair value related to the undelivered elements and recognize the remaining portion of the arrangement value through application of the residual method. Where VSOEFV has not been established for certain undelivered elements, revenue for all elements is deferred until those elements have been delivered or their fair values have been determined. Evidence of VSOEFV is determined for software products based on actual sales prices for the product sold to a similar class of customer and based on pricing strategies set forth in the Company’s standard pricing list. Evidence of VSOEFV for consulting services is based upon standard billing rates and the estimated level of effort for individuals expected to perform the related services. The Company establishes VSOEFV for maintenance agreements using the percentage method such that VSOEFV for maintenance is a percentage of the license fee charged annually for a specific software product, which in most instances is 18% of the portion of arrangement fees allocated to the software license element.

 

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Maintenance Revenue. In connection with the sale of a software license, a customer may elect to purchase software maintenance services. Most of the customers that purchase software licenses from us also purchase software maintenance services. These maintenance services are typically renewed on an annual basis. We charge an annual maintenance fee, which is typically a percentage of the initial software license fee and may be increased from the prior year amount based on inflation or other agreed upon percentage. The annual maintenance fee generally is paid to the Company at the beginning of the maintenance period, and we recognize these revenues ratably over the term of the related contract.

 

While most of our customers pay for their annual maintenance at the beginning of the maintenance period, a few customers have payment terms that allow them to pay for their annual maintenance on a quarterly or monthly basis. If the annual maintenance fee is not paid at the beginning of the maintenance period (or at the beginning of the quarter or month for those few maintenance customers), we will ratably recognize the maintenance revenue if management believes the collection of the maintenance fee is imminent. Otherwise, we will defer revenue recognition until the time that the maintenance fee is paid by the customer. We normally continue to provide maintenance service while awaiting payment from customers. When the payment is received, revenue is recognized for the period that revenue was previously deferred. This may result in volatility in software maintenance revenue from period to period.

 

Cloud-based offering. We have contracted with third parties to provide new and existing customers with hosting facilities providing all infrastructure and allowing us to offer our currently sold software, emPath® and SnAPPnet™, on a service basis. However, a contractual right to take possession of the software license or run it on another party’s hardware is not granted to the customer. We refer to the delivery method to give functionality to new customers utilizing this service as cloud-based. Since the customer is not given contractual right to take possession of the software, the scope of ASC 350-40 does not apply. A customer using cloud-based software can enter into an agreement to purchase a software license at any time. We generate revenue from cloud-based offering as the customer utilizes the software over the Internet.

 

We will provide consulting services to customers in conjunction with the cloud-based offering. The rate for such service is based on standard hourly or daily billing rates. The consulting revenue is recognized as services are performed. Customers utilizing their own computer to access cloud-based functionality are charged a fee equal to the number of employees paid each month multiplied by an agreed-upon rate per employee. The revenue is recognized as the cloud-based services are rendered each month.

 

Allowances for Doubtful Accounts

 

The Company maintains allowances for doubtful accounts, for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We review delinquent accounts at least quarterly to identify potential doubtful accounts, and together with customer follow-up, estimate the amounts of potential losses.

 

Deferred Taxes

 

The Company records a valuation allowance to reduce the deferred tax assets to the amount that management believes is more likely than not to be realized in the foreseeable future, based on estimates of foreseeable future taxable income and taking into consideration historical operating information. In the event management estimates that the Company will not be able to realize all or part of its net deferred tax assets in the foreseeable future, a valuation allowance is recorded through a charge to income in the period such determination is made. Likewise, should management estimate that the Company will be able to realize its deferred tax assets in the future in excess of its net recorded assets, an adjustment to reduce the valuation allowance would increase income in the period such determination is made.

 

Stock-Based Compensation

 

We account for share-based compensation in accordance with the provisions of share-based payments, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares granted and the quoted price of our common stock. Equity instruments issued to other than employees are valued at the earlier of a commitment date or upon completion of the services, based on the fair value of the equity instruments, and are recognized as expense over the service period.

 

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Valuation of the Embedded and Warrant Derivatives

 

The valuation of our embedded derivatives is determined by using the Company’s quoted stock price. An embedded derivative is a derivative instrument that is embedded within another contract, which under a convertible note (the host contract) includes the right to convert the note by the holder, certain default redemption right premiums and a change of control premium (payable in cash if a fundamental change occurs). In accordance with the guidance on derivative instruments, embedded derivatives are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. The practical effect of this has been that when our stock price increases so does our derivative liability, resulting in a non-cash loss that reduces our earnings and earnings per share. When our stock price declines, we record a non-cash gain, increasing our earnings and earnings per share.

 

The fair value recorded for the derivative liability varies from period to period. This variability may result in the actual derivative liability for a period either above or below the estimates recorded on our consolidated financial statements, resulting in significant fluctuations in other income (expense) because of the corresponding non-cash gain or loss recorded.

 

Recently Issued Accounting Pronouncements

 

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial position, operations or cash flows.

 

Results of Operations

 

Three Months Ended March 31, 2014 Compared To Three Months Ended March 31, 2013

 

Total Revenues. We had total revenues of $2,104,018 and $1,343,828 in the three months ended March 31, 2014 and 2013, respectively. The increase in total revenues was $760,190 for the three months ended March 31, 2014 representing a 56.6% increase compared to the total revenues for the three months ended March 31, 2013. Of the $2,104,018 and $1,343,828 total revenues for the three months ended March 31, 2014 and 2013, respectively, $1,174,722 and $1,309,796 of such amounts were related to the business operations of NOW Solutions, a 75% owned subsidiary of the Company. Revenue from SnAPPnet, Inc. was $54,296 or 2.6% of total revenue for the three months ended March 31, 2014 and $34,032 or 2.5% of total revenues for the three months ended March 31, 2013.

 

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from licenses and software increased by $875,000 compared to that for the three months ended March 31, 2013 due to new licensing in the first three months of 2014. Software maintenance in the three months ended March 31, 2014 decreased by $59,516 or 5.5% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to unfavorable currency rate changes on our Canadian revenue. Excluding the exchange rate effects, maintenance revenue increased 2.9% compared to the three months ended March 31, 2013. Consulting revenue, in the three months ended March 31, 2014 decreased by $32,637 from the same period in the prior year, which represents a 29.5% decrease. This decrease was primarily due to 2013 consulting services for two customers to install emPath® modules and to deploy emPath® at additional locations. Cloud-based revenues were $109,916 for the three months ended March 31, 2014 compared to $119,068 for the same period in the prior year, representing a $9,152 decrease or 7.7%. The decrease is primarily related to unfavorable currency rate changes on our Canadian cloud-based revenue. Other revenue in the three months ended March 31, 2014 decreased by $13,505 or 48% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

 

Cost of Revenues. We had direct costs associated with our revenues of $586,718 for the three months ended March 31, 2014, compared to $663,616 for the three months ended March 31, 2013. The decrease in cost of revenues of $76,898 represents a 11.6% decrease. The decrease in direct cost of revenues was primarily due to lower payroll, travel and royalty expenses for the three months ended March 31, 2014. During the three months ended March 31, 2014 and 2013, $33,200 and $5,873 of internal costs were capitalized, respectively.

 

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $1,432,953 and $823,860 in the three months ended March 31, 2014 and 2013, respectively. The increase of $609,093 is 73.9% more than for the same period in 2013. The increase is primarily due to increased legal fees, increased foreign taxes and tax penalties somewhat offset by a decrease in payroll costs.

 

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Income (Loss) from Operations. We had net income from operations of $72,428 for the three months ended March 31, 2014 compared to a net loss of $157,746 for the three months ended March 31, 2013. The increase was due to increased revenues, and decreased cost of revenues partially offset by higher selling, general and administrative expenses.

 

Impairment of Software Costs. During the three months ended March 31, 2014, $192,955 of capitalized software development costs were considered impaired.

 

Gain (Loss) on Derivative Liability. The existing derivative liability is adjusted each quarter for changes in the market value of the Company’s common stock. Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock. In general, as our stock price increases, the derivative liability increases, resulting in a loss. As our stock price decreases, the derivative liability decreases, resulting in a gain. The gain on derivative liability was $4,741 for the three months ended March 31, 2014 compared to a gain of $6,550 for the same period in 2013.

 

Forbearance Fees. Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended March 31, 2014 were $73,301. The fees are related to our senior secured debt for NOW Solutions.

 

Interest Expense. We had interest expense of $213,522 and $146,051 for the three months ended March 31, 2014 and 2013, respectively. Interest expense increased in 2014 by $67,471, representing an increase of 46.2% compared to the same expense in the three months ended March 31, 2013. The increase is primarily due to increased debt borrowings at March 31, 2014 compared to March 31, 2013 and additional interest on amounts due to vendors.

 

Net loss. We had a net loss of $402,601 and $297,240 for the three months ended March 31, 2014 and 2013, respectively. The net loss for the three months ended March 31, 2014 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating income of $72,428. Operating income was increased by the gain on derivative liability and decreased by impairment of software development, interest expense and forbearance fees, resulting in a net loss of $402,601 for the three months ended March 31, 2014. For the three months ended March 31, 2013, the operating loss of $157,746 was increased by interest expense of $146,051 and reduced by the gain on derivative liability resulting in a net loss of $297,240.

 

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $147,000 and $147,000 for the three months ended March 31, 2014 and 2013, respectively.

 

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $550,257 and $431,498 for the three months ended March 31, 2014 and 2013, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

 

Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the three months ended March 31, 2014 and 2013, respectively.

 

Liquidity and Capital Resources

 

At March 31, 2014, we had non-restricted cash-on-hand of $423,957 compared to $162,709 at December 31, 2013.

 

Net cash provided by operating activities for the three months ended March 31, 2014 was $193,898 compared to net cash used in operating activities of $53,291 for the three months ended March 31, 2013. For the three months ended March 31, 2014, we collected cash from our customers and other licensees of $1,535,110. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $480,650, attorney fees of $134,580, professional fees and consulting fees of $47,489 interest payments of $89,989, taxes (including sales tax and VAT) of $74,472, and other regular trade payables of $514,032. For the three months ended March 31, 2013, we collected cash from our customers of $1,378,566. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $674,519, attorney fees of $54,452, professional fees and consulting fees of $77,133 interest payments of $85,385, taxes (including sales tax and VAT) of $38,688, and other regular trade payables of $501,680.

 

A large portion of our cash (and revenue) comes from software maintenance. When we bill and collect for software maintenance, we record a liability in deferred revenue and recognize income ratably over the maintenance period. Deferred revenue increased $48,275 or 2.1% from the balance at December 31, 2013. The increase was primarily due to the impact of contractual price increases on renewing maintenance contracts during 2014.

 

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Our accounts receivable trade increased from $562,831 at December 31, 2013 to $1,002,528 (net of allowance for bad debts) at March 31, 2014. The increase is a primarily a result of a receivable due from licensing on intellectual property somewhat offset by seasonal fluctuations in the timing of billing for software maintenance which typically yields higher receivables in December compared to March.

 

The accounts payable and accrued liabilities went from $9,763,921 at December 31, 2013 to $10,550,115 at March 31, 2014. The resulting balance at March 31, 2014 is 10.5 times more than the balance in accounts receivable. This is one of the reasons why we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

 

We used cash to invest in equipment and the development of software products for the three months ended March 31, 2014 and March 31, 2013 of $33,200 and $9,287 respectively. Most of the equipment was computer equipment and peripherals for upgraded network servers to increase the productivity of our software developers, and new personal computers for developers, consultants and sales personnel. Software development relates to the development of new products.

 

For the three months ended March 31, 2014, we paid $44,636 of principal on notes payable and notes payable to related parties. For the three months ended March 31, 2013, we paid $1,801,490 of principal on notes payable and notes payable to related parties and had $1,759,150 of new debt funding in the same period.

 

The total change in cash for the three months ended March 31, 2014 was an increase of $261,248.

 

As of the date of the filing of this Report, we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms. Therefore, we need to raise additional funds through selling securities, obtaining loans, renegotiating the terms of our existing debt and/or increasing sales with our new products. Our inability to raise such funds or renegotiate the terms of our existing debt will significantly jeopardize our ability to continue operations.

 

As of March 31, 2014, the following contractual obligations and commercial commitments were outstanding:

 

   Balance at   Due in Next Five Years 
Contractual Obligations  March 31,
2014
   2014   2015   2016   2017   2018+ 
Notes payable  $4,812,111   $3,333,759   $115,893   $129,304   $144,267   $1,088,888 
Convertible debts   30,000    30,000    -    -    -    - 
Operating lease   99,310    69,458    29,852    -    -    - 
Total  $4,941,421   $3,405,423   $145,745   $129,304   $144,267   $1,088,888 

 

Of the above notes payable, the default status is as follows:

 

   March 31, 2014   December 31, 2013 
         
In default  $3,270,767   $3,299,806 
Not in default   1,571,344    1,586,864 
           
Total Notes Payable  $4,842,111   $4,886,670 

 

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We had a net loss of $402,601 for the three months ended March 31, 2014 and a net loss of $297,240 for the three months ended March 31, 2013, and we have historically incurred losses. Since December 31, 2009, we have used substantial funds in further developing our product line and in conducting present and new operations, and we need to raise additional funds and/or generate additional revenue through our existing businesses, including the licensing of our intellectual property, to accomplish our objectives. Additionally, at March 31, 2014, we had negative working capital of approximately $15.1 million (although this figure includes deferred revenue of approximately $2.4 million) and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

 

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Our management is continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations. We will require additional funds to pay down our liabilities, as well as finance our expansion plans consistent with our anticipated changes in operations and infrastructure. However, there can be no assurance that we will be able to secure additional funds and that if such funds are available, whether the terms or conditions would be acceptable to us and whether we will be able to turn into a profitable position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

Not applicable.

 

Item 4. Controls and Procedures

Our management, principally our chief executive officer (who is also currently serving as our Principal Accounting Officer), evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our management concluded that our disclosure controls and procedures as of the end of the period covered by this report were not effective such that the information required to be disclosed by us in reports filed under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding disclosure.

 

Management’s annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2013, as filed on April 15, 2014.

 

There have been no material changes in our internal control over financial reporting since our reporting on Form 10-K for the year ended December 31, 2013.

 

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PART II

OTHER INFORMATION

 

Item 1. Legal Proceedings

 

We are involved in the following ongoing legal matters:

 

On November 18, 2009, we sued InfiniTek Corporation (“InfiniTek”) in the Texas State District Court in Fort Worth, Texas for breach of contract and other claims (the “Texas Action”) seeking equitable relief and unspecified damages when a dispute between the Company and InfiniTek was not resolved. All agreements with InfiniTek have been cancelled. On January 15, 2010, InfiniTek filed a counter-claim for non-payment of amounts billed. InfiniTek claimed it was owed $195,000 plus lost opportunity costs of not less than $220,000.

 

On April 7, 2010, we were served with a lawsuit filed by InfiniTek in the California Superior Court in Riverside, California seeking damages in excess of $76,303 for breach of contract and lost profit (the “California Action”). This lawsuit related to one of the causes of action and the same set of underlying facts, as those in the Texas legal action. On May 7, 2010, we filed a motion to dismiss this action. On July 14, 2010, the court denied our motion. On August 13, 2010, we filed an answer to InfiniTek’s complaint, including a denial and affirmative defenses.

 

On December 31, 2011, the Company and InfiniTek entered into a settlement agreement whereby the Texas Action and the California Action were both dismissed. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek shall transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and accrued liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500 in payments due under the settlement agreement as of November 16, 2012 and each party is alleging the other party is in breach of the settlement agreement. We are currently seeking to resolve all disputes with InfiniTek.

 

On November 15, 2010, we filed a lawsuit in the Federal District Court for the Eastern District of Texas (the “Vertical Action”) against Interwoven, Inc. ("Interwoven"), LG Electronics MobileComm U.S.A., Inc., LG Electronics, Inc., Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (collectively, the "Defendants"). We sued the Defendants for patent infringement claims under United States Patent No. 6,826,744 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) and United States Patent No. 7,716,629 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) (collectively the “the Patents-in-Suit”), both of which are owned by the Company. We seek an award of monetary damages and other relief. The case is styled Vertical Computer Systems, Inc. v Interwoven, Inc., LG Electronics Mobilecomm U.S.A., Inc., No. 2:10-CV-00490.

 

On November 17, 2010, we were served with a lawsuit filed on October 14, 2010 by Interwoven in the United States District Court for the Northern District of California (the “Interwoven Action”). This lawsuit was instituted as a complaint for declaratory judgment, in which Interwoven requested that the court find that no valid and enforceable claim of either of the two patents referenced above has been infringed by Interwoven. The case is styled Interwoven, Inc. v Vertical Computer Systems, Inc. No. 3:10-CV-4645-RS.

 

On January 11, 2011, Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (“Samsung”) filed a lawsuit in the United States District Court for the Northern District of California seeking to consolidate its lawsuit with the Interwoven Action. This case is styled Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc., v. Vertical Computer Systems, Inc., No. 3:11-CV-00189-RS.

 

On May 2, 2011, the United States District Court for the Northern District of California denied Vertical’s renewed motion to transfer the Interwoven Action to the Eastern District of Texas and granted Vertical's motion to transfer the lawsuit filed by Samsung in the Northern District of California to the Eastern district in Texas. On May 11, 2011, the United States District Court for the Eastern District of Texas granted Interwoven’s motion to transfer the case to the Northern District of California with respect to Interwoven and denied Samsung’s motion to transfer its case to the Northern district.

 

On December 30, 2011, the United States District Court for the Northern District of California issued a claims construction order in the Interwoven Action concerning the terms found in the claims of the Patents-in-Suit.

 

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On October 12, 2012, the United States Patent and Trademark Office (“USPTO”) issued an ex parte reexamination certificate of United States Patent No. 7,716,629.  In the ex parte reexamination certificate, Claims 21-36, 29, 30, and 32 were confirmed; Claims 1, 8, 11, 13, 28 and 31 were determined to be patentable as amended, Claims 2-6, 9, 10, 12, 14-17, 19 and 20, which were dependent on an amended claim, were determined to be patentable, and claims 7, 18 and 27 were not reexamined.

 

On October 25, 2012, the USPTO notified the Company of its intent to issue an ex parte reexamination certificate concerning the ex parte reexamination of United States Patent No. 6,826,744.  In the notice of intent to issue ex parte reexamination certificate, the USPTO notified that the prosecution on the merits is closed in this ex parte reexamination proceeding and indicated that Claims 6, 8, 19, 22, 30, 32, 41, 44, 50, 51 were confirmed; Claims 1 and 26 were cancelled; Claims 12-17, 20, 34-39, 42 and 43 are not subject to reexamination; newly presented Claims 54-57 are patentable and continuation of patent claims amended: 2-5, 7, 9-11, 18, 21, 23-25, 27-29, 31, 33, 40, 45-49, 52 and 53.

 

On January 4, 2013, the United States District Court for the Northern District of California in the Interwoven Action denied Interwoven’s motion for summary judgment for unenforceability and invalidity of the Patents-in-Suit in its entirety.

 

On July 17, 2013, the United States District Court for the Northern District of California in the Interwoven Action ruled on Interwoven’s motion for summary judgment with respect to infringement and damages concerning the Patents-in-Suit. The court denied Interwoven’s motion for summary judgment on the issue of direct infringement and granted summary judgment in favor of Interwoven with respect to infringement on the doctrine of equivalents and with respect to indirect infringement. The court also granted in part and denied in part Interwoven’s motion to exclude certain expert witness testimony.

 

On September 16, 2013, the United States District Court for the Eastern District of Texas issued a claims construction order in the Vertical Action concerning the terms found in the claims of the Patents-in-Suit. On December 12, the Company settled the patent infringement claim that the Company initiated in federal court against LG. Pursuant to the confidential settlement agreement, the Company has granted to LG a non-exclusive, fully paid-up license under the two patents (“Patents-in-Suit”) with any continuation patents of the Patents-in-Suit and any other continuation patents with the same priority claim as the Patents-in-Suit.

 

On December 12, 2013, the Company settled its patent infringement claim against LG Electronics. Pursuant to the confidential settlement agreement, the Company granted to LG Electronics a non-exclusive, fully paid-up license under the Patents-in-Suit which were the subject of the legal proceeding. The litigation concerning the Patents-in-Suit with LG has been resolved.

 

On March 20, 2014, the Company settled the patent infringement claim that the Company initiated in federal court against Samsung. Pursuant to the confidential settlement agreement, the Company has granted to Samsung a non-exclusive, fully paid-up license under the Patents-in-Suit with any continuation patents of the Patents-in-Suit and any other patents with the same priority claim as the Patents-in-Suit. The litigation concerning the Patents-in-Suit with Samsung has been resolved.

 

On May 8, 2014, the Company settled the patent infringement claim that the Company initiated in federal court against Interwoven. Pursuant to the confidential settlement agreement, the Company has granted to Interwoven and its subsidiaries, affiliates and parent companies (which include Autonomy Corporation PLC and Hewlett-Packard Company, Inc.), a non-exclusive, fully paid-up license to the Patents-in-Suit with any continuation patents of the Patents-in-Suit and any other patents with the same priority claim as the Patents-in-Suit. The Interwoven Action has been resolved.

 

On July 8, 2011, we were served with a lawsuit in the Texas State District Court in Dallas, Texas by Clark Consulting Services, Inc. (“CCS”) for breach of contract and other claims.  CCS was seeking damages from us in excess of $133,750 plus attorney’s fees and interest.  On August 8, 2011, we filed an answer denying CCS’s claims and setting forth affirmative defenses.  In December 2011, the Company and CCS entered into a settlement agreement whereby the lawsuit was dismissed. Pursuant to the terms of the settlement agreement, the Company agreed to pay CCS $134,000, which was to be paid in installment payments. Due to the Company’s failure to make timely payments, an additional $60,000 was added to the outstanding balance. On October 26, 2012, we entered into an agreement under which we agreed to make monthly payments of $5,000 and pay the outstanding balance plus attorney’s fees and costs by February 1, 2013. As of December 31, 2012, the settlement amount of $149,000 has been included in accounts payable and accrued liabilities. During 2013, the parties entered into several agreements to extend the date by which the Company has to pay off the balance of the settlement amount whereby. Under these agreements, the Company agreed to make monthly payments of $10,000 (of which $2,500 of each payment would be applied as late fees) beginning in February 2013 through November 2013 until the outstanding balance has been paid. As of May 15, 2014, the outstanding settlement balance is $50,500.

 

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On October 11 2012, Micro Focus (US), Inc. (“Micro Focus”) filed a lawsuit against NOW Solutions in the United States District Court for the southern division district of Maryland alleging breaches of its contractual obligations under an independent software agreement and copyright infringement. On January 28, 2013, NOW Solutions and Micro Focus entered into a settlement agreement whereby NOW Solutions agreed to pay Micro Focus $420,000, of which $70,000 in installment payments were made with the outstanding balance due on April 30, 2013. In connection with the settlement, the Company entered into a guaranty agreement with Micro Focus concerning NOW Solutions’ obligations under the promissory note. The Company did not make the $375,000 payment due to Micro Focus. On May 15, 2013, Vertical was served with a lawsuit in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning the guaranty by Vertical to Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. On July 3, 2013, NOW Solutions was served with a lawsuit for a confessed judgment in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. On January 15, 2014, the Company and NOW Solutions consented to a judgment in the amount of $350,000, plus $36,000 in accrued interest and attorney’s fees in the amount of $80,000, plus accrued interest at the rate of 10% per annum until paid. As of May 15, 2014, the Company has made payments in the amount of $250,000 to Micro Focus.

 

On February 4, 2014, Victor Weber filed a lawsuit against Vertical Mountain Reservoir Corporation (“MRC”), and Richard Wade in the District Court of Clark County, Nevada for failure to make payment of the outstanding balance due under a $275,000 promissory note issued by Vertical to Mr. Weber. The plaintiff seeks payment of the principal balance due under the note $275,000, default interest at the rate of 18% per annum, attorney’s fees and court costs, and punitive damages. On April 14, the Company and MRC filed an answer to Mr. Weber’s complaint. We are currently seeking to resolve this matter with Mr. Weber. Mr. Wade is the President and CEO of Vertical and the President of MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade is the trustee of the W5 Family Trust.

 

Item 1A. Risk Factors

 

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2013, as filed on April 15, 2014.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

During the three months ended March 31, 2014, 400,000 shares granted to employees of the Company in 2012, valued at $7,900, vested.

 

During the period that runs from April 1, 2014 through May 15, 2014, 150,000 shares granted to a consultant of the Company in 2012, valued at $2,325, vested.

 

Item 3. Defaults Upon Senior Securities

 

None

 

Item 4. Mine Safety Disclosures

 

Not applicable

 

Item 5. Other Information

 

None

 

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Item 6. Exhibits

 

The following documents are filed as part of this report:

 

31.1   Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated   May 15, 2014   Provided herewith
         
32.1   Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated   May 15, 2014   Provided herewith
         
101.INS*   XBRL Instance Document   Provided herewith
         
101.SCH*   XBRL Taxonomy Extension Schema   Provided herewith
         
101.CAL *   XBRL Taxonomy Extension Calculation Linkbase   Provided herewith
         
101.DEF*   XBRL Taxonomy Extension Definition  Linkbase   Provided herewith
         
101.LAB*   XBRL Taxonomy Extension Label  Linkbase   Provided herewith
         
101.PRE*   XBRL Taxonomy Extension Presentation  Linkbase   Provided herewith

 

* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

 

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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.

 

    VERTICAL COMPUTER SYSTEMS, INC.
     
May 15, 2014   By: /s/ Richard Wade
    Richard Wade,
    President and Chief Executive Officer
    (Principal Executive Officer and
    Principal Accounting Officer)

 

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