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Note 1 – Description of Business and Summary of Significant Accounting Policies

The unaudited consolidated financial statements of Hydrocarb Energy Corp. ("Hydrocarb", "HEC", the "Company", "we", "us", or "our") have been prepared in accordance with accounting principles generally accepted in the United States and the rules of the Securities and Exchange Commission ("SEC"), and should be read in conjunction with the audited financial statements and notes thereto contained in our Annual Report filed with the SEC on Form 10-K for the year ended July 31, 2015, filed with the SEC on November 13, 2015 (the "Annual Report"). 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 financial statements which would substantially duplicate the disclosures contained in the audited financial statements for the most recent fiscal year ended July 31, 2015, as reported in the Annual Report, have been omitted.

We are a natural resource exploration and production company engaged in the exploration, acquisition, development, and production of oil and gas properties in the United States and onshore in Namibia, Africa.

 

Effective September 28, 2015, the Company filed a Certificate of Amendment to its Articles of Incorporation with the Secretary of State of Nevada, to (1) affect an amendment to the Company's Articles of Incorporation to increase the number of authorized shares of the Company's common stock to 1,000,000,000 shares; (2) affect an amendment to the Company's Articles of Incorporation to authorize 100,000,000 shares of "blank check" preferred stock (the "Blank Check Preferred Amendment"); (3) designate 10,000 shares of Series A 7% Convertible Voting Preferred Stock (the "Series A Amendment"); and (4) designate 35,000 shares of Series B Convertible Preferred Stock (the "Series B Amendment"), each of which amendments were approved by the stockholders of the Company at the Annual Meeting of Shareholders of the Company held on September 28, 2015. Previously, effective on September 21, 2015, the Company filed a Certificate of Correction with the Secretary of State of Nevada, which cancelled and rescinded in its entirety, the previously filed Series A 7% Convertible Voting Preferred Stock designation filed by the Board of Directors without stockholder approval on December 2, 2013.

In August 2015, the Company transferred the 39% working interest in certain Namibian oil and gas concessions then held by Namibia Exploration, Inc., the Company's wholly-owned subsidiary to Hydrocarb Namibia Energy (Pty) Limited, also the Company's wholly-owned subsidiary, to consolidate ownership of such working interests in Hydrocarb Namibia Energy (Pty) Limited.

Our common stock is quoted under the symbol "HECC" on the OTCQB Market.

Reclassifications

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Additionally, at the Company's Annual Meeting of Stockholders held on September 28, 2015, the Company's stockholders ratified the designation of the Company's Series A Preferred and on the same date, the Company designated Series A Preferred Stock with the Secretary of State of Nevada, provided that the approval of the Series A Preferred Stock was only to ratify the effect of certain prior transactions, and the Company has no outstanding Series A Preferred Stock and no current plans to issue Series A Preferred Stock at this time.

 

Note 2 – Oil and Gas Properties

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Note 4 – Asset Retirement Obligation

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Related Party Installment Note Payable

On July 21, 2015, Mr. Watts and the Company agreed in principle to reduce the number of total Units due to Mr. Watts to 30 units. On September 21, 2015, Mr. Watts and the Company entered into a First Amendment to Exchange Agreement, which amended the Exchange Agreement dated June 10, 2015. The First Amendment formally reduced the total Units due to Mr. Watts to 30 units, and as such, Mr. Watts received Convertible Promissory Notes with a principal amount of $3 million and 750,000 shares of common stock in connection with the exchange originally contemplated by the Exchange Agreement, valued at $614,141, which was recorded as a debt discount.

 

As of October 31, 2015, Convertible Promissory Notes with a principal amount of $3 million and $70,000 accrued interest have been fully converted into 3,070 shares of Series B Convertible Preferred Stock for $1,000 per share. The Company has immediately recognized $734,024 of amortization expense of the note discount upon conversion.

 

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On July 16, 2015, pursuant to a Note Subscription Agreement, we sold a $350,000 Convertible Secured Promissory Note (with a $7,000 original issuance discount) to Duma Holdings, LLC ("Duma Holding" and the "Duma Holdings Note"). The Duma Holdings Note (along with any unpaid interest thereon) is convertible at any time, provided the note is converted in full, into (a) 1.75 units ("Units"), each consisting of 25,000 shares of common stock of the Company and $100,000 in face amount of Convertible Subordinated Promissory Notes in the form currently offered by the Company in its ongoing private offering of Units as previously disclosed in the Current Report on Form 8-K filed by the Company with the Securities and Exchange Commission on June 19, 2015 (which will automatically convert automatically upon their issuance into shares of Series B Convertible Preferred Stock at the rate of $1,000 per share); and (b) 350,000 shares of common stock (393,750 shares of common stock in aggregate when combined with the shares which form part of the Units). The Duma Holdings Note was due and payable by us on November 30, 2015. The Duma Holdings Note accrues interest at the rate of 15% per annum, payable beginning on October 31, 2015, and quarterly thereafter through maturity. The Duma Holdings Note can only be repaid with the prior written approval of Duma Holdings. The Duma Holdings Note contains usual and customary events of default, representations and warranties. The payment of the principal and accrued interest due under the Duma Holdings Note is personally guaranteed by Kent P. Watts, our Chief Executive Officer, and Michael Watts, his brother, pursuant to separate guaranty agreements (the "Guarantee Agreements"), and secured by a first priority security interest on certain real estate owned by Kent P. Watts pursuant to a Deed of Trust, Assignment of Rents and Security Agreement.

 

As of October 31, 2015, the net payable balance is $348,215. During the three months ended October 31, 2015, $5,476 of amortization of debt discount was expensed. The Company also recognized $17,516 in amortization of debt issue costs.

 

On or around November 30, 2015, we and Duma Holdings agreed to amend the Duma Holdings Note to provide for an extension in the due date of the note until February 29, 2016, in connection with the payment by the Company of $19,705 of accrued interest on the note through November 30, 2015, and a $3,500 extension fee, and to allow for a subsequent extension in the discretion of the Company through May 31, 2016, with at least ten days’ notice to Duma Holdings before the current extended due date, and the payment to Duma Holdings of accrued interest owed through such extension date, and an extension fee of $3,500.

Kent P. Watts and S. Chris Herndon Convertible Subordinated Promissory Note Subscription

As of October 31, 2015, the Watts Notes payable balance is $32,535. During the three months ended October 31, 2015, $32,535 of amortization of debt discount was expensed.

 

As of October 31, 2015, the Herdon Note payable balance is $9,166. During the three months ended October 31, 2015, $9,166 of amortization of debt discount was expensed.

 

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Credit Agreement

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Pursuant to the Credit Agreement, we agreed to issue the Lenders their pro rata share of (a) 60,000 restricted shares of common stock on the effective date of the Credit Agreement, August 15, 2014 (the "Effective Date"); (b) 32,500 restricted shares in the event any amount of the Loans (or other obligations outstanding under agreements entered into in connection with the Loans, the "Loan Documents") were outstanding on the 12 month anniversary of the Effective Date; (c) 32,500 restricted shares in the event any amount was outstanding under the Loan Documents on the 18 month anniversary of the Effective Date; and (d) 25,000 restricted shares in the event any amount was outstanding under the Loan Documents on the 21 month anniversary of the Effective Date. The shares were to be issued pursuant to the terms and conditions of a Stock Grant Agreement, pursuant to which each of the Lenders made certain representations to the Company regarding their financial condition and other items in order for the Company to confirm that an exemption from registration existed and will exist for such issuances.

Effective June 10, 2015, we entered into an Amended and Restated Credit Agreement (the "Restated Credit Agreement") with Agent and Shadow Tree Funding Vehicle A—Hydrocarb LLC and Quintium Private Opportunities Fund, LP, as lenders (collectively, the "Lenders"), which amended and restated in its entirety the Credit Agreement, which was previously amended on February 17, 2015. As part of this agreement, we received an additional loan.

The Restated Credit Agreement, increased the amount of interest due on additional loans made pursuant to the terms of the Restated Credit Agreement (provided that no additional loans were made under the credit agreement prior to the additional loans made in connection with the Restated Credit Agreement as discussed below) to 16% per annum (from 14% per annum pursuant to the prior terms); accelerated the maturity date of amounts borrowed from the Lenders under the credit agreement to November 30, 2015 (previously amounts borrowed were due August 15, 2016); provided for the Lenders to make additional loans of $475,632 (less an aggregate of $73,023 in fees and expenses, not including placement and other fees totaling 6% of the amount borrowed) as of the date of the Restated Credit Agreement, which loans have been made to date; removed the right of the Company to request further loans under the credit agreement; provided for the payment to the Lenders of an exit fee in the amount of 4% of the amount repaid under the Restated Credit Agreement, if repaid in full prior to July 31, 2015 (which amount was not repaid in full), and 5% of such repaid amount if repaid after July 31, 2015; provided for the immediate issuance of an aggregate of 32,500 shares of the Company's restricted common stock to the Lenders and the termination of any other requirements of the Company to issue additional shares to the Lenders pursuant to the terms of the credit agreement (previously 32,500 shares were due on the 18 month anniversary of the original closing and 25,000 shares were due on the 21 month anniversary of the original closing); required us to make all contractually required payments to Linc Energy LLC and make all necessary payments to and take or cause to be taken all other commercially reasonable actions to cause the Redfish Reef field to be both producing and distributing meaningful quantities of oil and gas no later than July 15, 2015, subject to circumstances beyond our control; modified certain of the covenants described in the Credit Agreement; waived, effective as of the date of the Restated Credit Agreement all previous defaults which the Lenders had notice of under the original Credit Agreement; and effected various non-material revisions and updates to the original Credit Agreement.

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For the term loan, the Company has recognized $254,809 of amortization expense of the original issuance discount, with a net payable balance of $4,467,712 and unamortized original issuance discount of $77,743 as of October 31, 2015. In addition, we have recognized $283,455 of debt issuance cost related to professional fees and expenses, which we have classified within other non-current assets, related to the issuance of this debt. We are amortizing these costs over the term of the loan. During the year ended October 31, 2015, we recognized $68,342 of amortization expense and have $24,626 in unamortized debt issuance cost as of October 31, 2015.

For the additional loan, the Company has recognized $45,686 of amortization expense of the original issuance discount, with a net payable balance of $448,997 and unamortized original issuance discount of $26,635 as of October 31, 2015. In addition, we have recognized $23,782 of debt issuance cost related to professional fees and expenses, which we have classified within other non-current assets, related to the issuance of this debt. We are amortizing these costs over the term of the loan. During the three months ended October 31, 2015, we recognized $13,113 of amortization expense and have $4,930 in unamortized debt issuance cost as of October 31, 2015.

Installment Notes Payable

Convertible Notes Payable

The KBM Convertible Note included a $26,000 original issue discount and we paid $4,000 of KBM's attorney's fees in connection with the sale of the KBM Convertible Note and as such, the net amount, before our expenses, that we received upon sale of the KBM Convertible Note was $320,000.

We are required to keep reserved from our authorized but unissued shares of common stock eight times the number of shares of common stock issuable upon conversion of the KBM Convertible Note at all times and if we fail to keep such amount reserved it is considered an event of default under the KBM Convertible Note.

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The Warrant contains anti-dilution rights such that if we issue or sell or are deemed to issue or sell securities for less than the then applicable exercise price of the Warrant, subject to certain exceptions, the exercise price of the Warrant is reduced to such lower price and the number of shares of common stock issuable upon exercise of the Warrant increases, such that the aggregate exercise price payable upon exercise of the Warrant remains the same upon such anti-dilutive adjustment, up to a maximum of three times the current number of shares issuable upon exercise of the Warrant, subject to certain exceptions upon which there is no cap on the number of shares issuable upon exercise of the Warrant.

The amounts owed under the Typenex Convertible Note were secured by a Stock Pledge Agreement (the "Pledge Agreement") whereby CW Navigation, Inc., a Texas corporation, a significant shareholder of the Company, which is beneficially owned by Christopher Watts, the nephew of Kent P. Watts, our Chief Executive Officer and Chairman ("CW Navigation"), pledged one million one hundred thousand (1,100,000) shares of our common stock held by CW Navigation as security for our obligations under the Typenex Convertible Note and related documents. Pursuant to the Stock Pledge Agreement, in the event the value (determined based on the average closing trade price for our common stock) of the pledged shares, for the immediately preceding three trading days as of any applicable date of determination, declines below $900,000 it constitutes a default of the Typenex Convertible Note and CW Navigation is required to pledge additional shares to bring the total value of such pledged shares (as calculated above) to $900,000. Typenex also entered into a subordination agreement in favor our senior lender, Shadow Tree Capital Management, LLC ("Shadow Tree"), to subordinate the repayment of the Typenex Convertible Note to amounts owed by us to Shadow Tree.

As of October 31, 2015, we had repaid the note and all accrued interest. As of October 31, 2015, the Company had recognized the remaining discount of $142,165 into amortization expense of the note discount. The Company also recognized amortization of debt issue costs of $22,099.

 

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As of October 31, 2015, we had repaid the note and all accrued interest. As of October 31, 2015, the Company had recognized the remaining discount of $6,351 into amortization expense of the note discount. The Company also recognized amortization of debt issue costs of $16,712.

JMJ agreed to subordinate all amounts owed to it under the JMJ Convertible Note to the amounts we owe to our senior lender.

A one-time interest charge of 12% was applied to the principal amount of the note, which remains payable regardless of the repayment (or conversion) date of the note.

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Effective on July 15, 2015, the Company sold David Gillespie, 0.5 Unit for an aggregate purchase price of $50,000, with each Unit consisting of (a) 25,000 shares of the restricted common stock of the Company (the "Shares"); and (b) $100,000 in face amount of Convertible Subordinated Promissory Notes (each a "Note"). The Note was convertible into common stock of the Company at any time at Mr. Gillespie's option at a conversion price of $4 per share, and was automatically convertible into shares of Series B Convertible Preferred Stock of the Company upon designation of such Series B Convertible Preferred Stock with the Secretary of State of Nevada which occurred on September 28, 2015. The Note accrued interest (prior to its automatic conversion into Series B Preferred Stock), quarterly in arrears, which accrued interest is added to the principal balance of the Note. The interest rate of the Note was equal to the average of the closing spot prices for West Texas Intermediate crude oil on each trading day during the immediately prior calendar quarter divided by ten, plus two (the "WTI Interest Rate"), provided that in the event that the average quarterly closing spot price is $40 or less, the WTI Rate for the applicable following quarter is 0%. Any amounts not paid under the Note when due accrue interest at the rate of 12% per annum until paid in full.

 

As of October 31, 2015, Convertible Promissory Notes with a principal amount of $50,000 have been fully converted into 50 shares of Series B Convertible Preferred Stock for $1,000 per share. The Company has immediately recognized $17,282 of amortization expense of the note discount upon conversion.

On October 19, 2015, and effective October 16, 2015, we sold a Secured Convertible Promissory Note (the "Typenex Note") to Typenex Co-Investment, LLC ("Typenex") in the amount of $1,730,000. The Typenex Note was issued pursuant to the terms of a Securities Purchase Agreement dated as of the same date. The Typenex Note included a $475,000 original issuance discount and also included $5,000 which went to pay Typenex's legal fees in connection with the transaction. Additionally, a total of $263,011 of the purchase price of the Typenex Note was paid by way of the forgiveness by Typenex of amounts owed by us to Typenex under a Secured Convertible Promissory Note in the original principal amount of $350,000 which we sold to Typenex in March 2015 (provided the warrants granted to Typenex in connection with the prior March 2015 transaction remain outstanding). As a result, we received a total of $986,990 in cash in connection with the sale of the Typenex Note.

The Typenex Note is due on April 19, 2016 and no interest accrues on the Typenex Note unless an event of default occurs thereunder. The note is convertible into common stock, as discussed below, only if an event of default under the note occurs and is not cured pursuant to the terms of the note. Following an event of default, the note accrues interest at the rate of 22% per annum (subject to applicable usury laws) until paid in full. We have the right to pre-pay the Typenex Convertible Note prior to maturity, provided that we pay $1,492,500 on or before 90 days after the date the note is issued; $1,611,250 after 90 days, but before 135 days, after the note is issued; and the full amount of the note, $1,730,000, between the date that is 135 days after the note is issued and maturity.

 

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The amounts owed under the Typenex Note were secured by a Stock Pledge Agreement (the "Pledge Agreement") whereby CW Navigation, Inc., a Texas corporation, a significant shareholder of the Company, which is beneficially owned by Christopher Watts, the nephew of Kent P. Watts, our Chief Executive Officer and Chairman ("CW Navigation"), pledged two million one hundred thousand (2,100,000) shares of our common stock held by CW Navigation as security for our obligations under the Typenex Note and related documents. Pursuant to the Stock Pledge Agreement, in the event the value (determined based on the average closing trade price for our common stock) of the pledged shares, for the immediately preceding three trading days as of any applicable date of determination, declines below 1.5 times the then balance of the note (initially $2,595,000), at any time after November 1, 2015, it constitutes a default of the Typenex Note. From the date of funding until November 1, 2015 (and at any time thereafter at the request of Typenex), CW Navigation or its affiliates can pledge additional shares to bring the required value of the shares pledged above the minimum collateral value threshold or to over-collateralize the note. Subsequent to the closing, KW Navigation has pledged an additional one million (1,000,000) collateral shares to Typenex under the Pledge Agreement to bring the required value of the shares pledged above the required minimum collateral value threshold.

The Typenex Note provides for customary events of default such as failing to timely make payments under the Typenex Note when due, and including our failure to maintain a reserve of shares in connection with the conversion of the Typenex Note equal to at least three times the number of shares of common stock that could be issuable thereunder at any time (initially 3 million shares), failing to repay all of our currently outstanding variable rate convertible securities within thirty days of the date of the note, failing to repay our senior creditor (Shadow Tree, as defined below) by the maturity date of the Typenex Note or alternatively, failing to receive Shadow Tree's consent to repay the Typenex Note at maturity in cash, and in the event the value of the securities pledged pursuant to the Pledge Agreement (as discussed above) falls below the required value after November 1, 2015, subject where applicable to our ability to cure certain defaults. Additionally, it is an event of default under the note in the event we fail to repay all of our outstanding variable securities within 30 days of the date of the note (the "Variable Security Payment Date") or in the event we have any outstanding variable securities after such Variable Security Payment Date.

At any time following an uncured event of default, Typenex has the right to convert any or all of the outstanding principal amount of the note into our common stock. The conversion price of the Typenex Note is 80% of the five lowest closing bid prices of our common stock on the 20 trading days prior to any conversion, provided that if the average of such closing bid prices is below $0.75 per share, the conversion rate is decreased by 5% (to 75%), and provided further that the conversion rate is decreased by an additional 5% if we are not DWAC eligible at any time or DTC eligible at any time (for up to an aggregate of an additional 10% decrease in the conversion rate). Finally, in the event certain defaults (defined as major defaults under the note) occur, the conversion rate may be decreased by up to an additional 15% (an additional 5% decrease in the conversion rate per the occurrence of the first three major defaults). Typenex also has the right upon the occurrence of an event of default to require us to repay in full the amount owed under the note by providing us written notice, subject to the terms of a subordination agreement entered into by Typenex in favor of our senior lender. Additionally, upon the occurrence of certain events of default as described in the Typenex Note, we are required to repay Typenex liquidated damages in addition to the amount owed under the Typenex Note.

At no time may the Typenex Note be converted into shares of our common stock if such conversion would result in Typenex and its affiliates owning an aggregate of in excess of 4.99% of the then outstanding shares of our common stock, provided such percentage increases to 9.99% if our market capitalization is less than $10 million, and provided further that Typenex may change such percentage from time to time upon not less than 61 days prior written notice to us. Additionally, and at no time may pledged shares be received by Typenex pursuant to the terms of the Pledge Agreement, which would result in Typenex and its affiliates owning an aggregate of in excess of 9.99% of the then outstanding shares of our common stock.

We are subject to various fees and penalties under the Typenex Note for our failure to timely deliver shares due upon any conversion. The Typenex Note also includes various restrictions on our ability to enter into subsequent variable rate security transactions following the date thereof.

 

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Typenex also entered into a Subordination Agreement in favor of our senior lender, Shadow Tree Capital Management, LLC ("Shadow Tree"), to subordinate the repayment of the Typenex Note to amounts owed by us to Shadow Tree.

 

As of October 31, 2015, the Company has recognized $126,844 of amortization expense of the note discount, with a net payable balance of $309,339 and unamortized debt discount of $1,420,661. We are amortizing these discounts over the term of the note using the effective interest method. The Company also recognized $17,516 in amortization of debt issue costs.

 

 

Convertible Subordinated Promissory Note Offering

From August to September 2015, the Company sold $1,745,832 in Convertible Subordinated Promissory Notes (including $83,333 in notes sold to Clint Summers who was a director of the Company from September 7, 2015 until his untimely death shortly thereafter; $100,000 to the Company's director, S. Chris Herndon; and $516,667 to entities owned or controlled by Kent P. Watts, the Company's Chief Executive Officer and Chairman). The notes are due two years from their issuance date, accrue interest which is payable quarterly in arrears, at either a cash interest rate (equal to the WTI Rate described below) or a stock interest rate (12% per annum)(at the option of each holder at the beginning of each quarter), provided no principal or interest can be paid in cash until all amounts owed by the Company to its senior lender is paid in full. In the event the stock interest rate is chosen by the holder, restricted shares of common stock equal to the total accrued dividend divided by the average of the closing sales prices of the Company's common stock for the applicable quarter are required to be issued in satisfaction of amounts owed on a quarterly basis. In the event the cash interest rate is chosen, interest accrues until converted into common stock (as discussed below) or until the Company is able to pay such accrued interest in cash pursuant to the terms of the note. The "WTI Rate" equals an annualized percentage interest rate equal to the average of the closing spot prices for West Texas Intermediate crude oil on each trading day during the immediately prior calendar quarter divided by ten, plus two (the "WTI Interest Rate"). For example, if the average quarterly closing spot Price was $60 for the prior quarter, the applicable interest rate for the next quarter would be 8% per annum ($60 / 10 = 6 + 2 = 8%). Notwithstanding the above, in the event that the average quarterly closing spot price is $40 or less, the WTI Rate for the applicable following quarter is 0%. All principal and accrued interest on the notes are convertible into common stock at a conversion price of $0.75 per share at any time. Additionally, the Company may force the conversion of the notes into common stock in the event the trading price of the Company's common stock is equal to at least $5.00 per share for at least 20 out of any 30 consecutive trading days. Any shares of common stock issuable upon conversion of the notes are subject to a lock-up whereby no shares of common stock can be sold until January 1, 2016, and no more than 2,500 shares of common stock can be sold per day thereafter until the Company's common stock is listed on the NASDAQ or NYSE market or the trading volume of the Company's common stock is in excess of 100,000 shares per day. The notes have standard and customary events of default.

As of October 31, 2015, the Company has recognized $135,910 of amortization expense of the note discount, with a net payable balance of $135,910 and unamortized debt discount of $1,487,716. We are amortizing these discounts over the term of the note using the effective interest method.

Note 7 – Fair Value

As defined in FASB ASC Topic 820, fair value is the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This Topic requires disclosure that establishes a framework for measuring fair value and expands disclosure about fair value measurements. The statement requires fair value measurements be classified and disclosed in one of the following categories:

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Certain assets and liabilities are reported at fair value on a recurring or nonrecurring basis in the Company's consolidated balance sheets. These methods and assumptions are discribed in Note 8 - Derivative Liabilities

Note 8 – Derivative Liabilities

Derivative Liabilities

The following table sets forth, by level within the fair value hierarchy, the Company's financial assets and liabilities that were accounted for at fair value on a recurring basis as of October 31, 2015:

 

 

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Activity for embedded derivative instruments during the year ended October 31, 2015 was as follows:

 

		Balance at July 31, 2015				Initial Valuation of Embedded Derivative Instruments Issued During the Period				Increase (Decrease) in Fair Value of Derivative Liabilities				Fair Value of Derivative Liabilities on Repayment of Debt				Change of Derivative Liabilities upon Conversion				Balance at October 31, 2015
Typenex Co-Investment		$	1,212,688			$	1,072,506			$	(428,740	)		$	(789,040	)		$				$	1,067,414
Duma Holdings			546				-				(546	)			-								-
KBM Worldwide, Inc.			-				-				469,272				(469,272	)							--
VIS VIRES Group, Inc			-				-				504,222				(504,222	)							--
Embedded Convertible Note-Subtotal			1,213,234				1,072,506				544,208				(1,762,534	)							1,067,414
Tainted Kent P. Watts			319,960				692,719				(138,202	)			-				(363,659	)			510,818
Tainted Christian Smith & Jewell			167,077				-				(132,130	)			-								34,947
Tainted David L. Gillespie			4,956				-				824				-				(5,780	)			-
Tainted Brian Kenny			34,330				-				(3,540	)			-								30,790
Farid Barkhorder			-				78,685				(29,016	)			-								49,669
Robert Klinek and Susan Pack			-				389,566				(120,800	)			-								268,766
Lee Walinsky			-				34,074				(9,326	)			-								24,748
S. Chris Herndon			-				144,336				(44,997	)			-								99,339
Robert B. Kahw			-				120,023				(45,660	)			-								74,363
Donald P. Clary			-				68,148				(18,652	)			-								49,496
Jay Fishman			-				102,222				(27,978	)			-								74,244
Carl Miller and Deanna Miller			-				45,431				(12,434	)			-								32,997
Barry Robbins			-				50,746				(13,761	)			-								36,985
Brent & Silvia Sagissor			-				45,431				(12,435	)			-								32,996
David and Ginger Levy Trust			-				212,393				(63,114	)			-								149,279
Kevin R. Minor			-				45,431				(12,434	)			-								32,997
Timothy Hoke Smith			-				45,431				(12,434	)			-								32,997
Clint D. Summers			-				113,579				(31,087	)			-								82,492
Sean M. Crowley Trust			-				189,971				(41,438	)			-								148,533
Tainted Note - Subtotal			526,323				2,378,186				(768,614	)			-								1,766,456
Note Derivatives - Total		$	1,739,557			$	3,450,692			$	(224,406	)		$	(1,762,534	)		$	(369,439	)		$	2,833,870

As additional consideration for the loan evidenced by the Typenex Convertible Note, we granted Typenex a five year warrant (the "Typenex Warrants") to purchase shares of our common stock equal to $87,500 divided by the Market Price. The Market Price is defined as a Conversion Factor (70%-80%) multiplied by the average of the five (5) lowest Closing Bid Prices in the twenty (20) Trading Days immediately preceding the applicable Conversion. The warrants have an initial exercise price of $2.25 per share, and are initially exercisable for 38,889 shares of common stock.

In addition, the Typenex Warrants contain anti-dilution provisions that provide for a reduction in the exercise price of such warrants in the event that future common stock (or securities convertible into or exercisable for common stock) is issued (or becomes contractually issuable) at a price per share (a "Lower Price") that is less than the exercise price of such warrant at the relevant time. The amount of any such adjustment is determined in accordance with the provisions of the relevant warrant agreement and depends upon the number of shares of common stock issued (or deemed issued) at the Lower Price and the extent to which the Lower Price is less than the exercise price of the warrant at the relevant time. In addition, the number of shares issuable upon exercise of some of these warrants will be increased inversely proportional to any decrease in the exercise price, thus preserving the aggregate exercise price of the warrants both before and after any such adjustment. We have determined that these provisions could result in modification of the warrants exercise price based on a variable that is not an input to the fair value of a "fixed-for-fixed" option as defined under FASB ASC Topic No. 815 - 40.

Tainted Warrants

During the year ended July 31, 2011, we entered into a consulting agreement with Geoserve Marketing, LLC ("Geoserve"). Under the terms of the agreement, the Company granted warrants to purchase 400,000 shares of common stock that have a market condition. If the Company's common stock attains a five day average closing price of $22.50 per share, 200,000 warrants with an exercise price of $7.50 and an expiration date of February 15, 2016 shall be exercisable ("Warrant B"). If the Company's common stock attains a five day average closing price of $45.00 per share, 200,000 warrants with an exercise price of $7.50 and an expiration date of February 15, 2016 shall be exercisable ("Warrant C").

On February 17, 2015, the Warrant B and Warrant C that were previously issued to Geoserve were considered tainted derivative instruments due to the issuances of various convertibles notes during the three months ended April 30, 2014. Those convertible notes contain variable conversion price and therefore, we cannot conclude that we will have sufficient authorized unissued shares to settle all the warrants and convertible notes. Accordingly, the Company recorded a derivative liability for the aggregate fair value of the Warrant B and Warrant C.

 

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Note 9 – Capital Stock

 

Series B Preferred Stock

 

Effective on September 28, 2015, with the designation of its Series B Convertible Preferred Stock, the Convertible Promissory Notes received by Mr. Watts in connection with the Exchange Agreement automatically converted into 3,070 shares of Series B Convertible Preferred Stock for $1,000 per share.

 

Also on September 28, 2015, the Convertible Promissory Notes received by David L. Gillespie automatically converted into 50 shares of Series B Convertible Preferred Stock for $1,000 per share.

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During the three months ended October 31, 2015, we issued a total of 12,309 shares to settle stock interest for Convertible Subordinated Promissory Notes. The value of these shares is $17,419.

On September 8, 2015, 128,048 shares of common stock were issued for Typenex cashless warrant exercise. According to Lattice valuation  model, derivative liabilities amount of $342,236 have been resolved to additional paid in capital. Shares were issued at par value of Common Stock for 0.001 per share.

 

In August 2015, the Company issued 60,000 Form S-8 registered shares to James W. Christian, a partner at Christian Smith & Jewell, the Company's legal counsel, in consideration for legal fees owed. The fair value of the 60,000 shares issued for services is $84,000.

 

Receivables for Common Stock

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On April 27, 2015, the Board of Directors agreed to offer SMDRE the option, for 90 days, for the SMDRE note to be paid in full for a 67% discount (i.e., the offer to be paid $619,898 immediately) (the “Pre-Payment Option”).  Between April 27, 2015 and July 9, 2015, the Company received payments on the SMDRE LLC note in the amount of $531,000. The balance of the discounted note of $88,898 has been extended until the end of calendar year 2015. During fiscal year 2015, we have written off $1,239,981 related to the discount on this receivable.

Stock Compensation Plans

 

As of October 31,		2015				2014
Number of options granted			-				25,000
Compensation expense recognized		$	-			$	112,500
Weighted average exercise price of options granted		$	-			$	4.50

 

 

No non-vested stock options existed as of October 31, 2015

During the reporting period we have had transactions as described below with entities controlled by Michael Watts. Michael Watts is the father-in-law of Jeremy Driver, who served as a director and Chief Executive Officer of the Company through November, 2013. Additionally, Michael Watts is the brother of Kent P. Watts, who became the Company’s Chairman of the Board of Directors in October 2013. Michael Watts is a related party to the Company by virtue of his relationships with Mr. Driver and with Mr. Watts. Further, one of Michael Watts’ adult children is a significant shareholder of the Company’s common stock. Between them, they are beneficial owners of approximately 55% of the Company’s outstanding common stock.

In October 2013, prior to our acquisition of HCN, we settled our obligations to HCN under the HCN Consulting Agreement through the issuance of 619,960 shares of common stock of the Company. The HCN Consulting Agreement was between HCN and NEI and provided for HCN to be the primary negotiator and operator of the Namibian concession. These obligations consisted of the then-outstanding $2,400,000 Fee and $533,630 of interest and late fees associated with the Fee. Further, $25,000 of the related interest and fees was settled in cash. Prior to the Company’s acquisition of HCN, HCN sold these shares to an entity, in which Michael Watts has a minority interest, for a note receivable of $1,859,879. The Company arranged the sales of these shares in anticipation of a possible business combination, in an effort to ensure that the shares would remain as part of public float and therefore continue to be properly included in calculations for exchange-listing criteria and provide a source of funding for Company operations. It is anticipated that these shares will eventually be sold and the proceeds of their sales used to pay the receivable. As HCN is now our wholly-owned subsidiary, this receivable for the sale of the Company common stock is classified as receivable for common stock within equity. See discussion of this receivable in Note 10 – Capital Stock – Receivables for Common Stock.

On September 6, 2013, HCN sold 191,667 shares of HEC common stock to an employee of HCN (the nephew of our Chairman and Chief Executive Officer) in exchange for a note receivable in the amount of $1,000,000. HEC acquired this receivable upon its acquisition of HCN. The note is non-interest bearing and is payable only upon the sale of the common stock to a third party or HEC stock being listed on either the NASDAQ or NYSE stock exchanges. We will receive 95% of the proceeds up to $1,000,000 if the underlying stock is sold to a third party. Within 90 days of HEC stock being listed on a major stock exchange, we will receive up to $1,000,000, or the note can be paid earlier at the discretion of the other party. These shares of common stock are held in the name of the investors and are beneficially owned by the investors and the shares are not retrievable by the Company. At October 31, 2015, we have $325,000 outstanding on this receivable.

On December 4, 2013, HCN sold 619,960 shares of unregistered and restricted Company common stock in return for a $1,859,879 non-interest bearing note receivable from SMDRE LLC (“SMDRE”), an entity in which Michael Watts, the brother of our Chief Executive Officer, has a minority interest. The Company acquired this receivable upon its acquisition of HCN. The 619,960 shares of Company common stock were previously issued by the Company to HCN to settle liabilities due by the Company related to the consulting services agreement described below in Note 7 – Notes Payable. The receivable from the individual is due to the Company upon the following conditions: 1) 100% of the proceeds payable from the sale of all or part of the shares by the owner of the shares to a third party; 2) within sixty days of the six month anniversary of the December 4, 2013 stock sale or within sixty days from the date that the shares become unrestricted (whichever comes first); or 3) 100% of any remaining balance due within 90 days of the Company being listed on a major stock exchange and at such time as the share price is above $6.00 per share. As with the above receivable for common stock, this receivable for the sale of the Company common stock is classified as a receivable for common stock within equity. These shares of common stock are held in the name of the investors and are beneficially owned by the investors and the shares are not retrievable by the Company.

 

In November 2013, we issued a promissory note for funds received from Mr. Kent P. Watts, our Chairman, of $100,000. Under the terms of the note, principal on the note was due after one year and incurred interest at 5% per annum payable on a monthly basis. In April 2014, the Company entered into a new debt agreement whereby Mr. Watts agreed to loan the Company up to $600,000 at an interest rate of 6.25%. The previous debt of $100,000 was rolled into this new note. Additionally, we borrowed $200,000 from Mr. Watts during April 2014 and $300,000 from Mr. Watts in May 2014. The total balance on the note was $600,000 as of October 31, 2015. Accrued interest is payable monthly beginning in May 2014, and beginning in August 2014 the principal is due in 36 monthly payments through July 2017. The note is secured by the Company’s assets owned by GBE, subject to any other lien holder’s superior rights, if any. As part of the financing agreement with Shadow Tree, this note has been subordinated, and no payments will be made until the Shadow Tree debt has been repaid.

On April 27, 2015, the Board of Directors agreed to offer SMDRE the option, for 90 days, for the SMDRE note to be paid in full for a 67% discount (i.e., the offer to be paid $619,898 immediately) (the “Pre-Payment Option”).  Between April 27, 2015 and July 9, 2015 the Company received payments on the SMDRE LLC note in the amount of $531,000. The balance of the discounted note of $88,898 has been extended until the end of calendar year 2015. During fiscal year 2015, we have written off $1,239,981 related to the discount on this receivable.

 

As of October 31, 2015, the Company had current liabilities owed to Mr. Watts of approximately $156,585.

Legal

We are subject to legal proceedings, claims and liabilities which arise in the ordinary course of business. We accrue for losses associated with legal claims when such losses are probable and can be reasonably estimated. These accruals are adjusted as additional information becomes available or circumstances change. Legal fees are charged to expense as they are incurred.

 

Although we may, from time to time, be involved in litigation and claims arising out of our operations in the normal course of business, we are not currently a party to any material legal proceeding.

We accrue for losses associated with environmental remediation obligations when such losses are probable and can be reasonably estimated. These accruals are adjusted as additional information becomes available or circumstances change. Costs of future expenditures for environmental remediation obligations are not discounted to their present value. Recoveries of environmental remediation costs from other parties are recorded at their undiscounted value as assets when their receipt is deemed probable.

There is soil contamination at a tank facility owned by GBE. Depending on the technique used to perform the remediation, we estimate the cost range to be between $150,000 and $900,000. We cannot determine a most likely scenario, thus we have recognized the lower end of the range. We have submitted a remediation plan to the appropriate authorities and have not yet received a response. As of July 31, 2015, $150,000 has been recognized and is included in the consolidated balance sheets under the caption “Accounts payable and accrued expenses.”

 

In April 2015, this agreement was amended, as the Company will be handling the compression and dehydration of the gas with its own equipment. The agreement calls for ground lease, services fees, and other costs. The agreement is to continue until terminated by either party.

 

Letters of Credit

Oil and gas operators in the State of Texas are required to obtain a letter of credit in favor of the Railroad Commission of Texas as security that they will meet their obligations to plug and abandon the wells they operate. We have two letters of credit in the amount of $6,610,000 and $120,000 issued by Green Bank. These letters of credit are collateralized by a certificate of deposit held with the bank for the same amount. We pay a 1.5% per annum fee in conjunction with these letters of credit.

During the quarters ended October 31, 2015 and 2014, we prepaid the fees associated with the Greenbank letters of credit for the respective year’s interest upfront and amortized these fees on a straight-line basis over their respective annual periods. The following table reflects the prepaid balances as follows:

 

The accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has not generated any significant revenues from ongoing operations and incurred net losses since inception. These matters raise substantial doubt about the Company’s ability to continue as a going concern. The condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

 

Management’s principal objective is to maximize shareholder value by, among other things, increasing production by developing its acreage, increasing profit margins by evaluating and optimizing its production, and executing its business plan to increase property values, prove its reserves, and expand its asset base. While management currently has no plans to discontinue or revise its business plan, recent volatility and decrease in crude oil prices may cause management to cut back on its development or acquisition plans, or otherwise revisit its business and/or its capital expenditure plan. Continued volatility and decreases in crude oil prices may accelerate such cut back or revisions. To combat price volatility in crude oil process and further diversify the business, management has increased its focus on the development of the Company.

On November 9, 2015, we sold each of Adar Bays, LLC (“Adar”) and Union Capital, LLC (“Union”), identical 8% Short Term Cash Redeemable Notes (collectively, the “Initial Notes”) in the amount of $208,000 ($416,000 in aggregate). The Initial Notes were issued pursuant to the terms of Securities Purchase Agreements dated as of the same date. In addition to the Initial Notes, we sold Adar and Union each another secured note in the amount of $208,000 each ($416,000 in aggregate)(the “Second Notes”). The purchase price of the Initial Notes was paid in cash at closing (November 10, 2015), and the purchase price of the Second Notes was each paid by way of the issuance of an offsetting $208,000 secured note issued to us by each of Adar and Union (the “Buyer Notes”). Pursuant to the Securities Purchase Agreements, Adar and Union each agreed not to sell short any shares of our common stock so long as each purchaser’s Initial Note or Second Note is outstanding. In connection with the sale of the Initial Notes, we paid $16,000 in legal fees ($8,000 to each investor) and paid $30,000 in due diligence fees ($15,000 per Initial Note), provided that substantially similar fees are payable in connection with the Second Notes in the event such Second Notes are paid by Adar and Union as described in greater detail below.

The Initial Notes accrue interest at the rate of 8% per annum and have a two year term. We are required to pre-pay the Initial Notes 180 days after the issuance date (the “Pre-Payment Date”), provided that if we fail to prepay such notes in full on the Pre-Payment Date (or before), the holders thereof have the right to convert the principal and accrued interest owed under such Initial Notes into our common stock at a 40% discount (increasing to 50% if we receive a DTC “Chill” on our common stock or upon the occurrence of certain events of default) to the lowest trading price of our common stock during the 15 trading days prior to conversion. Notwithstanding the foregoing, there is an initial soft floor of $0.30 per share on conversions, which means that in the event our common stock closes below $0.30 per share, then the applicable holder may not convert its notes for the 10 trading days immediately preceding the first time the price closes below $0.30 per share. However, in the event the price of our common stock closes above $0.30 per share in that 10 day period, the holder may again convert, without waiting the balance of the 10 days. Additionally, following the 10 day period, the applicable holder has a three day grace period to convert, even if the common stock closes below the next lower soft floor level (as described in the following sentence). This process is repeated with soft floors of $0.15 per share and $0.075 per share. At no time may the Initial Notes be converted into shares of our common stock if such conversion would result in the applicable holder and its affiliates owning an aggregate of in excess of 9.9% of the then outstanding shares of our common stock.

The Initial Notes may be prepaid, including in connection with any pre-payment on or prior to the Pre-Payment Date, with the following penalties: (i) if the Initial Notes are prepaid within 60 days of the issuance date, then at 115% of the face amount plus any accrued interest; (ii) if the Initial Notes are prepaid after 60 days after the issuance date but less than 121 days after the issuance date, then at 135% of the face amount plus any accrued interest and (iii) if the Initial Notes are prepaid after 120 days after the issuance date but on or before the Pre-Payment Date, then at 145% of the face amount plus any accrued interest. The Initial Notes may not be prepaid after the Pre-Payment Date, except with the approval of the applicable holders. Additionally, upon the occurrence of certain fundamental transactions involving the Company and its common stock, the Initial Notes are required to be redeemed in cash for 150% of the principal amount then outstanding, plus accrued and unpaid interest (provided upon the occurrence of such event, such Initial Notes may also be converted into common stock at the option of the holders).

 

The Buyer Notes accrue interest at the rate of 8% per annum (which until the Buyer Notes are paid in full in cash, offset amounts due under the Second Notes) and are due on July 9, 2016, unless (a) we do not meet the “current information requirements” required under Rule 144 of the Securities Act of 1933, as amended; or (b) we provide the applicable investor at least 30 days’ notice prior to the six month anniversary of the issuance date of the Buyer Note of our intention to reject the payment of the Buyer Note, in which case the applicable holder may cross cancel its payment obligations under the applicable Buyer Note as well as our payment obligations under the offsetting Second Note. The holders may only prepay the Buyer Note with our written approval.

Pursuant to a side letter entered into with each of Adar and Union, each investor agreed to grant us an option for three 30 day conversion moratorium periods, with the first period beginning on the Pre-Payment Date, and the next two beginning 30 days and 60 days, respectively, after the end of such first period. We are able to exercise the conversion moratorium period options by notifying the applicable investor no later than 10 trading days prior to the Pre-Payment Date (or thereafter, the end of the next applicable conversion moratorium period) and by paying the applicable investor(s) $20,000 prior to five trading days before the end of the then current period (with the first such payment due at least five trading days prior to the Pre-Payment Date).

Each of Adar and Union also entered into a Subordination Agreement in favor of our senior lender, Shadow Tree Capital Management, LLC, to subordinate the repayment of the Initial Notes (and if applicable, the Second Notes) to amounts owed by us to Shadow Tree.

 

JSJ Investments Inc. Note

On November 9, 2015, we sold JSJ Investments Inc. (“JSJ”) an 8% Short Term Cash Redeemable Note (the “JSJ Note”) in the principal amount of $350,000. The JSJ Note accrues interest at the rate of 8% per annum and is payable on demand by JSJ at any time after November 9, 2016. We may prepay the JSJ note, together with accrued and unpaid interest, at any time prior to the 180^th day after the issuance date (the “JSJ Pre-Payment Date”). Along with any prepayment, we are required to pay the following pre-payment penalties in addition to the principal amount then outstanding under the JSJ Note: until the 60th day after the issuance date, a premium of 25% of the principal amount of the note, in addition to outstanding interest; from the 61st day to the 120th day after the issuance date, premium of 35% of the principal amount of the note, in addition to outstanding interest; from the 121st day to the JSJ Pre-Payment Date, a premium of 45% of the principal amount of the note, in addition to outstanding interest; and after the JSJ Pre-Payment Date, a premium of 50% of the then outstanding principal amount of the note, plus accrued interest (provided that after the JSJ Pre-Payment Date the JSJ Note can only be prepaid with the written consent of JSJ). Upon the occurrence of any event of default under the JSJ Note the amounts due thereunder accrue interest at the rate of 18% per annum. JSJ agreed not to sell short any shares of our common stock so long as the JSJ Note is outstanding.

Pursuant to a side letter entered into with JSJ, JSJ agreed to grant us an option for three 30 day conversion moratorium periods, with the first period beginning on the JSJ Pre-Payment Date, and the next two beginning 30 days and 60 days, respectively, after the end of such first period. We are able to exercise the options for conversion moratoriums by notifying JSJ no later than 10 trading days prior to the JSJ Pre-Payment Date (or thereafter, the end of the next applicable conversion moratorium period) and by paying the applicable investor(s) between $25,000 and $35,000 (depending on the applicable extension period) prior to five trading days before the end of the then current period (with the first such payment due at least five trading days prior to the Pre-Payment Date).

JSJ also entered into a Subordination Agreement in favor of our senior lender, Shadow Tree Capital Management, LLC, to subordinate the repayment of the JSJ Note to amounts owed by us to Shadow Tree.

 

On November 17, 2015, the Company sold Darling Capital, LLC (“Darling”) an 8% Short Term Cash Redeemable Note (the “Darling Note”) in the principal amount of $200,000. The Darling Note accrues interest at the rate of 8% per annum (22% upon the occurrence of an event of default) and is payable on September 12, 2016, provided that we have the option to extend the maturity date of the note for an additional nine months in the event we provide Darling at least 30 days’ notice of our intention to extend such maturity date. In the event we do not prepay the Darling note, together with accrued and unpaid interest, on or prior to the 180th day after the issuance date (the “Darling Pre-Payment Date”), together with the pre-payment penalties described below, Darling has the right to convert the principal and accrued interest owed under such note into our common stock.  The conversion price for such conversions is the greater of a 40% discount (subject to additional 10% discounts in the event we become subject to a DTC “chill” or there is not current available information regarding the Company on OTC Markets and further adjustments during the occurrence of certain major announcements), to the lowest closing bid price for our common stock during the 15 trading days immediately preceding a conversion request (the “Market Price”) and $0.001 per share. Notwithstanding the above, in the event the Market Price on the date (i) the conversion shares are transferred to and deposited into Darling’s brokerage account and (ii) Darling’s broker has confirmed that it can execute trades, is lower than the Market Price on the date of conversion, the conversion price is adjusted to such lower price and additional shares are required to be issued to the holder. Notwithstanding the foregoing, there is an initial soft floor of $0.30 per share on conversions, which means that in the event our common stock closes below $0.30 per share, then the holder may not convert its note for the 10 trading days immediately preceding the first time the price closes below $0.30 per share. However, in the event the price of our common stock closes above $0.30 per share in that 10 day period, the holder may convert, without waiting the balance of the 10 days. Additionally, following the 10 day period, the holder has a three day grace period to convert, even if the common stock closes below the next lower soft floor level (as described in the following sentence). This process is repeated with soft floors of $0.15 per share and $0.075 per share. At no time may the Darling Note be converted into shares of our common stock if such conversion would result in Darling and its affiliates owning an aggregate of in excess of 9.9% of the then outstanding shares of our common stock.

Pursuant to a side letter entered into with Darling, Darling agreed to grant us an option for three 30 day conversion moratorium periods, with the first period beginning on the Darling Pre-Payment Date, and the next two beginning 30 days and 60 days, respectively, after the end of such first period. We are able to exercise the options for conversion moratoriums by notifying Darling no later than 10 trading days prior to the Darling Pre-Payment Date (or thereafter, the end of the next applicable conversion moratorium period) and by paying Darling $20,000 prior to five trading days before the end of the then current period (with the first such payment due at least five trading days prior to the Pre-Payment Date).

Darling also entered into a Subordination Agreement in favor of our senior lender, Shadow Tree Capital Management, LLC, to subordinate the repayment of the Darling Note to amounts owed by us to Shadow Tree.

 

Voting Agreements

On or around August 25, 2015, Kent P. Watts, our Chief Executive Officer and Chairman, entered into a voting agreement in favor of S. Chris Herndon, a member of the Board of Directors of the Company. Pursuant to the voting agreement, Mr. Watts provided Mr. Herndon a voting proxy to vote all of the shares of common stock which Mr. Watts owned (approximately 4,946,955 shares as of his entry into the agreement) or which he may acquire in the future, to vote to elect or remove (as applicable) 66.6% of members of the Company’s Board of Directors on any stockholder vote (i.e., 2 out of 3 directors). The voting agreement was to become effective, only if Mr. Watts had sold $1 million in securities in private transactions on or before September 21, 2015 and was to remain effective from such date, if ever, until the earlier of: (a) August 19, 2017; and (b) the due date of a certain convertible note which a company affiliated with Mr. Herndon (Duma Holdings, LLC) may choose to purchase from the Company in the future as described in greater detail above under Note 7 – Notes Payable - “Convertible Notes Payable” – “Duma Holding Convertible Promissory Note”.

On or around the same date, Christopher Watts, the nephew of Kent P. Watts, and the largest shareholder of the Company, entered into a voting agreement with Mr. Herndon on substantially similar terms as the voting agreement with Kent P. Watts described above.

On November 25, 2015, we received a notice of default from Typenex (the “Default Notice”).  The Company vehemently disagrees with the Default Notice in every regard.

The Default Notice alleged the occurrence of an event of default under the terms of that certain Securities Purchase Agreement (the “SPA”) and Secured Convertible Promissory Note (the “Note”) sold by the Company to Typenex on October 16, 2015 as described above under “Note 7 – Notes Payable and Convertible Notes” – “Convertible Notes Payable” – “Typenex Co-Investment, LLC Convertible Note”. Specifically, the Default Notice alleged that the Company’s November 17, 2015 sale of an 8% Short Term Cash Redeemable Note to Darling Capital, LLC (the “Darling Note”), as disclosed above under “Darling Capital, LLC Note”, constituted a ‘variable security’ which therefore resulted in a breach of the provisions of the SPA and Note because the Company did not first receive the approval of Typenex for such sale as required thereby for the Company’s sale of a ‘variable security’.  The Default Notice also seeks to enforce default interest on the Note (22% per annum); to increase the balance of the Note by 15% (i.e., by $259,500 to a balance of $2,006,429) due to the alleged occurrence of the default; and further seeks to foreclose on 3.1 million shares of common stock of the Company pledged by related parties to secure amounts owed under the Note.

On November 30, 2015, the Company received a demand notice (the “Demand Notice”) from Typenex formally requesting and demanding the payment of the $2,006,429 alleged due under the Note by December 2, 2015.

 

 

The Company currently has no intention of paying Typenex, allowing Typenex to foreclose on the pledged shares or acknowledging that a default has occurred under the SPA or Note and is currently analyzing its options moving forward in regards to the erroneous claims made by Typenex, which may include, but not be limited to filing a lawsuit against Typenex. Notwithstanding the above, the existence of the alleged defaults, and/or resources the Company may be forced to expend in defending itself against the allegations made by Typenex may negatively affect the Company or its cash flow, which may ultimately result in a decline in the value of the Company’s common stock.

Effective November 30, 2015, we entered into (i) a First Amendment to Amended and Restated Credit Agreement, by and between the Company, as borrower, the Agent, and each of the Lenders, as lenders (the “First Amendment”), which amended that certain June 10, 2015 Amended and Restated Credit Agreement by and between the Company, the Agent and the Lenders described above under Note 7 – Notes Payable and Convertible Notes – Credit Agreement; and (ii) a Second Amendment to Stock Grant Agreement, by and between the Company and the Lenders (the “Stock Agreement”).

CAUTIONARY STATEMENT ON FORWARD-LOOKING INFORMATION

The Company is including the following cautionary statement for any forward-looking statements made by, or on behalf of, the Company. This quarterly report on Form 10-Q contains “forward looking statements” (as that term is defined in Section 27A(i)(1) of the Securities Act of 1933), including statements concerning plans, objectives, goals, strategies, expectations, future events or performance and underlying assumptions and other statements which are other than statements of historical facts. In some cases, you can identify forward-looking statements by terminology such as “may”, “should”, “expect”, “plan”, “intend”, “anticipate”, “believe”, “estimate”, “predict”, “potential” or “continue”, the negative of such terms or other comparable terminology. In evaluating these statements, you should consider various factors, including the assumptions, risks and uncertainties outlined in this  report, if any, and our Annual Report on Form 10-K for the year ended July 31, 2015, filed with the Securities and Exchange Commission (the “SEC”) on November 13, 2015 (the “Annual Report”), under “Risk Factors”. These factors or any of them may cause our actual results to differ materially from any forward-looking statement made in this report. Forward-looking statements in this report include, among others, statements regarding:

While these forward-looking statements, and any assumptions upon which they are based, are made in good faith and reflect our current judgment regarding future events, our actual results will likely vary, sometimes materially, from any estimates, predictions, projections, assumptions or other future performance suggested herein. Some of the risks and assumptions include, but are not limited to:

We advise the reader that these cautionary remarks expressly qualify in their entirety all forward-looking statements attributable to us or persons acting on our behalf. Important factors that you should also consider, include, but are not limited to, the factors discussed under “Risk Factors” in this report, if any, and our Annual Report.

The forward-looking statements in this report are made as of the date of this report and we do not intend or undertake to update any of the forward-looking statements to conform these statements to actual results, except as required by applicable law, including the securities laws of the United States.

Certain abbreviations and oil and gas industry terms used throughout this report are described and defined in greater detail under “Glossary of Oil and Natural Gas Terms” beginning on page 13 of the Annual Report, and readers are encouraged to review that section of the Annual Report.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

As used in this Quarterly Report: (i) the terms “we”, “us”, “our”, “Hydrocarb”, “HEC”, “Penasco”, “Galveston Bay”, “SPE”, “NEI” and the “Company” mean Hydrocarb Energy Corp and its wholly owned subsidiaries Penasco Petroleum Inc., Galveston Bay, LLC, SPE Navigation I, LLC, and Namibia Exploration, Inc. Hydrocarb Corporation (“HCN”), Hydrocarb Texas Corporation, Hydrocarb Energy DRC Corporation, Hydrocarb Namibia Energy (Pty) Limited and Hydrocarb Guinea SARL plus our 95% ownership interest of Otaiba Hydrocarb LLC, unless the context otherwise requires; (ii) “SEC” refers to the Securities and Exchange Commission; (iii) “Securities Act” refers to the Securities Act of 1933, as amended; (iv) “Exchange Act” refers to the Securities Exchange Act of 1934, as amended; and (v) all dollar amounts refer to United States dollars unless otherwise indicated.

The following discussion of our plan of operations, results of operations and financial condition as at and for the three months ended October 31, 2015 should be read in conjunction with our unaudited consolidated interim financial statements and related notes for the three months ended October 31, 2015, included in this Quarterly Report, as well as our Annual Report on Form 10-K for the year ended July 31, 2015.

Plan of Operations

In Namibia, Africa, we plan to interpret the newly acquired aerial gravity magnetic survey data and develop the acquisition plan for new 2-D seismic data over the concession. This will include seeking a new partner that will, at least partially, carry us through the seismic acquisition program. 3-D seismic will later be utilized for those identified structures which appear most prospective. Drilling of the first well is several years away. In the meanwhile, our goals are to increase the value and decrease the risk profile of our concession acreage in Namibia.

In September 2014 our CEO traveled to Abu Dhabi, United Arab Emirates (“UAE.”) and met with the board of directors of our subsidiary Otaiba Hydrocarb LLC. His goal was to proceed with oil company registration work that would allow the company to receive bids on oilfield services work with the hopes of developing a profitable business as has been the plan since the subsidiary was established. Instead of being able to proceed with the business plan, the partner in the UAE made it clear that they wanted more control over management of the subsidiary while still requiring us to fund ongoing expenses. This created an impasse between our partners and us. Together with consideration for the severe drop in oil prices, the board of directors made the decision to cease operations in the UAE in favor of our focus for oilfield services to be developed domestically. Thus, during the quarter ended April 30, 2015, the decision was made to close the office in the UAE and not to continue its operations, thereby reducing cash expense obligations that we have had in the past but no longer have. All expenses of operating there have been realized on an ongoing basis so the accounting effect of this shutdown is nil and immaterial.

 

Our plan of operations over the next twelve months is to increase cash flow upon one or more of the following occurring:

Our plan of operations over the next twelve months will always be subject to available capital which will be determined by the success of projects that are currently in progress or will begin soon. It is even possible that given a high degree success in recently initiated projects and upcoming projects we could actually exceed our planned operations and have more internally-derived funds available for capital expenditures for the next six months. As management, we will determine the best use of our capital given the circumstances at the time.

Results of Operations

The following table sets out consolidated data for the periods indicated:

Three months ended October 31, 2015 compared to the three months ended October 31, 2014:

 

* Less than 1%

We recorded net loss of $4,151,412, or (0.18) per basic and diluted common share, during the three months ended October 31, 2015, as compared to a net loss of $1,779,523, or ($0.08) per basic and diluted common share, during the three months ended October 31, 2014.

The changes in results were predominantly due to the factors below:

Revenues increased from $1,205,429 in the prior three month period ended October 31, 2014 to $1,211,406 in the current three month period ended October 31, 2015. Of the total revenue increase $615,296 was due to higher volume in both oil and gas offset by a decrease of $606,726 in revenue due to decreases in oil and gas prices. Oil price decreased by 110% to an average $44.15 per barrel while gas price decreased by 53% to an average $2.6 per thousand cubic feet (Mcf). Lease operating expenses decreased due to lower cost of operation period over period. Depreciation, depletion, and amortization increased because of higher production in the current year versus production in the same quarter of the comparable period prior year.

 

General and administrative expenses decreased primarily as a result of decreased compensation expense related to stock options. Interest income (expense) for the three months ended October 31, 2015 increased primarily result of debt related expense such as interest expense, debt issuance cost amortization and original issue discount amortization.

We continue to evaluate areas where we can reduce costs in lease operating expense and to increase production, which would increase revenues.

Liquidity, Capital Resources and Going Concern

The following table sets forth our cash and working capital as follows:

Net Cash Provided by Operating Activities

During the three months ended October 31, 2015, operating activities used $1,716,012 of cash compared to providing cash of $1,063,248 during the three months ended October 31, 2014. The change in the cash used by operating activities is primarily attributable to our net loss of $4,151,412 during the current period, in addition to an increase of $148,475 in other assets and receivables and a decrease of $210,872 in our accounts payable and accrued expenses for the current period compared to the prior period. Partially offsetting our cash flows used in operations were non-cash outflows of $1,223,789. Non-cash items were primarily comprised of share based compensation, share issued for services $1,564,000, accretion of $248,299, and amortization of $1,668,012 related to our original issuance discount and debt issuance cost on debt acquired. Change in derivative liabilities has non-cash inflow of $1,273,926.

Net Cash Used in Investing Activities

During the three months ended October 31, 2015, investing activities used cash of $90,408 compared to using cash of $404,941 during the three months ended October 31, 2014. The change is due mainly to purchases of oil and gas property.

Net Cash Provided by Financing Activities

During the three months ended October 31, 2015, financing activities provided net cash of $1,778,261 in comparison to using cash of $3,166,829 during the three months ended October 31, 2014. The change in cash provided is primarily a result of our borrowings related to our Convertible Subordinated Promissory Note Offering and Convertible Note issued to Typenex Co-Investment, LLC.

During the three months ended October 31, 2015 we received gross proceeds of $2,732,822 as a result of our convertible notes offering. The increase in cash provided by financing activities was partially offset by payments on notes of $954,561.

 

Critical Accounting Policies

The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and the rules of the SEC. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.

We regularly evaluate the accounting policies and estimates that we use to prepare our consolidated financial statements. In general, our estimates are based on historical experience, on information from third party professionals, and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results could differ from those estimates made by management.

We believe that our critical accounting policies and estimates include the accounting for oil and gas properties, long-lived assets reclamation costs, and accounting for stock-based compensation.

Oil and Natural Gas Properties

We account for our oil and natural gas producing activities using the full cost method of accounting as prescribed by the SEC. Under this method, subject to a limitation based on estimated value, all costs incurred in the acquisition, exploration, and development of proved oil and natural gas properties, including internal costs directly associated with acquisition, exploration, and development activities, the costs of abandoned properties, dry holes, geophysical costs, and annual lease rentals are capitalized within a cost center. Costs of production and general and administrative corporate costs unrelated to acquisition, exploration, and development activities are expensed as incurred.

 

Costs associated with unevaluated properties are capitalized as oil and natural gas properties but are excluded from the amortization base during the evaluation period. When we determine whether the property has proved recoverable reserves or not, or if there is an impairment, the costs are transferred into the amortization base and thereby become subject to amortization.

We assess all items classified as unevaluated property on at least an annual basis for inclusion in the amortization base. We assess properties on an individual basis or as a group if properties are individually insignificant. The assessment includes consideration of the following factors, among others: intent to drill; remaining lease term; geological and geophysical evaluations; drilling results and activity; the assignment of proved reserves; and the economic viability of development if proved reserves are assigned. During any period in which these factors indicate that there would be impairment, or if proved reserves are assigned to a property, the cumulative costs incurred to date for such property are transferred to the amortizable base and are then subject to amortization.

Capitalized costs included in the amortization base are depleted using the units of production method based on proved reserves. Depletion is calculated using the capitalized costs included in the amortization base, including estimated asset retirement costs, plus the estimated future expenditures to be incurred in developing proved reserves, net of estimated salvage values.

The net book value of all capitalized oil and natural gas properties within a cost center, less related deferred income taxes, is subject to a full cost ceiling limitation which is calculated quarterly. Under the ceiling limitation, costs may not exceed an aggregate of the present value of future net revenues attributable to prove oil and natural gas reserves discounted at 10 percent using current prices, plus the lower of cost or market value of unproved properties included in the amortization base, plus the cost of unevaluated properties, less any associated tax effects. Any excess of the net book value, less related deferred tax benefits, over the ceiling is written off as expense. Impairment expense recorded in one period may not be reversed in a subsequent period even though higher oil and gas prices may have increased the ceiling applicable to the subsequent period.

Sales or other dispositions of oil and natural gas properties are accounted for as adjustments to capitalized costs, with no gain or loss recorded unless the ratio of cost to proved reserves would significantly change.

Asset Retirement Obligations

We record the fair value of an asset retirement cost, and corresponding liability as part of the cost of the related long-lived asset and the cost is subsequently allocated to expense using a systematic and rational method. We record an asset retirement obligation to reflect our legal obligations related to future plugging and abandonment of our oil and natural gas wells and gas gathering systems. We estimate the expected cash flow associated with the obligation and discount the amount using a credit-adjusted, risk-free interest rate. At least annually, we reassess the obligation to determine whether a change in the estimated obligation is necessary. We evaluate whether there are indicators that suggest the estimated cash flows underlying the obligation have materially changed. Should those indicators suggest the estimated obligation may have materially changed on an interim basis (quarterly), we will accordingly update our assessment. Additional retirement obligations increase the liability associated with new oil and natural gas wells and gas gathering systems as these obligations are incurred.

Stock-Based Compensation

ASC 718, Compensation-Stock Compensation, requires recognition in the financial statements of the cost of employee services received in exchange for an award of equity instruments over the period the employee is required to perform the services in exchange for the award (presumptively the vesting period). We measure the cost of employee services received in exchange for an award based on the grant-date fair value of the award.

We account for non-employee share-based awards based upon ASC 505-50, Equity-Based Payments to Non-Employees. ASC 505-50 requires the costs of goods and services received in exchange for an award of equity instruments to be recognized using the fair value of the goods and services or the fair value of the equity award, whichever is more reliably measurable. The fair value of the equity award is determined on the measurement date, which is the earlier of the date that a performance commitment is reached or the date that performance is complete. Generally, our awards do not entail performance commitments. When an award vests over time such that performance occurs over multiple reporting periods, we estimate the fair value of the award as of the end of each reporting period and recognize an appropriate portion of the cost based on the fair value on that date. When the award vests, we adjust the cost previously recognized so that the cost ultimately recognized is equivalent to the fair value on the date the performance is complete.

 

We recognize the cost associated with share-based awards that have a graded vesting schedule on a straight-line basis over the requisite service period of the entire award.

Off-Balance Sheet Arrangements

We have not entered into any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes of financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

Pursuant to Item 305(e) of Regulation S-K (§ 229.305(e)), the Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined by Rule 229.10(f)(1).

Item 4.

Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Principal Executive Officer has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, our Principal Executive Officer has concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were not effective, due to the deficiencies in our internal control over financial reporting as described in our Annual Report on Form 10-K for our fiscal year ended July 31, 2015, which deficiencies have not yet been remedied.

Changes in Internal Control over Financial Reporting

We regularly review our system of internal control over financial reporting to ensure we maintain an effective internal control environment. There were no changes in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

 

Part II - Other Information

Item 1.

Legal Proceedings

Although we may, from time to time, be involved in litigation and claims arising out of our operations in the normal course of business, we are not currently a party to any material legal proceeding.

Previously, we were subject to Civ. Action No. 4:15-cv-00727, Hydrocarb Energy Corp., et al. v. Vincent Pasquale Scaturro; In the United States District Court for the Southern District of Texas Houston Division. Hydrocarb Energy Corp. was Plaintiff in this action, and had a claim of breach of contract against Mr. Scaturro and an application for preliminary and permanent injunction as a result of Mr. Scaturro’s violation of a Lock Up Leak-Out Agreement executed by the parties on or about December 20, 2014. Specifically, in November 2014, Pasquale V. Scaturro, the Company’s former Chief Executive Officer and Kent P. Watts, the Company’s current Chief Executive Officer and Chairman, entered into a stock purchase agreement, which was amended in December 2014, at which time certain of the adult children of Mr. Watts became party to the agreement. Pursuant to the agreement, Mr. Watts and his children agreed to sell Mr. Scaturro the outstanding capital stock of a company which they owned which is located in Namibia which owns real estate, in consideration for 475,000 shares of common stock held by Mr. Scaturro (deliverable in tranches between December 2014 and April 2015, of which an aggregate of 75,000 had been delivered as of the date of the lawsuit below) to be transferred to Mr. Watts’ children and a promissory note in the amount of $475,000 payable to Mr. Watts. Additionally, Mr. Scaturro also entered into a lock-up agreement, whereby he agreed to sell a maximum of 500 shares of the Company’s common stock which he holds or may hold in the future, per day, until the listing by the Company on a national exchange or NASDAQ, and thereafter to sell 5% of the ten day moving volume weighted average of shares per day, during the 24 months following the date of the December agreement. Subsequently, Kent P. Watts assigned his rights under the lock-up agreement to the Company and the lawsuit was filed by the Company seeking damages for Mr. Scaturro’s breach of contract. In July 2015, the parties entered into a settlement agreement whereby Mr. Scaturro agreed to transfer an aggregate of 2,237,500 shares of our common stock to Kent P. Watts, (of which 300,000 shares will be transferred to Mr. Watts’ legal counsel as part of a contingent settlement of amounts owed to such legal counsel) and an aggregate of 162,500 shares of our common stock to two children of Mr. Watts; Mr. Scaturro retained 307,058 shares (the “Remaining Shares”), all interests held by Mr. Watts’ children in the Namibia company were transferred to Mr. Scaturro, and the consulting agreement which was previously in place between the Company and Mr. Scaturro was terminated. The parties also agreed to dismiss the lawsuit and cross and counter claims with prejudice and release each other from outstanding claims and causes of actions. Finally, Mr. Scaturro agreed to sell no more than 500 of the Remaining Shares per day until December 18, 2016. Subsequently the parties dismissed the lawsuit with prejudice as of July 20, 2015.

The General Land Office of the State of Texas (“GLO”) has asserted claims against the Company under various Miscellaneous Easements. The GLO claims that the Company is obligated to either renew the various Miscellaneous Easements by paying a renewal fee to the GLO, or to remove any pipeline laid in the various Miscellaneous Easements. The GLO has asserted its claims, and the company has disclaimed any obligations under the various Miscellaneous Easements. On August 29, 2014, the Company filed a lawsuit in state district court in Chambers County, Texas asking the court to reform an assignment and assumption agreement in the property records of Chambers County. The Company has been in discussions with the GLO in an attempt to resolve the dispute. At this time, there is no estimate of loss with respect to this lawsuit.

Environmental

We accrue for losses associated with environmental remediation obligations when such losses are probable and can be reasonably estimated. These accruals are adjusted as additional information becomes available or circumstances change. Costs of future expenditures for environmental remediation obligations are not discounted to their present value. Recoveries of environmental remediation costs from other parties are recorded at their undiscounted value as assets when their receipt is deemed probable.

There is soil contamination at a tank facility owned by GBE. Depending on the technique used to perform the remediation, we estimate the cost range to be between $150,000 and $900,000. We cannot determine a most likely scenario, thus we have recognized the lower end of the range. We have submitted a remediation plan to the appropriate authorities and have not yet received a response. As of October 31, 2015, $150,000 has been recognized and is included in the consolidated balance sheets under the caption “Accounts payable and accrued expenses.”

 

Item 1A.

Risk Factors

There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended July 31, 2015, filed with the SEC on November 13, 2015, as of the date of this report, other than as set forth below, and investors should review the risks below and in the Form 10-K, prior to making an investment in the Company.

Typenex has alleged the occurrence of an event of default under its 8% Short Term Cash Redeemable Note and demanded that we repay amounts owed thereunder and we do not have sufficient funds, nor ability under our senior loan agreement, to repay the amounts alleged owed.

On November 25, 2015, we received a notice of default from Typenex. The Company vehemently disagrees with the Default Notice in every regard. The Default Notice alleged the occurrence of an event of default under the terms of that certain Securities Purchase Agreement and Secured Convertible Promissory Note sold by the Company to Typenex on October 16, 2015 as described above under “Part I - Financial Information” - “Item 1. Financial Statements” - “Note 7 – Notes Payable and Convertible Notes” – “Convertible Notes Payable” – “Typenex Co-Investment, LLC Convertible Note”. Specifically, the Default Notice alleged that the Company’s November 17, 2015 sale of an 8% Short Term Cash Redeemable Note to Darling Capital, LLC, as disclosed above under “Part I - Financial Information” - “Item 1. Financial Statements” -“Note 14 – Subsequent Events” – “Darling Capital, LLC Note”, constituted a ‘variable security’ which therefore resulted in a breach of the provisions of the SPA and Note because the Company did not first receive the approval of Typenex for such sale as required thereby for the Company’s sale of a ‘variable security’. The Default Notice also seeks to enforce default interest on the Note (22% per annum); to increase the balance of the Note by 15% (i.e., by $259,500 to a balance of $2,006,429) due to the alleged occurrence of the default; and further seeks to foreclose on 3.1 million shares of common stock of the Company pledged by related parties to secure amounts owed under the Note.

On November 30, 2015, the Company received a demand notice from Typenex formally requesting and demanding the payment of the $2,006,429 alleged due under the Note by December 2, 2015. The Company disputes the claim that an event of default has occurred under the SPA or the Note and further disputes and fails to acknowledge the claims and demands made by Typenex in the Default Notice and Demand Notice. The Darling Note was not a ‘variable security’ as such security is not convertible unless or until such note is not repaid by the 180^th day after the sale of such note and the Company therefore believes that the claims made by Typenex are invalid. Furthermore, pursuant to the terms and conditions of the Note, Typenex is required to provide us a 15 day cure period in the event we breach certain terms of the SPA, including the breach alleged by Typenex in the Default Notice, and Typenex has failed to provide us any right to cure as required by the SPA and Note. Additionally, pursuant to a subordination agreement entered into between Typenex and the Agent, Typenex agreed not to make any demand for payment of amounts owed under the Note, commence any action to enforce the repayment of the Note (except pursuant to the terms of the subordination agreement, which requires among other things, 60 days prior notice by Typenex to the Agent), collect any collateral (other than pledged shares), or accept any payment of amounts owed under the Note (including principal, interest and other amounts due) unless in the form of common stock of the Company, until or unless amounts owed to the Lenders under the Credit Agreement are first satisfied in full.

 

Notwithstanding the above, we may need to raise additional funding in the future to repay or refinance the Note, and as such may need to seek additional debt or equity financing. Such additional financing may not be available on favorable terms, if at all. If debt financing is available and obtained, our interest expense may increase and we may be subject to the risk of default, depending on the terms of such financing. If equity financing is available and obtained it may result in our shareholders experiencing significant dilution. If such financing is unavailable, we may be forced to curtail our operations, which may cause the value of our securities to decline in value and/or become worthless. Furthermore, the fact that the Note has been alleged in default (regardless of whether such allegation was valid or not) may negatively affect the perception of the Company and our ability to pay our debts as they become due in the future and could result in the price of our securities declining in value or being valued at lower levels than companies with similar histories of alleged defaults.

 

The Typenex Note is convertible into our common stock upon the occurrence of an event of default and an event of default has been alleged under the Typenex Note.

As described below, Typenex has previously alleged that the Note is currently in default, although as described above, we dispute such allegation. At any time following an uncured event of default, Typenex has the right to convert any or all of the outstanding principal amount of the Note into our common stock. The conversion price of the Typenex Note is 80% of the five lowest closing bid prices of our common stock on the 20 trading days prior to any conversion, provided that if the average of such closing bid prices is below $0.75 per share, the conversion rate is decreased by 5% (to 75%), and provided further that the conversion rate is decreased by an additional 5% if we are not DWAC eligible at any time or DTC eligible at any time (for up to an aggregate of an additional 10% decrease in the conversion rate). Finally, in the event certain defaults (defined as major defaults under the note) occur, the conversion rate may be decreased by up to an additional 15% (an additional 5% decrease in the conversion rate per the occurrence of the first three major defaults). Typenex also has the right upon the occurrence of an event of default to require us to repay in full the amount owed under the Note by providing us written notice, subject to the terms of the subordination agreement entered into by Typenex in favor of our senior lender. Additionally, upon the occurrence of certain events of default as described in the Typenex Note, we are required to repay Typenex liquidated damages in addition to the amount owed under the Typenex Note. At no time may the Typenex Note be converted into shares of our common stock if such conversion would result in Typenex and its affiliates owning an aggregate of in excess of 4.99% of the then outstanding shares of our common stock, provided such percentage increases to 9.99% if our market capitalization is less than $10 million, and provided further that Typenex may change such percentage from time to time upon not less than 61 days prior written notice to us.

If Typenex converts the Note into common stock, the conversion thereof will likely cause the value of our common stock, to decline in value. Additionally, if sequential conversions of the Note and sales of such converted shares take place, the price of our common stock may decline, and as a result, the holder of the Note will be entitled to receive an increasing number of shares in connection with conversions, which shares could then be sold in the market, triggering further price declines and conversions for even larger numbers of shares, to the detriment of our investors. The shares of common stock which the Note is convertible into may be sold without restriction pursuant to Rule 144. Additionally, the shares pledged to secure the repayment of the Note, which Typenex has disclosed its intention to transfer to its name and sell in the public market, may be sold without restriction pursuant to Rule 144. As a result, the sale of these shares may adversely affect the market price, if any, of our common stock. In addition, the common stock issuable upon conversion of the Note or upon sale of the pledged shares may represent overhang that may also adversely affect the market price of our common stock. Overhang occurs when there is a greater supply of a company’s stock in the market than there is demand for that stock. When this happens the price of the company’s stock will decrease, and any additional shares which shareholders attempt to sell in the market will only further decrease the share price. The Typenex Note, upon the occurrence of an event of default, is convertible into common stock at a discount to market as described above, and such discount to market provides the holder with the ability to sell its common stock at or below market and still make a profit. In the event of such overhang, Typenex will have an incentive to sell their common stock as quickly as possible. If the share volume of our common stock cannot absorb the discounted shares, then the value of our common stock will likely decrease. The issuance of common stock upon conversion of the Note will result in immediate and substantial dilution to the interests of other stockholders since Typenex may ultimately receive and sell the full amount of shares issuable in connection with the conversion of such Note. The conversion of the Note and sale of shares by Typenex and/or sale of the pledged shares by Typenex could cause the value our common stock to decline in value or become worthless.

 

The trading prices of our common stock may be adversely affected by short selling and our stockholders ownership of our common stock may be in doubt due to possible naked short selling of our common stock.

“Short selling” is the sale of a security that the seller does not own, including a sale that is completed by the seller’s delivery of a “borrowed” security (i.e. the short seller’s promise to deliver the security).  Short sellers make a short sale because they believe that they will be able to buy the stock at a lower price than their sales price. Significant amounts of short selling, or the perception that a significant amount of short sales could occur, could depress the market price of our common stock. The price decline could be exacerbated if sufficient “naked short selling” occurs, which is the practice by which short sellers place short sell orders for shares without first borrowing the shares to be sold, or without having first adequately located such shares and arranged for a firm contract to borrow such shares prior to the delivery date set to close the sale. The result is an artificial deluge into the market of shares for sale – shares that the seller does not own and has not even borrowed. Although there are regulations in the United States designed to address abusive short selling, the regulations may not be adequately structured or enforced. Because naked shorting may result in an artificial depression of our stock price, our stockholders could lose all or part of their investment in our common stock. As a result of this naked short selling, there may be a substantial number of purchasers who believe they are our stockholders, but who in fact would not be stockholders since their brokers may never have received any shares of our common stock for their account. In addition, naked short selling may deprive stockholders of the right to vote some or all of their shares.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

We have previously disclosed in our Annual Report on Form 10-K for the year ended July 31, 2015, as filed with the Securities and Exchange Commission on November 13, 2015, and/or the Current Reports on Form 8-K filed during the quarter ended October 31, 2015, or subsequent thereto and through the date of this filing, all unregistered equity securities that we issued and/or sold during the quarter ended October 31, 2015 and through the date of this filing.

Item 3.

Defaults Upon Senior Securities

On November 25, 2015, we received a notice of default from Typenex (the “Default Notice”).  The Company vehemently disagrees with the Default Notice in every regard.

The Default Notice alleged the occurrence of an event of default under the terms of that certain Securities Purchase Agreement (the “SPA”) and Secured Convertible Promissory Note (the “Note”) sold by the Company to Typenex on October 16, 2015 as described above under “Part I - Financial Information” - “Item 1. Financial Statements” - “Note 7 – Notes Payable and Convertible Notes” – “Convertible Notes Payable” – “Typenex Co-Investment, LLC Convertible Note”. Specifically, the Default Notice alleged that the Company’s November 17, 2015 sale of an 8% Short Term Cash Redeemable Note to Darling Capital, LLC (the “Darling Note”), as disclosed above under “Part I - Financial Information” - “Item 1. Financial Statements” -“Note 14 – Subsequent Events” – “Darling Capital, LLC Note”, constituted a ‘variable security’ which therefore resulted in a breach of the provisions of the SPA and Note because the Company did not first receive the approval of Typenex for such sale as required thereby for the Company’s sale of a ‘variable security’.  The Default Notice also seeks to enforce default interest on the Note (22% per annum); to increase the balance of the Note by 15% (i.e., by $259,500 to a balance of $2,006,429) due to the alleged occurrence of the default; and further seeks to foreclose on 3.1 million shares of common stock of the Company pledged by related parties to secure amounts owed under the Note.

On November 30, 2015, the Company received a demand notice (the “Demand Notice”) from Typenex formally requesting and demanding the payment of the $2,006,429 alleged due under the Note by December 2, 2015.

 

 

Item 4.

Mine Safety Disclosures

 

Not applicable.

Item 5.

Other Information

None.

Item 6.

Exhibits

See the Exhibit Index following the signature page to this Quarterly Report on Form 10-Q/A for a list of exhibits filed or furnished with this report, which Exhibit Index is incorporated herein by reference.

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.

 

EXHIBIT INDEX

 

 

*	Filed herewith.

**	Furnished herewith.

***	Indicates management contract or compensatory plan or arrangement.