(Exact Name of Registrant As Specified in Its Charter)
(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes o No x
The aggregate market value of the Registrant’s common stock held by non-affiliates computed by reference to the last reprinted sale price on June 30, 2008 was $72,845,677. As of March 1, 2009, there were outstanding 22,227,271 shares of the Registrant’s common stock.
Portions of the Arbinet-thexchange, Inc. definitive proxy statement for the 2009 Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the Registrant’s fiscal year are incorporated by reference into Part III of this Annual Report on Form 10-K reported, and certain documents are incorporated by reference to Part IV.
TABLE OF CONTENTS
Item 1.
Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Submission of Matter to a Vote of Security Holders
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Consolidated Financial Data
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
Item 10.
Directors, Executive Officers, and Corporate Governance
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Item 14.
Principal Accountant Fees and Services
Item 15.
Exhibits, Financial Statements, Financial Statement Schedules
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We are a leading solutions provider for the telecommunications industry, based primarily upon an electronic market for trading, routing and settling communications capacity. Members of our exchange, consisting primarily of communications services providers, buy and sell voice calls and Internet capacity through our centralized, efficient and liquid marketplace. Communications services providers that do not use our exchange, generally individually negotiate and buy access to the networks of other communications services providers to send voice calls and Internet capacity outside of their networks. We believe that we provide a cost-effective and efficient alternative to these direct connections. With a single interconnection to our exchange, members have access to all other members’ networks. Members or their agents place orders through our web-based interface. Sellers or their agents post sell orders on our exchange to offer voice calls and Internet capacity for specific destinations, or routes, at various prices. We independently assess the quality of these routes and include that information in the sell order. Buyers place buy orders based on route quality and price and are matched to sell orders by our trading platform and our proprietary software. When a buyer’s order is matched to a seller’s order, the voice calls or Internet capacity are then routed through our state-of-the-art facilities. We invoice and process payments for our members’ transactions and manage the credit risk of buyers primarily through our credit management programs with third parties. In addition to our trading activities, we have also developed a suite of complementary services to help customers become more cost and operationally efficient by, for example, reducing their number of bilateral agreements.
Through our exchange, members have access to communications capacity in substantially every country in the world. As of December 31, 2008, we had 1,146 members who subscribed to our voice trading services, including the world’s ten largest communications services providers. The following table illustrates the changing mix of the minutes traded on our exchange for voice calls:
We have traditionally operated as a neutral, anonymous exchange. However, as part of our strategy to improve our product and service offerings, and simplify our customers’ experiences, we created a separate subsidiary, Arbinet Carrier Services, Inc., which sought and obtained a license from the Federal Communications Commission, which provides the Company the authority to provide facilities-based and resale international common-carrier services pursuant to 47 C.F.R. section 63.18 (e)(1) and (2). It is our intention to utilize our common-carrier license to obtain international origination and termination for unserved or underserved markets on our exchange, thereby creating more supply and demand on our exchange.
The global communications services industry continues to evolve, providing significant opportunities and creating competitive pressures for the participants in the industry. The industry has been experiencing significant changes, including the proliferation of wireless and data products and services, increased voice and data volume, declining unit pricing and the emergence of new participants due to deregulation and low-cost technologies. The growth in competition and associated fragmentation along with declining unit pricing and an industry structure that is characterized by high fixed costs have resulted in increased pressure on communications services providers’ profitability.
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The voice industry is characterized by changes driven by deregulation in telecommunications markets around the world, an increase in and shift of minutes to wireless and the acceptance of Voice over Internet Protocol (“VoIP”) as an alternative to traditional TDM based wireline phone service. Over the past 25 years, international voice traffic has grown just over 14% annually. In the late 1990s competition in most of Europe and Asia resulted in sharp price declines of international termination substantially increasing voice traffic. More recently, volume increases have been driven by the rapid expansion of mobile phone usage. In 2008, the overall growth rate of voice minutes (TDM based and VoIP combined) was approximately 12% rather than the 13 – 15% per year growth rates experienced in previous years. This decline in the rate of growth is considered a permanent shift and is attributed to three primary factors: 1) increasing mobile saturation, 2) VoIP incursion and other computer-to-computer calling and 3) the diminished ability of price cuts to stimulate additional demand. Current drivers of existing demand include:
The Internet is a global collection of tens of thousands of interconnected computer networks. A network generally must connect with other networks in order to send and receive data. In addition, online businesses and Internet service providers that rely on high-quality Internet service currently must purchase Internet capacity from, and interconnect to, multiple Internet network owners and Internet capacity resellers. As with the voice industry, the data industry is characterized by management of multiple direct interconnections, which results in high operating and infrastructure costs.
The international data market is currently growing at over 40% per year driven by peer-to-peer networking and web browsing. Our current data offering includes an exchange for the buying and selling of internet capacity and services to enhance transit quality and reduce network cost such as OptimizedIP®. Given the high growth and term-based contracts associated with data services, we believe the data business provides a more predictable and stable revenue stream.
Communications services providers must access other networks to send and receive voice and data traffic. As the industry continues to fragment, establishing, managing and maintaining many direct interconnections have become cumbersome and expensive.
We believe both voice and data communications services providers typically buy and sell capacity based on a labor-intensive, costly, time-consuming and highly negotiated contractual process that leads to higher installation, network management, selling, legal, billing and collection costs.
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We believe this traditional process can take several months from initial contact through the time of interconnection. In addition, the negotiated prices between the buyer and seller may become obsolete by the time the interconnection has been established or as market conditions change. Further, this direct process burdens the parties with numerous interconnections that must be managed and maintained.
As a result of these problems, we believe the global communications services industry benefits from our exchange, which provides a centralized, efficient platform for the trading, routing and settling of communications capacity in order to improve profitability and optimize network utilization.
We have created a global, automated, standardized, single center of commerce to trade, route and settle voice calls. Our exchange-based trading system permits buyers and sellers to transact business in a centralized, broad, liquid, open market, rather than on a one-to-one basis, and incorporates the following attributes:
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Our exchange provides many benefits to our members. By trading, routing and settling voice calls and Internet capacity through our exchange, members can access multiple buyers and sellers, increase network utilization, achieve better pricing and improve profitability and cash flow by reducing the number of interconnections, reducing selling, legal, billing and collection expenses and eliminating disputes and bad debt.
The key elements of our strategy are:
Expand our voice and data business through the following initiatives:
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We offer the following services:
We operate the world’s largest electronic marketplace for communications trading. Our online trading platform enables 1,146 fixed and mobile service providers to buy, sell, deliver and settle over 13.2 billion minutes per year.
PrimeVoiceSM. PrimeVoice is our most dynamic service, rematching orders and updating a seller’s quality profile every four hours. PrimeVoice allows our buyers and sellers to take full advantage of changes in quality and prices of voice traffic on our exchange every four hours.
SelectVoiceSM. SelectVoice allows quality sensitive buyers to trade with the highest quality sellers. By requiring that the seller’s quality remain constant over a four-day period, SelectVoice offers stable supply to our buyers.
DirectAxcessSM. Many members require direct connection to the owner of an in-country network for the termination of segments of their voice traffic. DirectAxcess gives members a direct connection to fixed and mobile networks. Buyers purchase routes directly from the network operators. Sellers earn a premium for selling direct access to their network or bilateral connections. Bid and ask orders remain matched, ensuring long-term termination to quality routes.
RapidClearSM. RapidClear is an accelerated settlement service we offer for a fee, where sellers can elect to be paid in advance of our standard settlement terms.
SoftSwitchAxcessSM. Our SoftSwitchAxcess service allows communications services providers, including non-members, to outsource VoIP switching and control routing. It also provides carriers with a secure platform to safeguard their commercial relationships and company information, and manage routes and rates simply with an advanced online interface. We charge customers a per-minute fee for this service.
AssuredAxcessSM. AssuredAxcess is a service that automatically routes a buyer’s call directly to its destination. Buyers do not manage orders as they do in our traditional exchanges. Calls are automatically distributed between selling members to achieve the highest possible performance and lowest cost targets. Rates are fixed for 15 or 30 days.
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PrivateExchangeSM. PrivateExchange is an outsourced solution that allows communications services providers to manage their bilateral commercial agreements, including rate negotiations, while we manage routing, reporting, credit risk and settlement.
Global Number Portability. Global Number Portability Query Services allow a carrier to query our systems for information about the carrier currently serving an end customer in order to route and rate the call correctly.
We provide a leading marketplace for Internet Protocol (“IP”) transit and paid peering. More than 200 Internet service providers (“ISPs”) and content sites buy, sell, deliver and settle IP transit and peering on our exchange.
OptimizedIPSM. Businesses currently buy Internet capacity on a best efforts basis. By automatically measuring and selecting the best performing Internet routes from each seller, OptimizedIP supports our quality sensitive buyers that want to maximize the quality of their Internet traffic within their price requirements. Offered as an exchange-based route control and optimization service, buyers of OptimizedIP establish a price limit for their Internet capacity on our exchange and we optimize a buyer’s traffic by dynamically routing traffic across all of the sellers that meet the buyer’s price criteria using our proprietary and patent pending route optimization technology.
SelectIPSM. Companies that sell Internet capacity do not deliver the same quality levels to every destination. SelectIP allows members to trade, route and settle traffic directed to a specific destination on the Internet or autonomous system number, or ASN. Buyers simply place ASN-specific bids on our exchange and choose from responding seller offers. SelectIP allows our members to purchase Internet capacity for specific ASNs for varying lengths of time.
PrimeIPSM. Today, businesses purchase Internet capacity in a highly manual process involving requests for proposals. PrimeIP automates the buying and selling of Internet capacity, allowing our members to trade, route and settle standard Internet capacity through an automated system. Buyers simply place a bid on our exchange and can choose from responding sellers’ offers. PrimeIP allows our members to purchase Internet capacity for varying lengths of time.
We charge our members fees based on a variety of factors, including their membership type, usage and volume commitments, subscriptions to additional services, and the value of the destinations they buy or sell. Our members may pay the following fees:
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We market and sell our products and services through our direct sales force. We seek to expand the utilization of our exchange by our current members through account managers who are dedicated to specific customer accounts. Our sales team has extensive sales experience with a broad range of communications and technology companies and is located throughout the United States, Europe, Asia, Middle East and South America. Our sales process frequently involves a trial, where our members trade a small volume of traffic prior to trading larger volumes through our centralized exchange. With respect to our larger members, sales efforts are directed at multiple decision makers, frequently including senior corporate executives, chief information officers and vice presidents of procurement. We target our voice services sales efforts at the telecommunications industry, and, in particular, the market for international wireline, wireless and VoIP minutes.
Our marketing efforts are designed to drive awareness of our exchange and our service offerings and solutions. Our marketing activities include seminar programs, trade shows, web-site programs, public relations events, print advertising and direct mailings. We are also engaged in an on-going effort to maintain relationships with key communications industry analysts.
As a worldwide exchange of international communications traffic, we do a small amount of business with telecommunications carriers in Iran and Sudan representing approximately 0.1% of annual revenues in 2006 and 2007 and approximately 0.4% of our annual revenues in 2008. We believe our business dealings with the telecommunications carriers in Iran and Sudan are permitted transactions under the applicable U.S. sanctions regimes administered by the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”), which permits certain transactions related to the receipt and transmission of telecommunications involving those countries. To our knowledge, we have no agreements with the governments of Iran and Sudan. We take seriously our obligation to comply with all applicable laws and regulations, including OFAC sanctions programs, and have a comprehensive OFAC compliance program, including training for key employees and written policies and procedures.
Our technology consists of a web-based interface through which our members and their agents place buy and sell orders and an automated, scalable, patented and integrated trading platform to match, route and settle our members’ trades. The software platform we use to provide for the delivery of traded capacity is proprietary to us and we have patented the process that matches buy and sell orders on our exchange and affects the delivery of traded capacity. We integrate our state-of-the-art database, financial, and customer-care software, server hardware and communications switches, signaling devices and VoIP gateways acquired from leading manufacturers with our proprietary trading platform to provide a full service solution handling trading, routing and settlement of voice and data services. Our technology consists of:
Our members and their agents access our exchange through a web-based interface that allows them to place buy and sell orders that include quality and price parameters. Each member has its own dedicated, customizable trading environment that includes individualized traffic reports and online invoice access. Our member facing applications are run on state-of-the-art servers.
Our system automatically matches buy and sell orders on our voice exchange every four hours. Our trading platform automatically creates an individualized routing table that prioritizes member orders based on the quality and price parameters entered into our web-based interface. This routing table is automatically downloaded into an Arbinet-developed Service Control Point (“SCP”), which is queried on a call-by-call basis by our switches in order to determine the correct routing for that individual call or session. As a result, when a buyer sends a voice call to our exchange, our systems can automatically determine which seller best
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meets the buyer’s quality and price requirements and route the traffic to the appropriate seller. If the seller cannot terminate the voice call, our systems automatically forward that traffic to the next seller that meets the buyer’s quality and price requirements. If no seller is able to accept the buyer’s traffic, our systems automatically return the traffic to the buyer to try alternative service providers to complete the traffic.
Our systems automatically measure the seller’s route quality based on traffic the seller has received through our exchange. When we match the buy and sell orders, our systems automatically update the seller’s route quality rating. If the quality has declined below the buyer’s requirements, the seller will be unmatched from that buyer. Our proprietary routing software automatically directs a buyer’s traffic to the seller with the highest quality or lowest priced offer within the parameters selected by the buyer for the designated route.
Our systems automatically generate reports that summarize the total activity on our exchange and the buy and sell activity for each member. These reports are useful to our members in determining the parameters within which they buy and sell minutes on our exchange.
Our members connect their networks to either our TDM switches or our VoIP gateways using private or public interconnections. This interconnection enables us to route all traffic that is traded on our exchange under the control of our highly specialized SCP intelligence that is able to route traffic to the unique telephone number used by a service provider.
We use our proprietary operating support system to manage our billing and settlement functions. Our switches generate traffic records that are automatically sent to our proprietary rating software that adds the economic parameters of each minute or megabyte of capacity to the traffic detail record. The traffic detail record is then automatically sent to our billing system, which generates invoices that are posted on our website and notification is automatically emailed to our members.
Our members consist primarily of communications services providers seeking to buy or sell communications capacity and include national, multinational and regional telecommunications carriers, wireless carriers, resellers and VoIP service providers. As of December 31, 2008, we had 1,146 members who subscribe to our voice trading services, on our exchange, compared to 990 members as of December 31, 2007, representing approximately a 16% increase. Our members include the world’s ten largest international communications services providers. Our members traded approximately 13.2 billion minutes in 2008 and approximately 14.4 billion minutes in 2007, representing a decrease of approximately 8%. No member in 2008 represented over 5% of our fee revenue, and our top ten members represented, in the aggregate, approximately 21% of our fee revenues. As of December 31, 2008, we had 206 members of data on our exchange.
Our members trade, route and settle voice calls and Internet capacity based on route quality and price through our automated trading platform, proprietary software and state-of-the-art facilities. We believe that we currently do not have any significant direct competitors who offer communications services providers the ability to trade, route and settle capacity based on quality and price in a liquid marketplace similar to ours. Although historically a number of companies attempted to provide similar functionality to communications services providers, many of these companies have either ceased related operations, or have become resellers of voice calls and/or Internet capacity. Although we believe that the network effect of our exchange and our intellectual property are significant barriers to entry into this business, new competitors may be able to create centralized trading solutions that replicate our business model, especially in the VoIP space.
Our voice and data businesses both compete with the legacy processes through which communications services providers buy, sell, route and settle their communications traffic directly, without the use of an exchange. These processes include, but are not limited to, existing interconnection agreements and physical interconnections with other communications services providers and incumbent relationships. Many of these companies have longer operating histories, larger customer bases, greater brand recognition and significantly
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greater financial, marketing and other resources than we do and may have the ability to better attract and retain the same customers that we are targeting as members. Once communications services providers have established these business relationships, it could be extremely difficult to convince them to utilize our exchange or replace or limit their existing ways of conducting business. In addition, since our exchange provides full disclosure of prices offered by participating sellers on an anonymous basis, buyers may choose to purchase network capacity through our exchange instead of sending traffic to their existing suppliers at pre-determined, and often higher, contract prices. If suppliers of communications capacity fear or determine that the price disclosure and spot market limit order mechanisms provided by our exchange will “cannibalize” the greater profit-generating potential of their existing businesses, they may choose to withdraw from our exchange. If participants withdraw from our exchange in significant numbers, it could cause our exchange to fail and materially harm our business.
New technologies and the expansion of existing technologies may also increase competitive pressures on us. We cannot be certain that we will be able to compete successfully against current processes and future competitors, and competitive pressures faced by us could adversely affect our business.
Our success depends in part on our proprietary rights and technology. We rely on a combination of patent, copyright, trademark and trade secret laws, employee and third-party non-disclosure agreements and other methods to protect our proprietary rights.
We have been issued 40 domestic and international patents, and have 19 further pending patent applications related, among others, to a process for clearing telecommunications trading transactions. These patents relate, among other things, to a process that collects requests to purchase and offers to sell telecommunications services, from buyers and sellers of such services, matches the offers and requests and delivers the traded telecom services between matched sellers and buyers.
The patent positions of companies like ours are generally uncertain and involve complex legal and factual questions. Our ability to maintain and solidify our proprietary position for our technology will depend on our success in obtaining effective claims and enforcing those claims once granted. We do not know whether any of our patent applications will result in the issuance of any patents. Moreover, any issued patent does not guarantee us the right to practice the patented technology or commercialize the patented product or service. Third parties may have blocking patents that could be used to prevent us from commercializing our patented products or services and practicing our patented technology. Our issued patents and those that may be issued in the future may be challenged, invalidated or circumvented, which could limit our ability to stop competitors from marketing related products or the length of the term of patent protection that we may have for our products. In addition, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages against competitors with similar technology. Furthermore, our competitors may independently develop similar technologies. For these reasons, we may have competition for our exchange.
We rely, in some circumstances, on trade secrets to protect our technology. However, trade secrets are difficult to protect. We seek to protect our technology, in part, by confidentiality agreements with our corporate partners, employees, consultants, advisors and others. These agreements may be breached and we may not have adequate remedies for any breach. In addition, our trade secrets may otherwise become known or be independently discovered by competitors. To the extent that our corporate partners, employees, consultants, advisors and others use intellectual property owned by others in their work for us, disputes may arise as to the rights in related or resulting know-how and inventions.
Arbinet® and Arbinet-thexchange® are registered trademarks of Arbinet-thexchange, Inc. ThexchangeSM, voice on thexchangeSM, OptimizedVoiceSM, SelectVoiceSM, PrimeVoiceSM, DirectAxcessSM, AssuredAxcessSM, PrivateExchangeSM, PeeringSolutionsSM, data on thexchangeSM, OptimizedIPSM, SelectIPSM, PrimeIPSM, SwitchAxcessSM, RapidClearSM, SoftSwitchAxcessSM, AxcessCodeSM, AxcessRateSM, and CreditWatchSM, are service marks of Arbinet-thexchange, Inc. Our logos, trademarks and service marks are the property of Arbinet-thexchange, Inc.
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As of December 31, 2008, we had 121 employees. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our relations with our employees to be good.
The following table identifies our executive officers:
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None of our executive officers is related to any other executive officer or to any of our Directors. Our executive officers are elected annually by the Board of Directors and serve until their successors are duly elected and qualified or until their resignation or removal.
We make available the following public filings with the Securities and Exchange Commission free of charge through our Web site at www.arbinet.com as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission:
In addition, we make available our code of business conduct and ethics free of charge through our Web site. We intend to disclose any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed pursuant to rules of the Securities and Exchange Commission and the NASDAQ Global Market by filing such amendment or waiver with the Securities and Exchange Commission and posting it on our Web site.
No information on our Web site is incorporated by reference into this Annual Report on Form 10-K or any other public filing made by us with the Securities and Exchange Commission.
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If any of the following risks occur, our business, financial condition, results of operations or prospects could be materially adversely affected. In such case, the trading price of our common stock could decline.
Our failure to overcome these risks and difficulties, and the general risks and difficulties frequently encountered by companies in new and rapidly evolving markets, could impair our ability to expand our business, continue our operations or have a material effect on our financial condition and operating results.
We have incurred significant losses since our inception in November 1996. At December 31, 2008, our accumulated deficit was approximately $111.9 million. We incurred a net loss of $14.9 million and $6.9 for the years ended 2008 and 2007, respectively. Even though we have taken steps to reduce our cost structure, we expect to incur significant future expenses, particularly with respect to the development of new products and services, deployment of additional infrastructure, and expansion in strategic global markets. To return to profitability, we must continue to increase the usage of our exchange by our members and attract new members in order to improve the liquidity of our exchange as well as continue to closely manage expenses. We must also deliver superior service to our members, mitigate the credit risks of our business, and develop and commercialize new products and services. We may not succeed in these activities and may never generate revenues that are significant or large enough to return to profitability on a quarterly or annual basis. A large portion of our revenues is derived from our members on a per-minute and per-megabyte basis. Therefore, a general market decline in the price for voice calls and Internet capacity may adversely affect the fees we charge our members in order to keep or increase the volume of member business, which could materially impact our future revenues and profits. Our failure to return to profitability would depress the market price of our common stock and could impair our ability to expand our business, diversify our product and service offerings or continue our operations.
Traditionally, communications services providers buy and sell network capacity in a direct, one-to-one process. Our members may not trade on our exchange unless it provides them with an active and liquid
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market. Liquidity depends on, among other things, the number of buyers and sellers that actively trade on a particular communications route. Our ability to increase the number of buyers that actively trade on our exchange will depend on, among other things, the willingness and ability of prospective sellers to satisfy the quality criteria imposed by prospective buyers and upon the increased participation of competing sellers from which a buyer can choose in order to obtain favorable pricing, achieve cost savings and consistently gain access to the required quality services. Our ability to increase the number of sellers that actively trade on our exchange will depend upon the extent to which there are sufficient numbers of prospective buyers available to increase the likelihood that sellers will generate meaningful sales revenues. Alternatively, our members may not trade on our exchange if they are not able to realize significant cost savings. This may also result in a decline in trading volume and liquidity of our exchange. Trading volume is additionally impacted by the mix of hundreds of geographic markets traded on our exchange. Each market has distinct characteristics, such as price and average call duration. Declines in the trading volume on our exchange would result in lower revenues to us and would adversely affect our profitability because of our predominantly fixed cost structure. Volatility in trading volumes may have a significant adverse effect on our business, financial condition and operating results.
If our exchange continues to be an active, liquid market in which lower-priced alternatives are available to buyers, sellers may conclude that further development of our exchange will erode their profits and they may stop offering communications capacity on our exchange. Since our exchange provides full disclosure of prices offered by participating sellers, buyers may choose to purchase network capacity through our exchange instead of sending traffic to their existing suppliers at pre-determined, and often higher, contract prices. If suppliers of communications capacity fear or determine that the price disclosure and spot market limit order mechanisms provided by our exchange will “cannibalize” the greater profit-generating potential of their existing business, they may choose to withdraw from our exchange, which ultimately could cause our exchange to fail and materially harm our business.
In the second half of 2008, we began a concerted effort to increase the traffic quality of calls and the average call duration (“ACD”) of calls on our exchange. These measures included eliminating and streamlining many of the routes offered, resulting in a decline of the number of minutes bought and sold and a decline in our revenues. Although we completed this process in the fourth quarter of 2008, we cannot be certain that the volume of minutes bought and sold on our exchange will increase or return to previous levels, or that we will be able to reestablish the routes eliminated in this effort. We further cannot be certain that the increase in traffic quality will result in our revenues increasing or returning to previous levels. A failure to return to previous volumes or revenue levels could adversely affect our business, financial condition and operating results.
We have traditionally operated as a neutral, anonymous exchange. We established the carrier strategy to improve our product and service offerings, improve efficiencies and simplify our customers’ experiences. However, some of our members may view our development of a carrier strategy as competitive to their businesses and may limit or eliminate their activity on our exchange. Any such reduction could have a material affect on our financial condition and operating results.
Our member enrollment cycle for full membership on our exchange can be long, and may take up to 12 months or even longer from our initial contact with a communications services provider until that provider signs our membership agreement. Because we offer a new method of purchasing and selling international long-distance voice calls and Internet capacity, we must invest a substantial amount of time and resources to educate services providers regarding the benefits of our exchange. Factors that contribute to the length and
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uncertainty of our member enrollment cycle and which may reduce the likelihood that a member will purchase or sell communications traffic through our exchange include:
If we fail to enroll new members, we may not increase our revenues, which would adversely affect our business, financial condition and results of operations.
We expect to meet our cash requirements for the next 12 months through a combination of cash flow from operations, cash, cash equivalents and short-term investments. If our cash requirements vary materially from those currently planned, or if we fail to generate sufficient cash flow from our business, we may be required to borrow additional amounts under our credit facilities or seek additional financing sooner than anticipated.
Our current credit facility with SVB, expires on November 26, 2010. Even though we expect to extend the expiration date on this facility, we may default under this facility or may not be able to renew this credit facility upon expiration or on acceptable terms. In addition, we may seek additional funding in the future through public or private equity and debt financings. We also could be required to seek funds through arrangements with collaborators or others that may require us to relinquish rights to some of our technologies, product or service candidates or products or services, which we would otherwise pursue on our own. Additional funds may not be available to us on acceptable terms or at all, particularly in light of the current significant deterioration in general economic conditions and tightening of credit availability. If we are unable to obtain funding on a timely basis, we may not be able to execute our business plan. As a result, our business, results of operations and financial condition could be adversely affected and we may be required to significantly reduce or cease our operations.
Under our settlement procedures, we pay a seller on our exchange the net sales price, or the total amount sold by a member less the amount purchased by that member in a given period, for its trading activity. We may not, however, collect the net sales price from the buyers on our exchange until after we have paid the sellers. We have established credit risk assessment and credit underwriting services with each of GMAC and SVB, which protect us from credit losses in the event of nonpayment due to bankruptcy. We are subject to financial risk for any nonpayment by the buyers for receivables that GMAC and/or SVB do not accept. We seek to mitigate this risk by evaluating the creditworthiness of each buyer prior to its joining our exchange, as well as requiring deposits, letters of credit or prepayments from some buyers. We also manage our credit risk by reducing the amount owed to us by our buying members by netting the buy amount and the sell amount for each member on our exchange. In 2008, approximately 80% of our trading revenues were covered by our third party credit agreements, netting, prepayments or other cash collateral, of which our third party credit underwriters covered 35%. However, our credit evaluations cannot fully determine whether buyers can or will pay us for capacity they purchase through our exchange. In the future, we may elect to increase the amount of credit we extend to our customers we deem creditworthy in order to reduce our credit underwriting costs. As a
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result of the impact of current adverse market conditions on our customers, our customers may not be able to pay us when amounts are due or may be unable to pay us at any time. Similarly, current economic conditions may adversely impact GMAC or SVB resulting in the inability of such entities to pay us when they are obligated to do so or at any time. If buyers fail to pay us for any reason and we have not been able or have elected not to secure credit risk protection with respect to these buyers, our business could experience a material adverse effect. In the event that the creditworthiness of our buyers deteriorates, our credit providers and we may elect not to extend credit and consequently we may forego potential revenues which could materially affect our results of operations.
There have been adverse changes in the public and private equity and debt markets for communications services providers that have affected their ability to obtain financing or to fund capital expenditures. In some cases, the significant debt burden carried by certain communications services providers has adversely affected their ability to pay their outstanding balances with us and some of our members have filed for bankruptcy as a result of their debt burdens, making us an unsecured creditor of the bankrupt entity. Although these members may emerge from bankruptcy proceedings in the future, a bankruptcy proceeding can be a slow and cumbersome process and unsecured creditors often receive partial or no payment toward outstanding obligations. Furthermore, because we are an international business, we may be subject to the bankruptcy laws of other nations, which may provide us limited or no relief. Even if these members should emerge from bankruptcy proceedings, the extent and timing of any future trading activity is uncertain. We have experienced losses due to the failure of some of our members to meet their obligations and then subsequently seeking protection of applicable bankruptcy laws. Although these losses have not been significant to date, future losses, if incurred, could be significant, particularly as a result of the impact of current adverse economic conditions and the tightening of credit availability on customers, and could harm our business and have a material adverse effect on our operating results and financial condition.
In addition, because we generally pay the sellers on our exchange and then seek payment from the buyers on our exchange, a bankruptcy court may require us to return the funds received from a buyer if we, and not our sellers, are deemed to have received a preferential payment prior to bankruptcy. Although we have credit risk programs in place to monitor and mitigate the associated risks, including our arrangements with GMAC and SVB and our policy of netting a member’s buy and sell transactions on our exchange, we do not always utilize these programs for certain members and, in such instances, these programs are not effective in eliminating or reducing these credit risks to us.
In certain instances, we offer our customers a fixed rate for specific markets for a set duration. We may assume the risk on the price of the minutes and we may not be able to secure the prices from sellers to ensure we do not lose money on the minutes purchased by the buyers. We could incur significant losses related to having a higher cost of minutes sold in relation to the price offered to the buyer of this service.
We are dependent on the members of our senior management team, in particular, Shawn F. O’Donnell, our President and Chief Executive Officer, for our business success. Our employment arrangements with Mr. O’Donnell and our other executive officers are terminable on short notice or no notice. We do not carry key man life insurance on the lives of any of our key personnel. The loss of any of our executive officers would result in a significant loss in the knowledge and experience that we, as an organization, possess and could significantly affect our current and future growth. In addition, our growth may require us to hire a significant number of qualified technical and customer-facing personnel. There is intense competition for human resources, including management, in the technical fields in which we operate, and we may not be able to attract and retain qualified personnel necessary for the successful operation and growth of our exchange. The loss of the services of key personnel or the inability to attract new employees when needed could severely harm our business.
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We face competition for our voice trading services from communications services providers’ legacy processes and new companies that may be able to create centralized trading solutions that replicate our voice trading platform or circumvent our intellectual property. These companies may be more effective in attracting voice traffic than our exchange.
We may face a new set of competitors as we launch new products and services. Our PrivateExchange and AssuredAxcess solutions may compete with communications services providers’ legacy processes, communications services providers themselves and potentially other companies that provide software and services to communications services providers. Our VoIP Peering Solutions may compete with other companies trying to create solutions that help communications service providers and corporations that manage traffic across traditional and VoIP networks.
We may not have the financial resources, technical expertise, sales and marketing abilities or support capabilities to compete successfully with these new competitors. These new competitors may be able to develop services or processes that are superior to our services or processes, or that achieve greater industry acceptance or that may be perceived by buyers and sellers as superior to ours. Where we compete with legacy processes, it may be particularly difficult to convince customers to utilize our exchange or replace or limit their existing ways of conducting business. This competition may lead to reduced expected revenues, failure to meet projections, unexpected expenses and may have a significant adverse effect on our business, financial condition and operating results.
We face competition for our data trading services from Internet service providers and Internet capacity resellers. In addition, software-based, Internet infrastructure companies focused on Internet protocol route control products may compete with us for business. Furthermore, Internet network service providers may make technological advancements, such as the introduction of improved routing protocols to enhance the quality of their services, which could negatively impact the demand for our data services.
Some of our current and potential competitors may have greater financial resources than we do and may have the ability to adopt aggressive pricing policies. In addition, many of these companies have longer operating histories and may have significantly greater technical, marketing and other resources than we do and may be able to better attract the same potential customers that we are targeting. Once customers have established business relationships, it could be extremely difficult to convince them to utilize our exchange or replace or limit their existing ways of conducting business.
The communications services industry is highly regulated in the United States and in foreign countries. Our business may become subject to various United States, United Kingdom and other foreign laws, regulations, agency actions and court decisions. The Federal Communications Commission, or FCC, has jurisdiction over interstate and international communications in the United States. The FCC currently does not regulate the exchange services we offer, but does regulate the carrier services we offer. If, however, the FCC determined, on its own motion or in response to a third party’s filing, that it should regulate our exchange services and that certain of our services or arrangements require us to obtain regulatory authorizations, the FCC could order us to make payments into certain funds supported by regulatory entities, require us to comply with reporting and other ongoing regulatory requirements and/or fine us. Further, the FCC may increase the regulatory oversight or associated costs on our carrier services. Our growth strategy may include activities that will subject us to additional regulation by the FCC. We are currently not regulated at the state level, but could be subjected to regulation by individual states as to services that they deem to be within their jurisdiction.
In addition, like many businesses that use the Internet to conduct business, we operate in an environment of tremendous uncertainty as to potential government regulation. We believe that we are not currently subject to direct regulation of the services that we offer other than regulations generally applicable to all businesses. However, governmental agencies have not yet been able to adapt all existing regulations to the Internet environment. Laws and regulations may be introduced and court decisions reached that affect the Internet or other web-based services, covering issues such as member pricing, member privacy, freedom of expression, access
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charges, content and quality of products and services, advertising, intellectual property rights and information security. In addition, because we offer our services internationally, foreign jurisdictions may claim that we are subject to their regulations. Any future regulation may have a negative impact on our business by restricting our method of operation or imposing additional costs. Further, as a company that conducts a portion of our business over the Internet, it is unclear in which jurisdictions we are actually conducting business. Our failure to qualify to do business in a jurisdiction that requires us to do so could subject us to fines or penalties, and could result in our inability to enforce contracts in that jurisdiction. Any of these government actions could have a material adverse effect on our business.
Our carrier subsidiary, Arbinet Carrier Services, Inc., is subject to regulation by the FCC and other federal, state and local agencies, which may restrict our ability to operate in or provide specified products or services. The adoption of new laws or regulations or changes to the existing regulatory framework could adversely affect our business plans. Further, compliance with the regulatory scheme will add expenses to our operating costs. We expect that improved product and service offerings, improved efficiencies and simplified our customers’ experiences resulting from this service will offset these concerns. A failure in this strategy may have a significant impact on our operational results.
We expect to continue the expansion of our international operations, which will subject us to additional risks and uncertainties. We have established EDPs in New York City, Los Angeles, London, Frankfurt, Miami and Hong Kong, and we intend to expand our presence. Foreign operations are subject to a variety of additional risks that could have an adverse effect on our business, including:
Our inability to manage these risks effectively could adversely affect our business, financial condition and operating results.
The market for our new products and services might develop more slowly or differently than we currently anticipate, if at all. Our members and potential customers may decide that these new products and services do not meet their requirements or may not be willing to purchase them at the prices we seek to charge. Even if the market for these new products and services develops, our offerings may not achieve widespread acceptance. We may be unable to successfully and cost-effectively market and sell the services we offer to a sufficiently large number of members.
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As prices for international long-distance minutes continue to decline, we may need to charge our members less for utilization of our services. We may also need to reduce our prices to drive incremental minutes on our exchange. As we have a predominantly fixed-price operating cost structure, we are evaluating implementing pricing programs that maximize the volume and aggregate fee revenues to our exchange. We continue to explore additional volume discounting programs and alternative pricing programs to drive overall fee revenues. Our fee revenue per minute may decline in the coming quarters as we explore these pricing initiatives. We cannot be certain that our pricing programs will drive significant enough increases in volume to offset the price reduction and, therefore, our aggregate fee revenues could decline due to these pricing programs.
In an effort to maintain an appropriate cost structure in light of our decline in revenue, we adopted certain cost-cutting initiatives that resulted in the downsizing of administrative, management, and executive positions over the past years. These initiatives may result in losses of efficiency due to increased demands and an increased reliance on our remaining employees. Any such losses of efficiency, or our inability to retain our remaining personnel, may lead to reduced revenues, failure to meet projections, including guidance regarding our financial results, and unexpected expenses which may have a significant adverse effect on our business, financial condition and operating results.
We may in the future acquire complementary companies, products and technologies. Such acquisitions involve a number of risks, which may include the following:
These factors could have a material adverse effect on our business, results of operations and financial condition or cash flows, particularly in the case of a larger acquisition or multiple acquisitions in a short period of time. From time to time, we may enter into negotiations for acquisitions that are not ultimately consummated. Such negotiations could result in significant diversion of management time from our business as well as significant out-of-pocket costs.
The consideration that we pay in connection with an acquisition could affect our financial results. If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could
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be required to use a substantial portion of our available cash to consummate such acquisitions. To the extent we issue shares of stock or other rights to purchase stock, including options or other rights, our existing stockholders may experience dilution in their share ownership in our company and their earnings per share may decrease. In addition, acquisitions may result in the incurrence of debt, large one-time write-offs (such as of acquired in-process research and development costs) and restructuring charges. They may also result in goodwill and other intangible assets that are subject to impairment tests, which could result in future impairment charges. Any of these factors may materially and adversely affect our business and operations.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to furnish a report of management’s assessment of the design and effectiveness of our internal control over financial reporting as part of our Annual Report on Form 10-K filed with the Securities and Exchange Commission. Our independent auditors are required to report on the effectiveness of internal control over financial reporting. Our management is also required to report on the effectiveness of our disclosure controls and procedures. We have not had a material weakness in internal control since 2005, however, our management identified a material weakness in internal control over financial reporting which was disclosed in Amendment No. 1 to our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2005 Such material weakness and deficiencies in the effectiveness of internal control over financial reporting could result in inaccurate financial statements or other disclosures or fail to prevent fraud, which could have an adverse effect on our business, financial condition or results of operations. Further, if we do not remediate any known material weakness, we could be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission, we could fail to timely meet our regulatory reporting obligations, or investor perceptions could be negatively affected; each of these potential consequences could have an adverse effect on our business, financial condition or results of operations.
Unfavorable general economic conditions, such as a recession or economic slowdown in the U.S. or in one or more of our other major markets, could negatively affect the affordability of and demand for some of our products and services. The business and operating results of communications service providers have been, and will continue to be, materially affected by worldwide economic conditions. Under these conditions the customers that we serve in the U.S. and abroad may experience reduced demands for their services, resulting in a reduction of their use of our services. The current tightening of credit in financial markets may affect our ability to obtain credit underwriting for our customers adequate to support their utilization of our services at previous or desired levels. In addition, adverse economic conditions may lead to an increased number of our customers that are unable to pay for our services. We are unable to predict the likely duration and severity of the current disruption in financial markets and adverse economic conditions globally. If the global economic slowdown continues for a significant period or there is significant further deterioration in the global economy, the demand for our services will continue to be adversely impacted, and our results of operations, financial position and cash flows could be materially and adversely affected.
The communications services providers that use our exchange depend on us to accurately track, rate, store and report the traffic and trades that are conducted on our exchange. Software defects, system failures, natural disasters, human error and other factors could lead to inaccurate or lost information or the inability to access our exchange. From time to time, we have experienced temporary service interruptions. These interruptions may occur in the future. Our systems could be vulnerable to computer viruses, physical and electronic break-ins and third party security breaches. In a few instances, we manually input trading data, such as bid and ask prices, at the request of our members, which could give rise to human error and miscommunication of
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trading information and may result in disputes with our members. Any loss of information or the delivery of inaccurate information due to human error, miscommunication or otherwise or a breach or failure of our security mechanisms that leads to unauthorized disclosure of sensitive information could lead to member dissatisfaction and possible claims against us for damages. Our failure to maintain the continuous availability of our exchange for trading, to consistently deliver accurate information to members of our exchange or to maintain the security of their confidential information could expose us to liability and materially harm our business.
Our technology is complex and is susceptible to errors, defects or performance problems, commonly called “bugs.” Although we regularly test our software and systems extensively, we cannot ensure that our testing will detect every potential error, defect or performance problem. Any such error, defect or performance problem could have an adverse effect on our operations. Members and potential members of our exchange may be particularly sensitive to any defects, errors or performance problems in our systems because a failure of our systems to accurately monitor transactions could adversely affect their own operations.
Any breach of security relating to our members’ confidential information could result in legal liability to us and a reduction in use of our exchange or cancellation of our services, either of which could materially harm our business. Our personnel often receive highly confidential information from buyers and sellers that is stored in our files and on our systems. Similarly, we receive sensitive pricing information that has historically been maintained as a matter of confidence within buyer and seller organizations.
We currently have practices, policies and procedures in place to ensure the confidentiality of our members’ information. However, our practices, policies and procedures to protect against the risk of inadvertent disclosure or unintentional breaches of security might fail to adequately protect information that we are obligated to keep confidential. We may not be successful in adopting more effective systems for maintaining confidential information, so our exposure to the risk of disclosure of the confidential information of our members may grow as we expand our business and increase the amount of information that we possess. If we fail to adequately maintain our members’ confidential information, some of our members could end their business relationships with us and we could be subject to legal liability.
The communications services industry is subject to constant and rapid technological changes. We cannot predict the effect of technological changes on our business. In addition, widely accepted standards have not yet been developed for the technologies that we employ. New services and technologies may be superior to our services and technologies, or may render our services and technologies obsolete.
To be successful, we must adapt to and keep pace with rapidly changing technologies by continually improving, expanding and developing new services and technologies to meet customer needs. Our success will depend, in part, on our ability to respond to technological advances, meet the evolving needs of members and prospective members and conform to emerging industry standards on a cost-effective and timely basis, if implemented. We will need to spend significant amounts of capital to enhance and expand our services to keep pace with changing technologies. Failure to do so may materially harm our business.
Our business depends on providing members with highly reliable service. We must protect our infrastructure and the equipment of our members located in our EDPs. Our EDPs and the services we provide are subject to failure resulting from numerous factors, including:
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Problems at one or more of our EDPs, whether or not within our control, could result in service interruptions or significant equipment damage. Any loss of services, equipment damage or inability to terminate voice calls or supply Internet capacity could reduce the confidence of our members and could consequently impair our ability to obtain and retain members, which would adversely affect both our ability to generate revenues and our operating results.
Our EDPs are susceptible to electrical power shortages, planned or unplanned power outages caused by these shortages, such as those that occurred in California during 2001 and in the Northeast in 2003, and limitations, especially internationally, of adequate power resources. We attempt to limit exposure to system downtime by housing our equipment in data centers, and using backup generators and power supplies. Power outages that last beyond our backup and alternative power arrangements could harm our members and our business.
We seek to generate a high volume of traffic and transactions on our exchange. The satisfactory performance, reliability and availability of our processing systems and network infrastructure are critical to our reputation and our ability to attract and retain members. Our revenues depend primarily on the number and the volume of member transactions that are successfully completed. We need to expand and upgrade our technology, systems and network infrastructure both to meet increased traffic and to implement new features and functions. We may be unable to project accurately the rate or timing of increases, if any, in the use of our services or to expand and upgrade our systems and infrastructure to accommodate any increases in a timely fashion.
We use internally custom-developed systems to process transactions executed on our exchange, including billing and collections processing. We must continually improve these systems in order to accommodate the level of use of our exchange. In addition, we may add new features and functionality to our services that may result in the need to develop or license additional technologies. Our inability to add additional software and hardware or to upgrade our technology, transaction processing systems or network infrastructure to accommodate increased traffic or transaction volume could have adverse consequences. These consequences include unanticipated system disruptions, slower response times, degradation in levels of member support, impaired quality of the members’ experiences of our service and delays in reporting accurate financial information. Our failure to provide new features or functionality also could result in these consequences. We may be unable to effectively upgrade and expand our systems in a timely manner or to integrate smoothly any newly developed or purchased technologies with our existing systems. Current adverse economic conditions and tightening credit availability may impair our ability to expand and enhance our systems. These difficulties could harm or limit our ability to expand our business.
The success of our exchange will depend largely on the development and maintenance of the Internet infrastructure. This includes maintenance of a reliable network backbone with the necessary speed, data capacity and security, as well as timely development of complementary products, for providing reliable Internet access and services. The Internet has experienced, and is likely to continue to experience, significant growth in the numbers of users and amount of traffic. If the Internet continues to experience increased numbers of users, increased frequency of use or increased bandwidth requirements, the Internet infrastructure may be unable to support the demands placed on it. In addition, the performance of the Internet may be harmed by an increased number of users or bandwidth requirements or by “viruses,” “worms” and similar programs. The
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Internet has experienced a variety of outages and other delays as a result of damage to portions of its infrastructure, and it could face outages and delays in the future. These outages and delays could reduce the level of Internet usage as well as the level of traffic and the processing of transactions on our exchange.
Our success depends, in part, on our ability to protect proprietary methods and technologies that we develop or have purchased under the patent and other intellectual property laws of the United States and other countries, so that we can prevent others from using our inventions and proprietary information. However, we may not hold proprietary rights to some of our current or future methods and technologies, and some of the protections for our proprietary methods and technologies may not be recognized in all jurisdictions. Because patent applications in the United States and many foreign jurisdictions are typically not published until 18 months after filing, or in some cases not at all, and because publications of discoveries in industry-related literature lag behind actual discoveries, we cannot be certain that we were the first to make the inventions claimed in issued patents or pending patent applications, or that we were the first to file for protection of the inventions set forth in our patent applications. As a result, we may be required to obtain licenses under third-party patents. If licenses are not available to us on acceptable terms, or at all, we may not be able to operate our exchange or commercialize our product and services candidates.
Our strategy depends in part on our ability to rapidly identify and seek patent protection for our discoveries. This process is expensive and time consuming, and we may not be able to file and prosecute all necessary or desirable patent applications at a reasonable cost or in a timely manner. Despite our efforts to protect our proprietary rights, unauthorized parties may be able to obtain and use information that we regard as proprietary. The issuance of a patent does not guarantee that it is valid or enforceable, so even if we obtain patents, they may not be valid or enforceable against third parties. In addition, the issuance of a patent does not guarantee that we have the right to practice the patented invention. Third parties may have blocking patents that could be used to prevent us from marketing our own patented product and practicing our own patented technology.
Our pending patent applications may not result in issued patents. The patent position of technology-oriented companies, including ours, is generally uncertain and involves complex legal and factual considerations. The standards which the United States Patent and Trademark Office and its foreign counterparts use to grant patents are not always applied predictably or uniformly and can change. The laws of some foreign countries do not protect proprietary information to the same extent as the laws of the United States, and many companies have encountered significant problems and costs in protecting their proprietary information in these foreign countries. Accordingly, we do not know the degree of future protection for our proprietary rights or the breadth of claims allowed in any patents issued to us or to others. The allowance of broader claims may increase the incidence and cost of patent interference proceedings and/or opposition proceedings and the risk of such claims being invalidated by infringement litigation. Alternatively, the allowance of narrower claims may limit the value of our proprietary rights. Our issued patents may not contain claims sufficiently broad to protect us against third parties with similar technologies or products, or provide us with any competitive advantage. Moreover, once they have been issued, our patents and any patent, that we have licensed, may be challenged, narrowed, invalidated or circumvented. If our patents are invalidated or otherwise limited, other companies will be better able to develop products that compete with ours, which could adversely affect our competitive business position, business prospects and financial condition.
We also rely on trade secrets, know-how and technology, which are not protected by patents, to maintain our competitive position. If any trade secret, know-how or other technology not protected by a patent were to be disclosed to or independently developed by a competitor, our business and financial condition could be materially adversely affected.
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If any parties successfully claim that our creation, offer for sale, sale, import or use of technologies infringes upon their intellectual property rights, we might be forced to incur expenses to litigate the claims and pay damages (potentially including treble damages, if we are found to have willfully infringed such parties’ patents or copyrights). In addition, if we are unsuccessful in litigation, a court could issue a permanent injunction preventing us from operating our exchange or commercializing our product and service candidates for the life of the patent that we have been deemed to have infringed. Litigation concerning patents and other forms of intellectual property and proprietary technologies is becoming more widespread and can be protracted and expensive and can distract management and other key personnel from performing their duties for us.
Any legal action against us claiming damages and seeking to enjoin commercial activities relating to the affected methods, processes, products and services could, in addition to subjecting us to potential liability for damages, require us to obtain a license in order to continue to operate our exchange or market the affected product and service candidates. Any license required under any patent may not be made available on commercially acceptable terms, if at all. In addition, some licenses may be nonexclusive, and, therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to effectively operate our exchange or market some of our technology and products, which could limit our ability to generate revenues or achieve profitability and possibly prevent us from generating revenue sufficient to sustain our operations.
We may need to resort to litigation to enforce a patent issued to us or to determine the scope and validity of third-party proprietary rights. The cost to us of any litigation or other proceeding relating to intellectual property rights, even if resolved in our favor, could be substantial, and the litigation could divert our management’s efforts. Some of our competitors may be able to sustain the costs of complex patent litigation more effectively than we can because they have substantially greater resources. Uncertainties resulting from the initiation and continuation of any litigation could limit our ability to continue our operations, including the commercialization of our products and services.
In order to protect our proprietary technology, processes and methods, we also rely in part on confidentiality agreements with our corporate partners, employees, consultants, advisors and others. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information, and in such cases we could not assert any trade secret rights against such party. Costly and time consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.
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None.
Our headquarters are located at 120 Albany Street, Tower II, Suite 450, New Brunswick, New Jersey, where we lease approximately 11,500 square feet of office space.
Our leased properties are as follows:
In addition, we lease circuit capacity from other communications services providers to support our EDPs in Miami, Florida; London, United Kingdom; Frankfurt, Germany; Hong Kong. As part of our agreements with these communications services providers, they provide us with our physical connection point in those markets.
We believe our existing facilities are adequate for our current needs and that suitable additional or alternative space will be available in the future on commercially reasonable terms as needed.
From time to time, we are involved in legal proceedings in the ordinary course of our business. The litigation process is inherently uncertain, and we cannot guarantee that the outcome of any proceedings or lawsuits in which we may become involved will be favorable to us or that any such proceedings and lawsuits will not be material to our business, results of operations or financial position. We do not currently believe there are any matters pending that will have a material adverse effect on our business, results of operations or financial position.
On March 18, 2003, World Access, Inc. f/k/a WAXS, Inc., WA Telcom Products Co., Inc., WorldxChange Communications, Inc., Facilicom International LLC and World Access Telecommunications Group, Inc. f/k/a Cherry Communications Incorporated d/b/a Resurgens Communications Group (collectively, “the Debtors”), filed a lawsuit against us in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division. The Debtors had previously filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. The Debtors sought recovery of certain payments they made to us as a buyer on our exchange, which totaled approximately $855. The Debtors claimed that such payments were preferential transfers under the Bankruptcy Code. The Debtors also sought costs and expenses, including attorneys’ fees and interest. We filed an answer to the complaint on April 18, 2003, denying the Debtors’ claims for relief and asserting several affirmative defenses. The parties entered into a Settlement Agreement dated November 19, 2008, and the action has been dismissed.
Not applicable.
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Our common stock is quoted on the NASDAQ Global Market under the symbol “ARBX.” We began trading on the NASDAQ National Market on December 16, 2004. The following table sets forth the range of high and low stock closing prices for our common stock as reported on the NASDAQ Global Market for the period indicated below.
As of March 1, 2009, the approximate number of holders of record of our common stock was 72.
On February 28, 2008, we announced that our Board of Directors approved a special one-time cash distribution of $0.40 per share of common stock. The aggregate total distribution of approximately $10.0 million was paid on March 28, 2008 to record holders of our common stock as of the close of business on March 12, 2008. The special cash distribution replaced a $15.0 million stock repurchase plan previously announced on June 11, 2007 (“2007 Repurchase Plan”) under which we repurchased approximately 836,997 shares. Other than this one-time cash distribution, we do not currently anticipate paying any cash dividends in the foreseeable future.
(b) Use of Proceeds from Registered Securities
On December 21, 2004, we sold 4,233,849 shares of our common stock in connection with the closing of our initial public offering. The Registration Statement on Form S-1 (Reg. No. 333-117278) we filed to register our common stock in the offering was declared effective by the Securities and Exchange Commission on December 16, 2004.
After deducting expenses of the offering, we received net offering proceeds of approximately $66.6 million. We used approximately $15.2 million of our net proceeds to redeem the outstanding shares of our Series B and Series B-1 preferred stock and approximately $10.0 million to repay principal and interest outstanding under our credit facility with SVB. Approximately $40.0 million of the net proceeds of the offering were invested in investment-grade marketable securities within the guidelines defined in our investment policy.
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(c) The following table provides information as of and for the quarter ended December 31, 2008 regarding shares of our common stock that were repurchased under our stock repurchase program authorized by the Board of Directors on November 4, 2008 and amended on November 21, 2008 (the “November 2008 Repurchase Plan”).
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The following table sets forth our selected consolidated historical financial data as of the dates and for the periods indicated. Our selected consolidated financial information for 2006, 2007 and 2008 should be read in conjunction with the Consolidated Financial Statements and the Notes and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this Annual Report on Form 10-K.
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We are a leading electronic market for trading, routing and settling communications capacity. Members of our exchange, consisting primarily of communications services providers, buy and sell voice minutes and Internet capacity through our centralized, efficient and liquid marketplace. Communications services providers that do not use our exchange generally individually negotiate and buy access to the networks of other communications services providers to send voice calls and Internet capacity outside of their networks. We believe that we provide a cost-effective and efficient alternative to these direct connections. With a single interconnection to our exchange, members have access to all of our other members’ networks. Members or their agents place orders through our web-based interface. Sellers or their agents on the exchange post sell orders to offer voice calls and Internet capacity for specific destinations, or routes, at various prices. We independently assess the quality of these routes and include that information in the sell order. Buyers place buy orders based on route quality and price and are matched to sell orders by our trading platform and our proprietary software. When a buyer’s order is matched to a seller’s order, the voice calls or Internet capacity are then routed through our state-of-the-art facilities. We invoice and process payments for our members’ transactions and manage the credit risk of buyers primarily through our credit management programs with third parties.
We generate revenues from both the trading that members conduct on our exchange, which we refer to as trading revenues, and the fees and other charges we derive from members for the ability to trade on our exchange, which we refer to as fee revenues. Our trading revenue represents the aggregate dollar value of the calls that are routed through our switches at the price agreed to by the buyer and seller of the capacity. For example, if a 10-minute call is originated in France and routed through our facilities to a destination in India for $0.11 per minute, we record $1.10 of trading revenue for the call. Certain members contract to buy minutes to specific markets at fixed rates. We may generate profit or incur losses associated with this trading activity and other transactions executed on our exchange. Historically, such losses have not been material to our operating results. Our system automatically records all traffic terminated through our switches.
We record trading revenues because:
Our fee revenues represent the amounts we derive from buyers and sellers for the following:
Our cost of trading revenues consists of the cost of calls that are routed through our switches at the price agreed to by both the buyer and seller of the capacity. In the preceding example, we would record cost of trading revenues equal to $1.10, an amount that we would pay to the seller.
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Indirect cost of trading and fee revenues consists of costs related to supporting the operations of our exchange, such as salaries, benefits, and related costs of engineering, technical support, product and software development, and system support personnel, as well as facilities and interconnect costs. It is impractical to break down such expense between indirect cost of trading revenues and indirect cost of fee revenues.
Sales and marketing consists of salaries, benefits, commissions, and related costs of sales and marketing personnel, trade shows and other marketing activities.
General and administrative costs consist of salaries, benefits, and related costs of corporate, finance and administrative personnel, facilities costs, bad debt expense and outside service costs, such as legal and accounting fees.
We will continue to seek to increase our trading volume. We aim to achieve this by increasing participation on our exchange from existing members, increasing membership on our exchange, expanding our global presence, developing and marketing complementary services and leveraging our 214 license to provide wholesale carrier services. We currently have EDPs in New York, Los Angeles, Miami, London, Frankfurt and Hong Kong. We can initially establish an EDP in a new market without any additional capital by directly connecting the new EDP to one of our existing EDPs through a leased network, as with our EDPs in Frankfurt and Miami. Once we have sufficient business in a new market, we may install a new switch for the EDP in that market for a cost of approximately $1.0 million. We plan to develop, market and expand services that are complementary to our existing offerings, including enhanced trading, credit and clearing services and switch partitioning. We may not be successful in doing so due to many factors, including the business environment in which we operate and current adverse global economic conditions. For a further discussion of regulatory, technological and other changes relevant to our business, see “Business — Industry Background.”
In August 2006, we established a new subsidiary, Arbinet Digital Media Corporation, to explore and develop products and services to address the market opportunity presented by the exchange of digital media. In December 2006, we, through our wholly-owned subsidiary, Broad Street Digital, Inc., acquired all of the outstanding common stock of Flowphonics Limited, now known as Broad Street Digital Limited, a license management platform for intellectual property rights and digital content distribution. The purchase price was approximately $2.1 million, including transaction costs.
To increase resources available for our core businesses, in the first quarter 2008, we announced a decision to explore strategic alternatives for Broad Street Digital. As a result of this decision, we recognized an impairment charge of approximately $2.3 million, in the fourth quarter of 2007, to write down the intangible and long-lived assets of Broad Street Digital to their estimated fair value.
During the second quarter of 2008, we ceased all activities related to the digital media market. As a result, the digital media segment has been presented as a discontinued operation in the accompanying financial statements for all periods.
On August 5, 2008, we entered into an agreement to sell substantially all of the assets of Broad Street Digital. In the second quarter of 2008, we recorded a charge of $250, to adjust the carrying value of the Broad Street Digital assets to the estimated net proceeds from the transaction, which was completed on August 19, 2008.
In connection with ceasing all digital media activities, we entered into a separation and release agreement with the Chief Operating Officer of Arbinet Digital Media Corporation and terminated the remaining employees in this segment. We recognized a severance charge of $0.5 million in the three months ended September 30, 2008, which is reflected in loss from discontinued operations.
Our management’s discussion and analysis of our financial condition and results of our operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements
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requires management to make estimates and judgments that affect the amounts reported for assets, liabilities, revenues, expenses and the disclosure of contingent liabilities. Our significant accounting policies are more fully described in Note 1 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2008.
Our critical accounting policies are those that we believe are both important to the portrayal of our financial condition and results of operations and often involve difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management evaluates these estimates, including those related to bad debts, income taxes, long-lived assets, restructuring, contingencies and litigation on an ongoing basis. The estimates are based on historical experience and on various assumptions about the ultimate outcome of future events. Our actual results may differ from these estimates because we did not estimate correctly.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:
In 2007, we adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, Accounting for Income Taxes” (“FIN 48”). FIN 48 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that, on a cumulative basis, has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. As a result of the implementation of FIN 48, we identified an aggregate of approximately $625 of unrecognized tax benefits, including related estimated interest and penalties, due to uncertain
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tax positions. Approximately $589 of these uncertain tax positions resulted in a reduction of deferred tax assets against which we had recorded a full tax valuation allowance on our balance sheet. The balance of the unrecognized tax benefits, amounting to $36, which includes interest and penalties, was recorded as an increase to accumulated deficit and an increase of $36 to “other long-term liabilities.” While we believe that we have identified all reasonably identifiable exposures and that the established reserves for such exposures are appropriate under the circumstances, it is possible that additional exposures exist and that exposures will be settled at amounts different than the amounts reserved. It is also possible that changes in facts and circumstances could cause us to either materially increase or reduce the amount of our tax reserve.
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Trading revenues decreased 13.5% to $418.5 million for the year ended December 31, 2008 from $483.9 million for the year ended December 31, 2007. The decrease in trading revenues was due to a decrease in overall minutes traded on our exchange coupled with a decrease in the average trade rate per minute.
As a result of decreases in trading revenues, cost of trading revenues decreased 13.5% to $418.9 million for the year ended December 31, 2008 from $484.1 million for the year ended December 31, 2007.
Indirect costs of trading and fee revenues decreased 3.3% to $19.7 million for the year ended December 31, 2008 from $20.4 million for the year ended December 31, 2007. This decrease was principally attributed to lower compensation related expenses of $1.3 million, a decrease in utilities of $0.3 million and a $0.3 million decrease in certain hardware and software maintenance expenses. These cost reductions were partially offset by $0.5 million of moving costs related to the relocation of our London switch to a co-location facility, and higher interconnection costs of $0.6 million.
Fee revenues decreased 3.4% to $48.4 million for the year ended December 31, 2008 from $50.1 million for the year ended December 31, 2007. Fee revenues decreased as a result of lower minutes bought and sold on our exchange, as discussed above, partially offset by favorable pricing. Average fee revenue per minute was $0.0037 in the year ended December 31, 2008 compared to the $0.0035 in the year ended December 31, 2007. Average fee revenue per minute increased due to higher access fees and an increase in the sale of premium services such as RapidClear. We may provide incentives to improve liquidity in our exchange in the future and that, along with members continuing to achieve higher volume levels, may lead to a decline in average fee revenue per minute in the future.
Sales and marketing expenses increased 5.4% to $10.2 million for the year ended December 31, 2008 from $9.7 million for the year ended December 31, 2007. This increase was primarily the result of increased employee-related expenses of $0.6 million offset by lower professional fees of $0.2 million.
General and administrative expenses decreased 13.5% to $11.7 million for the year ended December 31, 2008 from $13.5 million for the year ended December 31, 2007. This amount was primarily related to a decrease in professional fees of $2.1 million, and a decrease in insurance costs of $0.2 million. These
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decreases were partially offset by higher expenses related to certain hardware and software maintenance contracts and an increase in facilities expenses of $0.2 million.
Depreciation and amortization decreased slightly from $7.6 million for the year ended December 31, 2007 to $7.5 million for the year ended December 31, 2008. The decrease was principally the result of certain assets becoming fully depreciated during 2008.
We recognized severance charges of $1.4 million and $1.3 million for the years ended December 31, 2008 and 2007, respectively. In 2008, this charge represents costs related to a departure and transition services agreement entered into with our former Chief Executive Officer, and a company-wide workforce reduction, including the termination without cause of our Chief Operating Officer and Chief Marketing Officer. The 2007 severance expense represents charges related to a resignation agreement entered into with our former Chief Executive Officer and a workforce reduction of certain employees.
During 2001 and 2002, we exited two leased facilities and established a reserve for the future lease obligations, net of estimated sub-lease income. In August 2007, the Company decommissioned certain fixed assets at 611 West 6th Street in Los Angeles and relocated our Los Angeles switch operations to one of the sites which had been exited in December 2002. As a result, the Company recognized a gain of $1.0 million representing the reversal of the remaining liability related to abandoned space placed back into service. In addition, the Company recognized a charge of $0.3 million representing the present value of future lease obligations remaining on the West 6th Street location. A net gain of $0.7 million, representing the impact of these two transactions, was reflected as a restructuring benefit in the accompanying statement of operations for the year ended December 31, 2007.
During 2006 and 2007, we decommissioned certain fixed assets located at our exchange delivery points (“EDP”) in New York City, Los Angeles and London, England. To date, we have sold a nominal amount of these assets. During the third quarter of 2008, we recorded an impairment charge of approximately $0.5 million, to adjust the carrying value of the assets to their estimated fair market value. The carrying value of this equipment as of December 31, 2007 and December 31, 2008 is approximately $0.5 million and $12, respectively, and is included in “prepaids and other current assets” in the accompanying consolidated balance sheets.
We performed our annual impairment testing at the beginning of the fourth quarter of 2008, which indicated there was no impairment to our goodwill and other intangible assets. However, business conditions worsened during the fourth quarter, and the market’s perception of the value of our stock resulted in a reduction in our market capitalization below our book value. These factors caused us to perform additional impairment testing as of December 31, 2008. As a result of this additional testing, we determined that our goodwill and certain of our intangible assets were impaired. Accordingly, we recorded a $3.0 million non-cash impairment charge related to goodwill and other intangible assets in our Voice & Data business.
During the year ended December 31, 2007, we recognized a charge of $1.9 million representing the settlement of certain litigation matters.
Interest income decreased 65.5% to $0.9 million for the year ended December 31, 2008 from $2.7 million for the year ended December 31, 2007. This decrease was primarily due to lower average invested amounts of cash, cash equivalents and marketable securities in 2008 versus 2007 combined with lower average interest rates. Interest expense decreased to $0.6 million for the year ended December 31, 2008 from $1.0 million for the year ended December 31, 2007. This decrease was principally due to lower fees paid by us under our third party credit arrangements, mainly attributable to a decrease in trading activity on our exchange and reduced utilization of credit by our members. Other income (expense), net decreased to $0.3 million for the year ended December 31, 2008 from $0.6 million for the year ended December 31, 2007. This principally reflects a $0.4 million decrease in late fees charged to our members.
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We recorded a foreign currency exchange loss of $7.0 million for the year ended December 31, 2008 compared to a foreign currency exchange gain of $0.1 million for the year ended December 31, 2007. The foreign currency translation gains (losses) represent the impact of currency fluctuations on U.S. denominated obligations of our U.K. subsidiary.
We recorded income tax provisions of approximately $392 and $232 for the years ended December 31, 2008 and 2007, respectively. The provisions in both periods primarily represent the statutory requirements for state taxes.
In August 2006, we established a new subsidiary, Arbinet Digital Media Corporation, to explore and develop products and services to address the market opportunity presented by our exchange of digital media. As part of our digital media strategy, in December 2006, we, through our wholly-owned subsidiary, Broad Street Digital Inc., acquired all of the outstanding common stock of Flowphonics Limited (renamed Broad Street Digital (“Broad Street Digital”)), a license management platform for intellectual property rights and digital content distribution. The purchase price was approximately $2.1 million, including transaction costs.
To increase resources available for our core businesses, in the first quarter of 2008, we announced a decision to explore strategic alternatives for Broad Street Digital. As a result of this decision, we recognized an impairment charge of approximately $2.3 million in the fourth quarter of 2007, to write down the intangible and long lived assets, including $0.4 million of goodwill, of Broad Street Digital to their estimated fair value.
During the second quarter of 2008, we ceased all activities related to the digital media market. As a result, the digital media segment has been presented as a discontinued operation in the accompanying financial statements for all periods presented.
On August 5, 2008, we entered into an agreement to sell substantially all of the assets of Broad Street Digital. In the second quarter of 2008, we recorded a charge of $250, to adjust the carrying value of the Broad Street Digital assets to the estimated net proceeds from the transaction, which was completed on August 19, 2008. In connection with ceasing digital media activities, we entered into a separation and release agreement with the Chief Operating Officer of Arbinet Digital Media Corporation and terminated the remaining employees in this segment. We recognized a severance charge of $0.5 million in the third quarter of 2008, which is reflected in loss from discontinued operations.
In October 1999, we ceased the operations of Bell Fax, Inc., (“Bellfax”), a wholly-owned subsidiary. Bellfax was engaged in the sale and rental of telecommunication equipment and operating international routes. In the first quarter of 2008, management determined that the remaining liabilities of Bellfax were no longer required. Accordingly, $226, net of income tax of $11, was recorded as income from discontinued operations in the first quarter of 2008.
Trading revenues decreased 2.3% to $483.9 million for the year ended December 31, 2007 from $495.1 million for the year ended December 31, 2006. The decrease in trading revenues was due to a decrease in the average trade rate per minute and a decrease in the average call duration, which was partially offset by an increase in the volume traded by our members principally due to an increase in the number of members on our exchange to 990 on December 31, 2007 from 693 on December 31, 2006. Specifically the factors affecting trading revenues included:
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As a result of decreases in trading revenues, cost of trading revenues decreased 2.2% to $484.1 million for the year ended December 31, 2007 from $495.2 million for the year ended December 31, 2006.
Fee revenues increased 4.6% to $50.1 million for the year ended December 31, 2007 from $47.9 million for the year ended December 31, 2006. Fee revenues increased as a result of higher minutes bought and sold on our exchange offset, in part, by lower pricing. Average fee revenue per minute was $0.0035 in the year ended December 31, 2007 compared to $0.0038 in the year ended December 31, 2006. Average fee revenue per minute declined as the average trade rate declined, impacting per minute access fees as well as credit risk management fees and RapidClear fees, which are charged as a percentage of trading revenues. In addition, we offered volume-based discounts and limited fee discounts to certain high-quality sellers in order to incentivize those sellers to add supply to certain markets, which had higher demand within our exchange. We may provide incentives to improve liquidity in our exchange in the future and that, along with members continuing to achieve higher volume levels, may lead to a decline in average fee revenue per minute in the future.
Indirect costs of trading and fee revenues increased 19.1% to $20.4 million for the year ended December 31, 2007 from $17.1 million for the year ended December 31, 2006. This increase was primarily the result of increased employee-related expense of $2.0 million, higher interconnection costs of $0.3 million and increased hardware and software maintenance costs of $1.0 million, principally associated with the migration to a new switching platform.
Sales and marketing expenses increased 19.2% to $9.7 million for the year ended December 31, 2007 from $8.1 million for the year ended December 31, 2006. This increase was primarily the result of higher employee-related expenses of $1.5 million, and professional fees of $0.3 million. Partially offsetting this increase was lower marketing expenses of $0.2 million.
General and administrative expenses decreased 16.6% to $13.5 million for the year ended December 31, 2007 from $16.2 million for the year ended December 31, 2006. This amount was primarily related to a decrease in professional fees of $1.9 million, and a decrease in employee related expenses of $1.0 million.
Depreciation and amortization increased 9.4% to $7.6 million for the year ended December 31, 2007 from $6.9 million for the year ended December 31, 2006. This increase was principally the result of depreciation expense relating to capital expenditures during 2007 and 2006.
During the year ended December 31, 2007, we recognized a charge of $1.3 million, principally representing severance charges related to a resignation agreement entered into with our former Chief Executive Officer and a workforce reduction. During the year ended December 31, 2006, we recognized a charge of approximately $0.3 million, representing severance charges related to a resignation agreement.
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During 2001 and 2002, we exited two leased facilities and established a reserve for the future lease obligations, net of estimated sub-lease income. In August 2007, we decommissioned certain fixed assets at 611 West 6th Street in Los Angeles and relocated its Los Angeles switch operations to one of the sites which had been exited in December 2002. As a result, we recognized a gain of $1.0 million representing the reversal of the remaining liability related to abandoned space placed back into service. In addition, we recognized a charge of $0.3 million representing the present value of future lease obligations remaining on the West 6th Street location. A net gain of $0.7 million, representing the impact of these two transactions, has been reflected as a restructuring benefit in the accompanying statement of operations for the year ended December 31, 2007.
During the year ended December 31, 2006, we recognized a charge of $0.6 million representing management’s estimate of the cost to settle a litigation matter. This amount was partially offset by a benefit of $0.1 million as we settled certain litigation for less than the amount previously accrued. During the year ended December 31, 2007, we recognized a charge of $1.9 million representing the settlement of certain litigation matters.
We recorded foreign currency gains of approximately $0.1 million and $1.0 million for the years 2007 and 2006, respectively. The gain from foreign currency transactions is primarily due to the weakening of the U.S. dollar versus the British pound and its effect on a U.S. dollar-denominated liability of our U.K. subsidiary.
Interest income decreased 12.5% to $2.7 million for the year ended December 31, 2007 from $3.1 million for the year ended December 31, 2006. This decrease was primarily due to lower average invested amount of cash, cash equivalents and marketable securities in 2007 versus 2006. Interest expense decreased 15.5% to $1.0 million for the year ended December 31, 2007 from $1.1 million for the year ended December 31, 2006, on lower average outstanding balances. Other income (expense), net increased to $0.6 million for the year ended December 31, 2007 from $0.3 million for the year ended December 31, 2006, principally reflecting a $0.2 million increase in late fees charged to our members.
We recorded an income tax provision of approximately $232 for the year ended December 31, 2007 primarily representing the statutory requirements for state taxes. In 2006, we recorded an income tax provision of $2.0 million. Included in the 2006 provision was approximately $1.5 million of expense related to reestablishing a full valuation allowance against the net deferred tax assets since we were unable to conclude that it was more likely than not that we would realize those assets.
Management reevaluated the $350 liability related to a discontinued operation from 1999 and determined that approximately $225 was needed at December 31, 2006. Accordingly, $121, net of income tax of $4 was recognized as income from discontinued operations in 2006. No adjustment to the liability was recognized in 2007.
In August 2006, we established a new subsidiary, Arbinet Digital Media Corporation, to explore and develop products and services to address the market opportunity presented by our exchange of digital media. As part of our digital media strategy, in December 2006, we, through our wholly-owned subsidiary, Broad Street Digital Inc., acquired all of the outstanding common stock of Flowphonics Limited (renamed as Broad Street Digital Limited (“Broad Street Digital”), a license management platform for intellectual property rights and digital content distribution. The purchase price was approximately $2.1 million, including transaction costs.
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To increase resources available for our core businesses, in the first quarter of 2008, we announced a decision to explore strategic alternatives for Broad Street Digital. As a result of this decision, we recognized an impairment charge of approximately $2.3 million in the fourth quarter of 2007 to write down the intangible and long-lived assets, including $0.4 million of goodwill, of Broad Street Digital to their estimated fair value.
Until 2005 our primary source of liquidity had been cash received through the sale and issuance of equity and debt securities. We received equity investments between April 1999 and May 2003 in an aggregate amount of approximately $125.0 million. Our principal liquidity requirements have been for working capital, capital expenditures and general corporate purposes. On December 21, 2004, we completed our initial public offering and raised net proceeds of approximately $66.6 million.
Our capital expenditures in 2005 related primarily to developing our trading platform, which included investments in software development and hardware and the purchase of computer and telecommunications switching equipment. During 2008 and 2007, we invested approximately $6.2 million and $7.9 million, respectively, in capital expenditures related to enhancements to our trading platform, including software development and switching equipment, which we funded primarily from cash on hand and cash generated through operations. At December 31, 2008, we had cash and cash equivalents of $16.2 million and marketable securities of $7.9 million. We also are party to a $25.0 million lending facility with SVB, under which we can borrow against our accounts receivable and general corporate assets. As of December 31, 2008, $3.6 million was outstanding under this facility. Our current credit facility with SVB expires on November 26, 2010.
On February 26, 2008 we announced that our Board of Directors had approved a special one-time cash distribution of $0.40 per share of our common stock. The aggregate total distribution of approximately $10.0 million was paid on March 28, 2008 to record holders of our common stock as of the close of business on March 12, 2008. The special cash distribution replaced our existing $15.0 million 2007 Repurchase Plan, previously announced on June 11, 2007, under which we repurchased 836,997 shares of our common stock. Other than this one-time distribution, we have not paid and do not currently anticipate paying any cash dividends in the foreseeable future.
We believe that our current cash balances and cash flows from operating activities should be sufficient for us to fund our current operations for the foreseeable future. To the extent we require additional capital to fund our working capital or capital expenditures, we intend to draw down on our existing SVB credit facility and/or seek additional financing in the credit or capital markets, although we may be unsuccessful in obtaining financing on acceptable terms, if at all.
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The following table sets forth components of our cash flows for the following periods:
Cash provided by operating activities — continuing operations for the year ended December 31, 2008 was comprised of a net loss of $12.7 million, certain adjustments for non-cash charges including depreciation and amortization of $7.5 million, non-cash compensation of $1.8 million, impairment charges of $3.4 million, a foreign currency exchange loss of $7.0 million and a net change in operating assets and liabilities of ($4.8) million. The change in operating assets and liabilities principally reflects a reduction in accounts payable due to a decline in trading volume on our exchange combined with payments made in 2008 for certain 2007 expenditures including legal and capital items. The net change in operating assets and liabilities also reflects an increase in other current assets, principally reflecting an increase in the VAT receivable for our U.K. Subsidiary. Cash used in operating activities for discontinued operations was $1.4 million for the year ended December 31, 2008.
Cash provided by operating activities — continuing operations for the year ended December 31, 2007 was comprised of a net loss of $1.7 million, certain adjustments for non-cash charges including depreciation and amortization of $7.6 million, non-cash compensation of $2.2 million, a foreign currency exchange loss of $0.1 million and a net change in operating assets and liabilities of ($0.9) million, which includes a reduction in accounts receivable due to more timely collections and a reduction in accounts payable due to payments made in 2007 for legal and capital spending that occurred in 2006. The net change in operating assets and liabilities from 2006 also reflects prepayments for insurance and certain hardware and software contracts during 2007 and the decommission of certain fixed assets located at our EDP in London, which were reclassified as assets held for sale. Cash used in operating activities for discontinued operations was $2.8 million for the year ended December 31, 2007.
Cash provided by operating activities — continuing operations for the year ended December 31, 2006 was comprised of a net loss of $41, certain adjustments for non-cash charges including depreciation and amortization of $6.9 million, non-cash compensation of $0.9 million, foreign currency exchange loss of $1.0 million, deferred income taxes of $1.5 million and a net change in operating assets and liabilities of ($4.1) million, which includes an increase in accounts receivable due to increased member trading on our exchange and an increase in accounts payable due to increased legal and capital spending. Cash used in operating activities for discontinued operations was $0.4 million for the year ended December 31, 2006.
Total capital expenditures for the year ended December 31, 2008 were $6.2 million primarily related to the purchase of capitalized software and telecommunications equipment. Total purchases of marketable securities and total proceeds from sales and maturities of marketable securities for the year ended December 31, 2008 were $18.1 million and $30.5 million, respectively. We recorded net cash proceeds from the sale of Broad Street Digital assets of $0.2 million.
Total capital expenditures for the year ended December 31, 2007 were $7.9 million related primarily to software development and the purchase of computer and telecommunications switching equipment. Total
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purchases of marketable securities and total proceeds from sales and maturities of marketable securities for the year ended December 31, 2007 were $42.8 million and $52.5 million, respectively.
In December 2006, we, through our wholly-owned subsidiary, Broad Street Digital Inc., acquired all of the outstanding common stock of Flowphonics Limited, now known as Broad Street Digital Limited, a license management platform for intellectual property rights and digital content distribution. The purchase price was approximately $2.1 million, including transaction costs. The purchase price was comprised of cash and the issuance of approximately $0.6 million of notes payable. Total purchases of marketable securities and total proceeds from sales and maturities of marketable securities for the year ended December 31, 2006 were $57.4 million and $50.6 million, respectively.
Cash used in investing activities for discontinued operations was $0.5 million for the year ended December 31, 2008. Amounts were insignificant in 2007 and 2006.
Cash used in financing activities for the year ended December 31, 2008 was primarily attributable to a one time special cash distribution of approximately $10.0 million, paid on March 28, 2008 to record holders of our common stock as of the close of business on March 12, 2008. In addition, $11.2 million was utilized for the purchase of treasury shares in accordance with stock repurchase plans approved by our Board of Directors. In December 2008, we drew down $3.6 million on the SVB line of credit facility. We also paid $0.5 million in notes payable and received an advance from SVB under the Non-Recourse Receivable Purchase Agreement of $0.1 million.
During fiscal year 2007, cash used in financing activities was primarily attributable to the repayment of approximately $7.8 million to SVB under the Non-Recourse Receivable Purchase Agreement and repurchase of our common stock of $3.1 million under the 2007 Repurchase Plan.
During fiscal year 2006, cash provided by financing activities was primarily attributable to advances of $5.0 million from SVB under the Non-Recourse Receivable Purchase Agreement partially offset by approximately $0.8 million in the repayment of debt.
We do not currently have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
We manage the invoicing, credit risk and settlement of all traffic traded on our exchange. Since we are obligated to pay the seller regardless of whether we ultimately collect from the buyer, we assume the credit risk associated with all traffic traded on our exchange. As part of managing the credit risk associated with buyers on our exchange, we have an integrated credit risk management program under which the following arrangements assist in the mitigation of this credit risk:
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We occasionally issue internal credit lines to our members based on our review of a member’s financial statements and payment history with us. These internal credit lines may be in excess of the credit lines issued by our third party underwriters. We evaluate the credit risk, on a case-by-case basis, of each member who is not covered by our third-party credit arrangements, our netting policy, prepayments or other cash collateral. We have adopted written procedures to determine authority levels for certain of our officers to grant internal credit lines. In 2008, approximately 80% of our trading revenues were covered by our third party underwriters, netting, prepayments or other cash collateral, of which our third party underwriters covered 35%. However, our credit evaluations cannot fully determine whether buyers can or will pay us for capacity they purchase through our exchange. In the event that the creditworthiness of our buyers deteriorates, our credit providers and we may elect not to extend credit and consequently we may forego potential revenues which could materially affect our results of operations.
Pursuant to the terms of our agreements with each of GMAC and SVB we are required to pay aggregate minimum annual commissions of $0.4 million. Our agreement with GMAC, expires effective April 30, 2009 and we are in the process of securing replacement credit risk assessment and credit underwriting services. Our agreement with SVB terminates on November 26, 2010.
The following table summarizes our contractual obligations as of December 31, 2008:
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which clarifies the definition of fair value, establishes a framework for measuring fair value and expands the disclosures on fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 for financial assets and liabilities and November 15, 2008 for non-financial assets and liabilities. We will adopt SFAS 157 effective at the beginning of our fiscal 2009 for non-financial assets and non-financial liabilities, which we do not expect will have a material impact on our results of operations or financial operations.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”), a replacement of SFAS No. 141. SFAS 141R is effective for fiscal years beginning on or after December 15, 2008 and applies to all business combinations. SFAS 141R provides that, upon initially obtaining control, an acquirer shall recognize 100 percent of the fair values of acquired assets, including goodwill, and assumed liabilities, with only limited exceptions, even if the acquirer has not acquired 100 percent of its target. As a consequence, the current step acquisition model will be eliminated. Additionally,
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SFAS 141R changes current practice, in part, as follows: (1) contingent consideration arrangements will be fair valued at the acquisition date and included on that basis in the purchase price consideration; (2) transaction costs will be expensed as incurred, rather than capitalized as part of the purchase price; (3) pre-acquisition contingencies, such as legal issues, will generally have to be accounted for in purchase accounting at fair value; and (4) in order to accrue for a restructuring plan in purchase accounting, the requirements in SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met at the acquisition date. While there is no expected impact to our consolidated financial statements on the accounting for acquisitions completed prior to December 31, 2008, the adoption of SFAS 141R on January 1, 2009 could materially change the accounting for business combinations consummated subsequent to that date and for tax matters relating to prior acquisitions settled subsequent to December 31, 2008.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — An Amendment of ARB No. 51” (“SFAS 160”). SFAS 160 requires the recognition of a noncontrolling interest (minority interest) as equity in the financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the results of operations. SFAS 160 clarifies that changes in parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. SFAS 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and is to be applied prospectively as of the beginning of the fiscal year in which the statement is applied. Early adoption is not permitted. We do not expect the adoption of SFAS No. 160 to have a material effect on our financial position or results of operations.
In April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets” (FSP 142-3). FSP 142-3 removes the requirement under SFAS No. 142, “Goodwill and Other Intangible Assets” to consider whether an intangible asset can be renewed without substantial cost or material modifications to the existing terms and conditions, and replaces it with a requirement that an entity consider its own historical experience in renewing similar arrangements, or a consideration of market participant assumptions in the absence of historical experience. FSP 142-3 also requires entities to disclose information that enables users of financial statements to assess the extent to which the expected future cash flows associated with the asset are affected by the entity’s intent and/or ability to renew or extend the arrangement. We were required to adopt FSP 142-3 effective January 1, 2009 on a prospective basis. We do not expect the adoption of FSP 142-3 on January 1, 2009 to have a material effect on our financial position or results of operations.
This Annual Report on Form 10-K contains forward-looking statements regarding anticipated future revenues, growth, capital expenditures, management’s future expansion plans, expected product and service developments or enhancements, and future operating results. Such forward-looking statements may be identified by, among other things, the use of forward-looking terminology such as: “believes,” “expects,” “may,” “will,” “should,” “seeks,” or “anticipates,” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. Various important risks and uncertainties may cause our actual results to differ materially from the results indicated by these forward-looking statements, including, without limitation: members (in particular, significant trading members) not trading on our exchange or utilizing our new and additional services (including DirectAxcessSM, PrivateExchangeSM, AssuredAxcessSM and PeeringSolutionsSM); continued volatility in the volume and mix of trading activity; our uncertain and long member enrollment cycle; the failure to manage our credit risk; failure to manage our growth; pricing pressure; investment in our management team and investments in our personnel; regulatory uncertainty; system failures, human error and security breaches that could cause us to lose members and expose us to liability; our ability to obtain and enforce patent protection for our methods and technologies; losses in efficiency due to cost cutting and restructuring initiatives; decreased trading volumes due to our efforts to increase call quality on our exchange; economic conditions and volatility of financial markets,
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decreased availability of credit to us or buyers on our exchange, and the impact they may have on us and our members; and disruption or uncertainty resulting from recent changes in senior management. For a further list and description of the risks and uncertainties we face, please refer to Part I, Item 1A of this Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 16, 2009, and other filings that have been filed with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise and such statements are current only as of the date they are made.
The financial position and results of operations of our U.K. subsidiary are measured using British Pounds Sterling as the functional currency. The financial position and results of operations of our U.K. subsidiary are reported in U.S. dollars and included in our consolidated financial statements. Our exposure to foreign currency fluctuation is mitigated, in part, by the fact that we incur certain operating costs in the same foreign currencies in which fee revenues are denominated. There were no trading revenues denominated in British Pounds Sterling.
We are exposed to interest rate fluctuations. We invest our cash in short-term interest bearing securities. Although our investments are available for sale, we generally hold such investments to maturity. Our investments are stated at fair value, with net unrealized gains or losses on the securities recorded as accumulated other comprehensive income (loss) in shareholders’ equity. Net unrealized gains and losses were not material at December 31, 2008 or 2007. The fair market value of our marketable securities could be adversely impacted due to a rise in interest rates, but we do not believe such impact would be material. Securities with longer maturities are subject to a greater interest rate risk than those with shorter maturities and at December 31, 2008 our portfolio maturity was relatively short in duration. Assuming an average investment level in short-term interest bearing securities of $16.2 million, which is the balance of cash and cash equivalents at December 31, 2008, a one-percentage point decrease in the applicable interest rate would result in a $162 decrease in interest income annually.
Under the terms of our credit agreement with SVB, our borrowings bear interest at the prime rate, subject to a minimum of 4.0% rate. Therefore, a one-percentage point increase in the prime rate would result in additional annualized interest expense of $10 assuming $1.0 million of borrowings. At December 31, 2008, we had $3.6 million of outstanding borrowings under this agreement.
The financial statements required to be filed pursuant to this Item 8 are appended to this Annual Report on Form 10-K. A list of the financial statements filed herewith is found at “Item 15. Exhibits, Financial Statements, and Financial Statement Schedule.”
Management of the Company, with the participation of its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures. Based on their evaluation, as of the end of the period covered by this Annual Report on Form 10-K, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Act”)) are effective.
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There were no changes in internal control over financial reporting during the fourth quarter of 2008 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Responsibility for the integrity and objectivity of the Company’s financial statements rests with management. The financial statements report on management’s stewardship of Company assets. These statements are prepared in conformity with generally accepted accounting principles and, accordingly, include amounts that are based on management’s best estimates and judgments. Non-financial information included in this Annual Report on Form 10-K has also been prepared by management and is consistent with the financial statements.
The Audit Committee of the Board of Directors, which is comprised solely of independent directors, meets regularly with the Company’s independent registered public accounting firm and representatives of management to review accounting, financial reporting, internal control and audit matters, as well as the nature and extent of the audit effort. The Audit Committee is responsible for the engagement of the independent registered public accounting firm. The independent registered public accounting firm has free access to the Audit Committee.
The financial statements and other financial information included in this Annual Report on Form 10-K fairly present, in all material respects, the Company’s financial condition, results of operations and cash flows. Our formal certification to the Securities and Exchange Commission is included in this Annual Report on Form 10-K.
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2008 based on criteria in Internal Control — Integrated Framework issued by COSO. Ernst & Young LLP, an independent registered public accounting firm, has performed its own assessment of the effectiveness of the Company’s internal control over financial reporting and its attestation report is included in this Annual Report on Form 10-K.
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The Board of Directors and Stockholders ofArbinet-thexchange, Inc.
We have audited Arbinet-thexchange, Inc.’s internal control over financial reporting, as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Arbinet-thexchange, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Arbinet-thexchange, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2008 and 2007 and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2008 of Arbinet-thexchange, Inc. and our report dated March 13, 2009 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP Iselin, New Jersey March 13, 2009
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The information relating to our directors and nominees for election as directors under the heading “Election of a Class of Directors” in our definitive proxy statement to be filed with the Securities and Exchange Commission for the 2009 Annual Meeting of Stockholders (the “Proxy Statement”) is incorporated herein by reference.
The information relating to our executive officers in response to this item is contained, in part, under the caption “Executive Officers” in Part I of this Annual Report on Form 10-K, and the remainder is incorporated herein by reference to our Proxy Statement of the Registrant.
The information relating to our Audit Committee and our Audit Committee financial expert under the headings “Board Structure and Compensation — Board of Director Meetings and Committees — Audit Committee” and “Board Structure and Compensation — Affirmative Determination Regarding Director Independence and Other Corporate Governance Matters” in our Proxy Statement is incorporated herein by reference.
The information under the heading “Other Matters — Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy Statement is incorporated herein by reference.
The information relating to any material changes to our procedures by which security holders may recommend nominees to our Board of Directors under the heading “Other Matters — Director Candidates” is incorporated herein by reference.
We have adopted a written Code of Business Conduct and Ethics that applies to all of our employees, including our principal executive officer, principal financial officer, principal accounting officer, controller, and persons performing similar functions, as well as our board of directors. Our Code of Business Conduct and Ethics is available on our Web site at www.arbinet.com under the heading “Investors Information — Corporate Governance.” We annually require all employees and members of our Board of Directors to recertify their compliance with this code. We intend to disclose any amendments to, or waivers from, our Code of Business Conduct and Ethics that are required to be publicly disclosed pursuant to rules of the Securities and Exchange Commission and the NASDAQ Global Market by filing such amendment or waiver with the Securities and Exchange Commission and by posting it on our Web site.
The discussion under the headings “Executive Compensation,” “Director Compensation,” “Compensation Discussion and Analysis,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” in our Proxy Statement is incorporated herein by reference.
The discussion under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Policies and Procedures for Related Party Transactions” in our Proxy Statement is incorporated herein by reference.
The discussion under the heading “Information about Equity Compensation — Equity Compensation Plan Table” in our Proxy Statement is incorporated herein by reference.
The discussion under the heading “Certain Relationships and Related Transactions” in our Proxy Statement is incorporated herein by reference.
The discussion under the heading “Board Structure and Compensation — Affirmative Determination Regarding Director Independence and Other Corporate Governance Matters” in our Proxy Statement is incorporated herein by reference.
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The discussion under the headings “Auditors Fees and All Other Fees” and “Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Registered Public Accounting Firm” in our Proxy Statement is incorporated herein by reference.
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(1)
Consolidated Financial Statements.
Reference is made to the Index to Consolidated Financial Statements on Page F-1.
(2)
Consolidated Financial Statement Schedule.
Reference is made to the Index to Financial Statement Schedule on Page F-1.
(3)
Exhibits.
Reference is made to the Index to Exhibits on Page 50.
Schedules other than as listed above are omitted as not required or inapplicable or because the required information is provided in the consolidated financial statements, including the notes thereto.
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Pursuant to the requirements of Section 13 or 15(d) 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 this 13th day of March, 2009.
By:
/s/ Shawn F. O’DonnellShawn F. O’Donnell, President, Chief Executive Officer and Director (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
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F-1
The Board of Directors and Stockholders Arbinet-thexchange, Inc.
We have audited the accompanying consolidated balance sheets of Arbinet-thexchange, Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, statements of stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedule included in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Arbinet-thexchange, Inc. and subsidiaries at December 31, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 and 11 to the consolidated financial statements, effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, Accounting for Income Taxes”.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Arbinet-thexchange, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2009 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Iselin, New Jersey March 13, 2009
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The accompanying notes are an integral part of these consolidated financial statements.
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F-7
Arbinet-thexchange, Inc. and subsidiaries (“Arbinet” or the “Company”) operates an electronic market for trading, routing and settling communications capacity. Members of the Company’s exchange can anonymously buy and sell voice calls and Internet capacity based on route quality and price through the Company’s exchange. Through the Company’s web-based interface and fully automated trading platform, members’ orders are automatically matched using the Company’s proprietary software and delivered through its telecommunications facilities.
The consolidated financial statements include the accounts of Arbinet and its wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.
Cash is stated at cost, which approximates market. The Company considers all highly liquid investments with original maturity dates of three months or less when purchased to be cash equivalents. Cash equivalents are measured at carrying value or fair value based on the nature of the investment.
Marketable securities generally consist of certificates of deposit with original maturities of between 90 and 360 days and highly liquid debt securities of corporations, agencies of the U.S. government and the U.S. government. These investments can be readily purchased or sold using established markets. In accordance with Statement of Financial Accounting Standards, or SFAS, No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designations as of each balance sheet date. Such investments are classified as available-for-sale and are carried at fair value based on quoted market prices with unrealized gains and losses reported in stockholders’ equity as a component of comprehensive income. Interest on marketable securities is recognized as income when earned. Realized gains and losses are calculated using specific identification.
Property and equipment are stated at cost, net of accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Amortization for leasehold improvements and assets acquired under capital leases is computed using the straight-line method over the shorter of the term of the lease or estimated useful lives of the assets, and is included in depreciation and amortization expense in the Statement of Operations. Expenditures for repairs and maintenance are expensed as incurred.
The Company follows the guidance of SFAS No. 141, “Business Combinations,” which requires that business combinations be accounted for using the purchase method of accounting and acquired intangible assets meeting certain criteria be recorded apart from goodwill.
Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired (See Note 14). Intangible assets consist of purchased existing technology, customer relationships and other intangible assets, all of which are generally amortized over periods ranging from two to ten years. Intangible assets are stated at cost, less accumulated amortization.
F-8
The Company accounts for the costs of computer software developed or obtained for internal use pursuant to Statement of Position, or SOP, 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” or SOP 98-1, which requires the capitalization of internal use software and other related costs under certain circumstances. External direct costs of materials and services related to the application development stage of projects have been capitalized in accordance with SOP 98-1. Capitalized costs of the project are amortized on a straight-line basis over the estimated useful life of five years from the point when the systems are placed in service.
In accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-2, “Accounting for Web Site Development Costs,” costs related to the planning and post implementation phases of Web site development efforts, as well as minor enhancements and maintenance, are expensed as incurred. Direct costs incurred in the development phase are capitalized. These capitalized costs are included in property and equipment in the accompanying consolidated balance sheets and are depreciated over a five-year period.
The Company assesses impairment of other long-lived assets in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment review is performed whenever events or changes in circumstances indicate that the carrying value of assets may not be recoverable. Factors considered by the Company include, but are not limited to, significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of use of the acquired assets or the strategy for the overall business; and significant negative industry or economic trends. When the Company determines that the carrying value of a long-lived asset, other than goodwill, may not be recoverable based upon the existence of one or more of the above indicators of impairment, the Company estimates the future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future undiscounted cash flows and eventual disposition is less than the carrying amount of the asset, the Company recognizes an impairment loss. An impairment loss is reflected as the amount by which the carrying amount of the asset exceeds the fair value of the asset, based on the fair market value if available, or discounted cash flows, if not.
In addition, the Company tests goodwill for impairment as of the first day of its fiscal fourth quarter using a two-step process prescribed in SFAS No. 142, “Goodwill and Other Intangible Assets.” The first step of the goodwill impairment test compares the fair value of the Company’s net assets with their carrying value, including goodwill. If the fair value exceeds the carrying amount, goodwill is not impaired. If the carrying amount exceeds the fair value, the Company compares the fair value of goodwill with its carrying amount and recognizes an impairment loss for the amount by which the carrying amount exceeds the fair value. Fair value is determined based on a weighted average of comparable market multiples and discounted cash flows. In 2008, the fair value test was performed on an entity level as there were no separate reporting units.
The Company recognizes trading revenues from minutes traded on its exchange, and fee revenues from access fees, credit risk premium fees, colocation service fees, annual membership fees and other value-added service fees. Revenues from minutes traded represent the price per minute multiplied by the number of minutes purchased by buyers through the Company’s exchange. The Company recognizes trading revenues on a gross basis, pursuant to EITF No. 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent,” because the Company acts as a principal in the transactions and not in a broker or agent capacity. Additionally, the Company has the risks and rewards of ownership since the Company collects directly from the buyer
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and pays directly to the seller. The Company bears the credit risk of the transactions and any potential default by the buyer does not absolve the Company from paying the seller. Revenues from access fees generally represent the amounts the Company charges sellers and buyers based on their trading activity on the exchange with other customers (which the Company defines as “Members”).
Revenues from credit risk premium fees represent the amount the Company charges members based on each Member’s gross selling activity on its exchange for that period. Revenues from colocation service fees represent the amount the Company charges members in order for the member-owned equipment to be placed in the Company’s premises. The Company recognizes revenue for access fees, credit risk premium fees and colocation service fees as the service is provided. Initial membership fees are recognized over a period of one year. Deferred revenue includes the portion of membership fees not yet recognized and fees billed in advance of the month when services are provided.
The Company’s U.K. subsidiary accounted for approximately 25%, 24%, and 21% of total fee revenues and 54%, 48%, and 42% of total trade revenues in each of the years ended December 31, 2006, 2007 and 2008, respectively. The Company’s Hong Kong subsidiary accounted for approximately 1%, 2% and 3% of total fee revenues and 1% of total trade revenue in each of the years ended December 31, 2006, 2007 and 2008, respectively. No single Member accounted for more than 10% of total revenues for the years ended December 31, 2006, 2007 and 2008.
The Company accounts for income taxes pursuant to SFAS No. 109, “Accounting for Income Taxes,” or SFAS 109. Under SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets or liabilities of a change in tax rates is recognized in the period in which the tax change occurs. Valuation allowances are established, when necessary, to reduce deferred tax assets to amounts the realization of which is considered to be more likely than not.
Effective January 1, 2007, the Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, Accounting for Income Taxes” (“FIN 48”). FIN 48 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.
Financial instruments that subject the Company to concentration of credit risk consist primarily of cash and cash equivalents, marketable securities and trade accounts receivables. The Company maintains cash with various financial institutions, some of which exceed federally insured thresholds. The Company performs periodic evaluations of the relative credit standing of these institutions.
The Company performs ongoing credit evaluations of its Members and, in certain cases, requires collateral from Members in the form of a cash deposit. For those Members that are both sellers and buyers of minutes during a specific trading period, the Company offsets the amounts receivable against the amounts
F-10
payable by the Company to such Member in accordance with the respective membership agreements. The Company has the legal right of offset according to its standard trading terms with Members.
The Company evaluates the collectibility of its accounts receivable based on a combination of factors. Where the Company is aware of circumstances that may impair a specific customer’s ability to meet its financial obligations to the Company, the Company records a specific allowance against amounts due to it and thereby reduces the net receivable to the amount the Company reasonably believes is likely to be collected. For all other customers, the Company recognizes allowances for doubtful accounts based on the length of time the receivables are outstanding, industry and geographic concentrations, the current business environment and its historical experience. If the financial condition of the Company’s customers deteriorates or if economic conditions worsen, additional allowances may be required.
The Company has agreements with certain finance companies that provide the Company with global credit risk management services. Under these agreements, the finance companies provide credit protection on certain of the Company’s Members in the event of their inability to pay due to bankruptcy. The Company established credit risk assessment and credit underwriting services with GMAC Commercial Finance LLC, or GMAC, which provides a level of credit risk protection. In addition, the Company and Silicon Valley Bank, or SVB, entered into a Non-Recourse Receivable Purchase Agreement on November 28, 2005 (“SVB Receivable Agreement”) whereby SVB agrees to buy from the Company all right and title to and interest in the payment of all sums owing or to be owing from certain Members arising out of certain invoices of such members up to an aggregate of $10 million. The Company has determined that the SVB Receivable Agreement does not qualify for sale treatment pursuant to SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities — A Replacement of FASB Statement 125.” Specifically, the Company does not believe the transfer of receivables meets the first conditionset forth in paragraph 9(a) of SFAS 140, requiring the isolation of the transferred assets from the transferor. Settlement of transferred receivables are routinely made by members by making payments on account rather than paying off specific invoices. In addition, since the Company nets its members’ buying and selling activity, certain invoices are settled via buying a members’ activity on the exchange. Remittances received from members in payment of receivables are commingled with assets of the Company and as such are not deemed to be “put presumptively beyond the reach of the transferor and its creditors,” as required under SFAS 140. In accordance with SFAS No. 140, the Company records the proceeds from the sale of receivables under the SVB Receivable Agreement as a liability until sums received from Members are remitted to SVB. As of December 31, 2007 and 2008, approximately $285 and $371 of proceeds from the sale of receivables are reflected in “Trade Accounts Receivable” and “Due to Silicon Valley Bank” in the accompanying balance sheets. Under the terms of our agreements with GMAC and SVB, either GMAC or SVB assumes the credit risk of selected Members to enable such members to purchase voice calls or Internet capacity on our exchange.
The Company has certain minimum annual commissions due pursuant to the terms of its agreements with each of GMAC and SVB. Pursuant to the terms of the Company’s agreement with GMAC, which has been extended until April 30, 2009, and pursuant to the terms of the Company’s agreement with SVB, which terminates on November 26, 2010, the Company is required to pay minimum annual commissions of $0.4 million.
On January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments.
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We adopted SFAS 123(R) using the modified prospective method, which requires the application of the accounting standard as of January 1, 2006. In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).
Stock-based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest. Stock-based compensation expense recognized in the consolidated statement of operations during 2006, 2007, and 2008 included compensation expense for stock-based payment awards granted prior to but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS 148”), and compensation expense for the stock-based payment awards granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with SFAS 123(R). As stock-based compensation expense recognized in the statement of operations in 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
As a result of management changes and work force reductions, the estimated forfeitures for certain groups of options and stock-based awards were revised in 2008. The change in estimated forfeiture rates resulted in a cumulative reduction in stock-based compensation expense of approximately $0.6 million in 2008. The estimated forfeitures for certain groups of options were revised during 2006.
Total stock-based compensation expense recognized by the Company in the years ended December 31, 2006, 2007 and 2008 is reflected below:
The financial position and results of operations of the Company’s U.K. subsidiary are measured using the local currency, which is the functional currency, in accordance with SFAS 52 “Foreign Currency Translation”. Assets and liabilities of this subsidiary are translated at the exchange rate in effect at year-end. Income statement accounts and cash flows are translated at the average rate of exchange prevailing during the period. Translation adjustments, arising from the use of differing exchange rates, are included in accumulated other comprehensive income (loss). Net gains (losses) resulting from foreign currency transactions were approximately $1.0 million, $0.1 million, and $(7.0) million for the years ended December 31, 2006, 2007 and 2008, respectively.
In the second quarter of 2005, the Company designated, on a prospective basis, approximately $12.0 million of its US dollar denominated receivable from its U.K. subsidiary as permanent in nature and commenced reporting foreign exchange translation gains and losses on that amount as a component of accumulated other comprehensive income (loss) included in stockholders’ equity. Prior to its designation as long term, the foreign currency gains and losses related to this portion of the intercompany receivable were included in other income (expense), net in the accompanying consolidated statements of operations.
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The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results may differ from those estimates.
The Company accounts for leases in accordance with SFAS No. 13, “Accounting for Leases” and other related authoritative guidance. The Company records rent expense for leases that contain scheduled rent increases on a straight-line basis over the lease term from the time the Company controls the property.
Certain amounts in the comparative periods have been reclassified to conform to the current period’s presentation in the consolidated statements of operations. The Company reclassified “Operating and development costs” from “Costs and expenses” to “Indirect cost of trading and fee revenues”. In addition, costs related to the Company’s third party credit arrangements were reclassified from “Other income (expense)” to “Interest expense” in the accompanying consolidated statements of operations.
The Company accounts for discontinued operations in accordance with SFAS 144. Under SFAS 144, the operating results of a business unit are reported as discontinued if its operations and cash flows can be clearly distinguished from the rest of the business, the operations have been sold or will be sold within a year, there will be no continuing involvement in the operation after the disposal date and certain other criteria are met. Significant judgments are involved in determining whether a business component meets the criteria for discontinued operation reporting and the period in which these criteria are met.
The Company adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”) as of January 1, 2008. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements; rather, it applies to other accounting pronouncements that require or permit fair value measurements. The provisions of SFAS 157, as issued, were effective January 1, 2008. However, the FASB issued FASB Staff Position No. SFAS 157-2, “Effective Date of FASB Statement No. 157”, which allows entities to defer the effective date of SFAS 157 for one year for certain non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (i.e., at least annually). The Company elected the deferral related to the measurement of fair value used when evaluating goodwill, other intangible assets and other long-lived assets for impairment. The effect of adopting this standard was not significant.
Fair value is defined under SFAS 157 as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date. SFAS 157 also establishes a three-level hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
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The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability on the measurement date. The three levels are defined as follows:
The following table presents assets measured at fair value on a recurring basis as of December 31, 2008, by SFAS 157 valuation hierarchy:
The fair value of the marketable securities is based upon the market values quoted by the financial institutions as of December 31, 2008.
The Company’s other financial instruments at December 31, 2008 consist of accounts receivable, accounts payable and debt. For the year ended December 31, 2008, the Company did not have any derivative financial instruments. The Company believes the reported carrying amounts of its accounts receivable and accounts payable approximate fair value, based upon the short-term nature of these accounts. The carrying value of the Company’s loan agreements approximate fair value as each of the loans bears interest at a floating rate. The carrying value of the Company’s notes payable approximates fair value due to its short-term maturity.
SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of SFAS No. 115” (SFAS 159), permits but does not require the Company to measure financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The Company did not elect to fair value any financial instruments under the provisions of SFAS 159 and therefore, the adoption of this statement effective January 1, 2008 did not have an impact on the consolidated financial statements.
Basic earnings (loss) per share is computed by dividing net income (loss) available for common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share is calculated based on the weighted average number of outstanding common shares plus the dilutive effect of restricted stock, restricted stock units, stock options and warrants as if they were exercised. During a loss period, the effect of the potential exercise of restricted stock, restricted stock units, stock options and warrants are not considered in the diluted earnings (loss) per share calculation since the effect would be antidilutive.
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The following is a reconciliation, on a weighted average basis, of basic number of common shares outstanding to diluted number of common and common share equivalent shares outstanding:
For the years ended December 31, 2006, 2007 and 2008 outstanding stock options of 3,248,321; 3,644,470 and 3,517,840, respectively, have been excluded from the above calculations because the effect on net loss per share would have been antidilutive. For the years ended December 31, 2007 and 2008, 1,439 warrants, respectively, have been excluded from the above calculations because the effect on net loss per share would have been antidilutive. Unvested restricted stock units of 306,109; 480,320 and 411,995 have been excluded from the above calculations for the years ended December 31, 2006, 2007 and 2008, respectively, as the impact would have been antidilutive.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”), a replacement of SFAS No. 141. SFAS 141R is effective for fiscal years beginning on or after December 15, 2008 and applies to all business combinations. SFAS 141R provides that, upon initially obtaining control, an acquirer shall recognize 100 percent of the fair values of acquired assets, including goodwill, and assumed liabilities, with only limited exceptions, even if the acquirer has not acquired 100 percent of its target. As a consequence, the current step acquisition model will be eliminated. Additionally, SFAS 141R changes current practice, in part, as follows: (1) contingent consideration arrangements will be fair valued at the acquisition date and included on that basis in the purchase price consideration; (2) transaction costs will be expensed as incurred, rather than capitalized as part of the purchase price; (3) pre-acquisition contingencies, such as legal issues, will generally have to be accounted for in purchase accounting at fair value; and (4) in order to accrue for a restructuring plan in purchase accounting, the requirements in SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met at the acquisition date. While there is no expected impact to the Company’s consolidated financial statements on the accounting for acquisitions completed prior to December 31, 2008, the adoption of SFAS 141R on January 1, 2009 could materially change the accounting for business combinations consummated subsequent to that date and for tax matters relating to prior acquisitions settled subsequent to December 31, 2008.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — An Amendment of ARB No. 51” (“SFAS 160”). SFAS 160 requires the recognition of a noncontrolling interest (minority interest) as equity in the financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the results of operations. SFAS 160 clarifies that changes in parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. SFAS 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and is to be applied prospectively as of the beginning of the fiscal year in which the statement is applied. Early adoption is not permitted.
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The Company does not expect the adoption of SFAS No. 160 to have a material effect on the Company’s financial position or results of operations.
In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets (FSP 142-3). FSP 142-3 removes the requirement under SFAS No. 142, Goodwill and Other Intangible Assets to consider whether an intangible asset can be renewed without substantial cost or material modifications to the existing terms and conditions, and replaces it with a requirement that an entity consider its own historical experience in renewing similar arrangements, or a consideration of market participant assumptions in the absence of historical experience. FSP 142-3 also requires entities to disclose information that enables users of financial statements to assess the extent to which the expected future cash flows associated with the asset are affected by the entity’s intent and/or ability to renew or extend the arrangement. We were required to adopt FSP 142-3 effective January 1, 2009 on a prospective basis. The Company does not expect the adoption of FSP 142-3 on January 1, 2009 to have a material effect on the Company’s financial position or results of operations.
During 2001 and 2002, the Company exited two separate facilities and accordingly recorded charges for the future lease obligations, net of estimated sub-lease income.In August 2007, the Company decommissioned certain fixed assets at 611 West 6th Street in Los Angeles and relocated its Los Angeles switch operations to one of the sites that had been exited in December 2002. As a result, the Company recognized a gain of $1.0 million representing the reversal of the remaining liability related to the abandoned space placed back into service. In addition, the Company recognized a charge of $0.3 million representing the present value of the future lease obligations remaining on the West 6th Street site. A gain of $0.7 million, representing the net impact of these two transactions, has been reflected as a restructuring benefit in the accompanying statement as operations for the year ended December 31, 2007.
The table below shows the amount of the charges and the cash payments related to the Company’s restructuring liabilities.
As of December 31, 2008, the balance is recorded in accrued expenses and other current liabilities, in the accompanying balance sheet.
In June 2007, the Company recorded severance charges related to a resignation agreement entered into with the former Chief Executive Officer and a workforce reduction of certain employees. In accordance with SFAS No. 112, “Employers’ Accounting for Post-employment Benefits” (“SFAS 112”), an amendment of FASB Statements No. 5 and 43, benefits were provided pursuant to a severance plan which used a standard formula of paying benefits based upon tenure with the Company. The accounting for these severance costs has met the four requirements of SFAS 112, which are: (i) the Company’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered; (ii) the
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obligation relates to rights that vest or accumulate; (iii) payment of the compensation is probable; and (iv) the amount can be reasonably estimated. All severance related obligations have been paid.
During the second half of 2008, the Company recorded severance charges of $1.4 million related to a departure and transition services agreement entered into with its former Chief Executive Officer, and an overall workforce reduction, including the termination without cause of our Chief Operating Officer and Chief Marketing Officer.
In October 1999, the Company ceased the operations of Bell Fax, Inc. (“Bellfax”), a wholly-owned subsidiary. Bellfax was engaged in the sale and rental of telecommunication equipment and operating international routes. In the first quarter of 2008, management determined that the remaining Bellfax liability of $226 was no longer required. This amount has been recorded as income from discontinued operations, net of income tax of $11, in the first quarter of 2008.
In August 2006, the Company established a new subsidiary, Arbinet Digital Media Corporation, to explore and develop products and services to address the market opportunity presented by the exchange of digital media. As part of the Company’s digital media strategy, in December 2006, the Company, through its wholly-owned subsidiary, Broad Street Digital Inc., acquired all of the outstanding common stock of Flowphonics Limited (renamed Broad Street Digital Limited (“Broad Street Digital”)), a license management platform for intellectual property rights and digital content distribution. The purchase price was approximately $2.1 million, including transaction costs.
The results of operations of this business and the estimated fair market values of the acquired assets have been included in the consolidated financial statements from the date of the acquisition. The results of operations of this business that are included for the year ended December 31, 2006 are immaterial. The components of the aggregate costs of the transaction are as follows:
As part of the consideration of the acquisition, Broad Street Digital Inc. issued notes payable to two former shareholders of Broad Street Digital Limited. Subsequent to the transaction, these former shareholders became employees of the Company. These notes bear interest at 5% per annum. Notes payable totaling $93 were paid in June 2007 and notes payable totaling approximately $388 were paid in January 2008, with the balance of $80 being paid in eight monthly installments of $10 based upon conditions outlined in the underlying notes.
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The purchase price for the Broad Street Digital acquisition was allocated to assets acquired based on their estimated fair values determined by management with the assistance of a third-party appraiser as follows:
To increase resources available for its core business, in the first quarter of 2008, the Company announced a decision to explore strategic alternatives for Broad Street Digital. As a result of this decision, the Company recognized an impairment charge of approximately $2.3 million in the fourth quarter of 2007 to write down the intangible and long lived assets, including $0.4 million of goodwill, of Broad Street Digital to their estimated fair value.
During the second quarter of 2008, the Company made a decision to cease all activities related to the digital media market. As a result, the digital media segment has been presented as a discontinued operation in the accompanying financial statements for all periods presented.
On August 5, 2008, the Company entered into an agreement to sell substantially all of the assets of Broad Street Digital. In the second quarter of 2008, the Company recorded a charge of $250, to adjust the carrying value of the Broad Street Digital assets to the estimated net proceeds from the transaction, which was completed on August 19, 2008.
In connection with ceasing digital media activities, the Company entered into a separation and release agreement with the Chief Operating Officer of Arbinet Digital Media Corporation and terminated the remaining employees in this segment. The Company recognized a severance charge of $0.5 million in the third quarter of 2008 which was recorded in loss from discontinued operations.
Summarized financial information for discontinued operations is shown below.
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As a result of the decision to cease activities of digital media and its presentation as discontinued operations, the Company operates in one reporting segment.
Gross realized gains and losses from the sale of securities classified as available-for-sale were not material for the year ended December 31, 2008. All marketable securities at December 31, 2008 have a maturity of one year or less. As of December 31, 2007 and 2008, the Company’s net unrealized gains in its available-for-sale securities were not material. All of the marketable securities held at December 31, 2007 matured at various dates in 2008 resulting in no material gain or loss. The following is a summary of marketable securities at December 31, 2007 and 2008 by type:
There were no individual marketable securities that carried an unrealized loss for the past twelve consecutive months.
Property and equipment consisted of the following:
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Property and equipment, net, includes equipment under capital leases of $905 and $551 (net of accumulated depreciation of $3,977 and $4,331) at December 31, 2007 and 2008, respectively. Property and equipment, net, includes capitalization of software for internal use of $6,226 and $6,903 (net of accumulated amortization of $24,182 and $26,921) at December 31, 2007 and 2008, respectively. Amortization of capitalized software for internal use was $2,500, $2,751 and $2,750 in 2006, 2007 and 2008, respectively. Property and equipment, net includes approximately $4.7 million and $3.0 million of assets located in the Company’s leased facilities in the United Kingdom and approximately $0.5 million of assets located in the Company’s leased facility in Hong Kong as of December 31, 2007 and 2008.
During 2006 and 2007, the Company decommissioned certain fixed assets located at its exchange delivery points (“EDP”) in New York City, Los Angeles and London, England. Management has engaged a third party to facilitate the sale of this equipment. To date, the Company has sold a nominal amount of these assets. During the year ended December 31, 2008, the Company recorded an impairment charge of approximately $0.5 million, to adjust the carrying value of the assets to their estimated fair market value. The carrying value of this equipment as of December 31, 2007 and 2008 is approximately $0.5 million and $12, respectively, and is included in “prepaids and other current assets” in the accompanying consolidated balance sheets.
In November 2008, the Company entered into a Seventh Amendment to an Accounts Receivable Financing Agreement (“Loan Agreement”) with Silicon Valley Bank, which further amends the financing arrangement dated February 3, 2003. Under the Loan Agreement, the Company may borrow up to $25.0 million from time to time under a secured revolving facility for a two-year period. Borrowings under the Loan Agreement are on a formula basis, based on eligible accounts receivable. There are no financial covenants under the Loan Agreement. Interest on gross borrowings under the Loan Agreement is based on the bank’s prime rate, subject to a minimum rate of 4.0%. The Loan Agreement is collateralized by substantially all the Company’s assets.
The Loan Agreement has a minimum finance charge of $12,000 monthly or $144,000 annually. Additionally, the amendment to the Loan Agreement is subject to a $75,000 annual modification fee.
As of December 31, 2008, $3.6 million was outstanding under the Loan Agreement. The Loan Agreement expires on November 26, 2010.
Accrued expenses and other current liabilities consist of the following:
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On June 11, 2007, the Board of Directors of Arbinet authorized the repurchase of up to $15.0 million of the Company’s common stock at anytime and from time to time (the “2007 Repurchase Plan”). On February 26, 2008 the Company’s Board of Directors terminated the 2007 Repurchase Plan, under which an aggregate of 838,797 shares had been purchased. Shares of the Company’s common stock repurchased under the 2007 Repurchase Plan aggregate approximately $4.7 million, of which $2.1 million was repurchased in the first quarter of 2008.
On February 28, 2008, the Company announced that its Board of Directors had approved a special one-time cash distribution of $0.40 per share. The aggregate total distribution of approximately $10.0 million was paid on March 28, 2008 to holders of record of the Company’s common stock as of the close of business on March 12, 2008. Adjustments were made to the outstanding stock options and restricted stock grants to restore the respective holders to their position before the issuance of the distribution. These modifications were treated as adjustments in connection with an equity restructuring in accordance with applicable accounting standards.
On May 22, 2008, the Board of Directors authorized the repurchase of up to $8.0 million of the Company’s common stock (“May 2008 Repurchase Plan”). Prior to the expiration of the May 2008 Repurchase Plan in August 2008, 1,918,516 shares were repurchased for $7.1 million.
On November 4, 2008, the Board of Directors of the Company authorized the repurchase of up to $5.0 million of the Company’s common stock (the “November 2008 Repurchase Plan”). Stock repurchases are made from time to time in the open market. As of December 31, 2008, 1,006,574 shares were repurchased for $2.0 million. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. The November 2008 Repurchase Plan may be suspended or terminated at any time without prior notice, and has no expiration date.
On November 21, 2008, the Board of Directors of the Company authorized an amendment to the November 2008 Repurchase Plan. Under the amendment, stock repurchases will also be made from time to time through privately negotiated transactions in compliance with applicable laws and other legal requirements. Except as specifically amended, the November 2008 Repurchase Plan remains in full force and effect in accordance with its terms.
The components of accumulated other comprehensive income (loss) are as follows:
“Other” represents changes associated with the accounting for valuation adjustments relating to certain available for sale securities, which has been excluded from net income and reflected in equity.
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The Company established a 2004 Stock Incentive Plan, as amended (the “2004 Plan”), which provides the granting of options to officers, employees, directors, and consultants of the Company. As of December 31, 2008, options to purchase 1,388,988 shares of common stock were available for future grants under the 2004 Plan. Common stock shares of 3,517,840 and 3,664,470, as of December 31, 2008 and 2007, respectively, were reserved for stock options granted. As of December 31, 2007 and 2008, 1,439 shares were reserved for warrants to purchase common stock. These warrants are exercisable at $4.99 per share. Options outstanding as of December 31, 2007 and December 31, 2008 include option grants under the 2004 Plan as well as the Amended and Restated 1997 Stock Incentive Plan and the First Amended and Restated Non-employee Directors’ and Advisors’ Stock Option Plan.
Options granted under the 2004 Plan generally have a four-year vesting period and expire ten years after grant. Most of the Company’s stock options vest ratably during the vesting period, as opposed to awards that vest at the end of the vesting period. The Company recognizes compensation expense for options using the straight-line basis, reduced by estimated forfeitures. Total unrecognized stock-based compensation expense related to total nonvested stock options expected to vest was approximately $1.8 million at December 31, 2008 with a remaining weighted average period of approximately 36 months over which such expense is expected to be recognized. Upon exercise of stock options, the Company typically issues new shares of its common stock (as opposed to using treasury shares).
On June 11, 2007, the Chief Executive, President and Director of Arbinet, resigned. In connection with the resignation, Arbinet entered into a Resignation Agreement dated June 11, 2007 (the “Resignation Agreement”). The Resignation Agreement provided for the acceleration of outstanding stock options, restricted stock, and restricted stock units, resulting in additional stock-based compensation of $197 being recognized in the second quarter of 2007.
On August 25, 2005, the Company’s Board of Directors approved the accelerated vesting of all unvested employee stock options issued under the 2004 Plan with an exercise price in excess of $10.00 per share. Pursuant to this action, options to purchase approximately 1.4 million shares of the Company’s common stock became exercisable immediately. Based on the closing price on August 24, 2005 of $6.35, none of these options had intrinsic economic value at the time. The vesting acceleration enabled the Company to avoid recognizing in its income statement compensation expense associated with these options in future periods, upon adoption of SFAS 123(R) in January 2006. As a result of this change, the Company reduced the pre-tax stock option expense it otherwise would have been required to record under SFAS 123(R) by approximately $7.8 million over a four-year period, from 2006 to 2009.
The fair market value of each option has been estimated on the date of grant using the Black-Scholes Option Pricing Model with the following assumptions:
Expected volatilities are based on historical volatility of the stock of the Company and guideline companies. The expected life of options granted is based on historical experience and on the terms and conditions of the options. The risk-free rates are based on the U.S. Treasury Strip yield in effect at the time of the grant.
The weighted average grant date fair value of options granted during the years ended December 31, 2006, 2007 and 2008 was $2.38, $2.67 and $1.59, respectively.
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A summary of the Company’s stock options activity (including options granted outside the 2004 Plan to non-employees) during the year ended December 31, 2008, is presented below:
As of December 31, 2008, there were 3,517,840 options outstanding with 7.72 weighted average years remaining on the contractual life, of which 3,187,328 shares have vested or are expected to vest. The aggregate intrinsic value of both the outstanding shares and the shares that are vested or expected to vest is $0.2 million at December 31, 2008, based on the closing stock price of $1.50.
The intrinsic value of options exercised during the years ended December 31, 2008 and 2007 was approximately $114 and $4.1 million, respectively.
Restricted stock awards granted under the 2004 Plan generally have a three-year vesting period. Most of the Company’s restricted stock awards are subject to graded vesting in which portions of the award vest at different times during the vesting period, as opposed to awards that vest at the end of the vesting period. The Company recognizes compensation expense for restricted stock awards subject to graded vesting using the straight-line basis, reduced by estimated forfeitures. Total unrecognized stock-based compensation expense related to total nonvested restricted stock awards expected to vest was approximately $1.5 million at December 31, 2008 with a remaining weighted average period of approximately 23 months over which such expense is expected to be recognized. The fair value of shares that vested during the year ended December 31, 2008 was approximately $1.2 million.
Restricted stock activity for the year ended December 31, 2008 is presented below:
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The Company provides certain Performance Share Awards (the “Awards”) whereby it grants performance shares to certain executives of the Company. These Awards provide recipients with the opportunity to earn shares of common stock of the Company, the number of which shall be determined pursuant to, and subject to the attainment of specific Company operating performance goals. Under SFAS 123(R), accruals of compensation expense for an award with a performance condition is based on the probable outcome of the performance conditions. During the years ended December 31, 2006, 2007 and 2008, the Company recorded expense of $0, $0, and $17, respectively, relating to performance awards.
The components of income from continuing operations before income taxes are as follows for the years ended December 31:
The income tax (benefit) expense consists of the following for the years ended December 31:
The Company recorded an income tax provision of approximately $392 and $232 for the years ended December 31, 2008 and December 31, 2007 primarily representing the statutory requirements for state taxes. The Company recorded an income tax provision of approximately $2.0 million for the year ended December 31, 2006 primarily related to the reestablishment of a full valuation allowance recorded against deferred tax assets.
The difference between the federal statutory tax rate and the effective tax rate is primarily related to the expected utilization of certain of the Company’s net operating loss carryforwards in 2008 and 2007, as well as the impact of state taxes and the impact of foreign taxes on the portion of pre-tax income associated with the Company’s U.K. subsidiary. The difference between the federal statutory tax rate and the effective tax rate for 2006 is primarily related to the reversal of the expected utilization of certain of the Company’s net operating loss carryforwards in 2005, as well as the impact of state taxes and the impact of foreign taxes on the portion of pre-tax income associated with the Company’s U.K. subsidiary. The reconciliation of income taxes from continuing operations computed at U.S. federal statutory rates to income tax expense is as follows:
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Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for tax purposes. Significant components of the deferred tax assets and liabilities at December 31 are as follows:
When evaluating the ability for the Company to record a net deferred tax asset, SFAS No. 109 “Accounting for Income Taxes” requires the Company consider all sources of taxable income as well as all available evidence to determine whether it is more likely than not that it will be able to utilize this asset. At December 31, 2007 and 2008, a full valuation allowance in the amount of $41.6 and $44.0 million, respectively, has been recorded against net deferred tax assets since, at those dates, the Company was unable to conclude that it was more likely than not that it would realize those assets. The increase in the valuation allowance is mainly attributable to the increase in the net operating losses as well as other temporary differences that will reverse in future periods. The Company will continue to refine and monitor all available evidence during future periods to evaluate the recoverability of our deferred tax assets.
Approximately $743 of the valuation allowance for deferred tax assets is attributable to employee stock option deductions, the benefit from which will be allocated to additional paid-in capital rather than current income when subsequently recognized.
At December 31, 2008, the Company had net operating loss, or NOL, carryforwards of approximately $79 million for U.S. federal and state income tax purposes that expire on various dates between 2020 and 2028 if not utilized. The availability of NOL carryforwards to offset future taxable income may be subject to annual limitations imposed by Internal Revenue Code Section 382 as a result of an ownership change. Management has concluded that an ownership change occurred during 2007. However, based on the market value
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of the Company at such date, the Company believes that this ownership change will not significantly impact its ability to use net operating losses in the future to offset taxable income. At December 31, 2008, the Company had NOL carryforwards of approximately $21 million for foreign income tax purposes. The foreign NOL carryforwards do not expire.
The Company adopted the provisions of FIN 48 effective January 1, 2007. As a result of the implementation of FIN 48, the Company identified an aggregate of approximately $625 of unrecognized tax benefits, including related estimated interest and penalties, due to uncertain tax positions. Approximately $589 of these uncertain tax positions resulted in a reduction of deferred tax assets against which the Company had recorded a full tax valuation allowance on its balance sheet. The balance of the unrecognized tax benefits, amounting to $36, which includes interest and penalties, was recorded as an increase to accumulated deficit and an increase of $36 to “other long-term liabilities.” While the Company believes that it has identified all reasonably identifiable exposures and that the reserve it has established for such exposures is appropriate under the circumstances, it is possible that additional exposures exist and that exposures will be settled at amounts different than the amounts reserved. It is also possible that changes in facts and circumstances could cause the Company to either materially increase or reduce the amount of our tax reserve.
As of January 1, 2007, after the implementation of FIN 48, the amount of unrecognized tax benefits is $625, including interest and penalties, of which recognition of $36 would impact the Company’s effective tax rate. At December 31, 2008, the amount of unrecognized tax benefits is $650, including interest and penalties, of which recognition of $61 would impact the Company’s effective tax rate.
A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows:
The Company recognizes potential interest and penalties relating to income tax positions as a component of the provision for income taxes. As of January 1, 2007, the Company recorded a liability for the payment of interest and penalties of $3 and $8, respectively. The Company recorded an additional $3 and $4 in interest expense in its income tax provision related to these positions for the years ended December 31, 2007 and 2008 respectively. These amounts resulted in an increase in “other long-term liabilities.”
The Company’s U.S. subsidiaries join in the filing of a U.S. federal consolidated income tax return. The Company is not currently under examination by the Internal Revenue Service. The U.S. federal statute of limitations remains open for the years 2005 onward. State income tax returns are generally subject to examination for a period of three to five years after filing of the respective return. The state impact of any federal changes remains subject to examination by various states for a period of up to one year after formal notification to the states. The Company is not currently under examination in any state jurisdictions. The Company is no longer subject to federal, state or foreign income tax assessments for years prior to 2003.
Foreign income tax returns are generally subject to examination for a period of three to nine years after filing of the respective return. The Company is currently under examination in the United Kingdom for its 2004 and 2005 tax years. In the event that the Company’s income tax examination in the United Kingdom concludes within the next twelve months, the Company’s total amounts of unrecognized tax benefits, excluding related estimated interest and penalties, may change. Depending on the outcome of this examination, a reasonable estimate of the range of this possible change is from an increase of $408 to a decrease of $612 in deferred tax assets. The Company had recorded a full tax valuation allowance on its balance sheet and this item will have no impact on the statement of operations.
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The Company contributions under the 401(k) Plan are computed at 4% of an employee’s eligible compensation subject to certain limits. Contributions into the 401(k) Plan in the years ended December 31, 2006, 2007 and 2008 were approximately $278, $340 and $366, respectively. These contributions were recorded as expense for each year in the consolidated statements of operations.
From time to time, the Company is involved in legal proceedings in the ordinary course of its business. The litigation process is inherently uncertain, and the Company cannot guarantee that the outcome of any proceedings or lawsuits in which the Company may become involved will be favorable to the Company or that they will not be material to the business, results of operations or financial position. The Company does not currently believe there are any matters pending that will have a material adverse effect on its business, results of operations or financial position.
On March 18, 2003, World Access, Inc. f/k/a WAXS, Inc., WA Telcom Products Co., Inc., WorldxChange Communications, Inc., Facilicom International LLC and World Access Telecommunications Group, Inc. f/k/a Cherry Communications Incorporated d/b/a Resurgens Communications Group (collectively “the Debtors”), filed a lawsuit against the Company in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division. The Debtors had previously filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. The Debtors sought recovery of certain payments they made to the Company as a buyer on the exchange, which totaled approximately $855. The Debtors claimed that such payments were preferential transfers under the Bankruptcy Code. The Debtors also sought costs and expenses, including attorneys’ fees and interest. The Company filed an answer to the complaint on April 18, 2003, denying the Debtors’ claims for relief and asserting several affirmative defenses. The parties entered into a Settlement Agreement dated November 19, 2008 and the action has been dismissed.
The Company leases office facilities and certain equipment under operating leases expiring through 2017. As these leases expire, it can be expected that in the normal course of business they will be renewed or replaced. In addition, certain lease agreements contain renewal options and rent escalation clauses. The Company does not consider any individual lease material to its operations. Aggregate future minimum rental payments and future sublease income are:
Rent expense for the years ended December 31, 2006, 2007 and 2008, was approximately $2,938, $2,971 and $3,314, respectively. Sub-lease income was $0.1 million for the years ended 2006, 2007 and 2008. Approximately $2.4 million and $2.1 million of security deposits as of December 31, 2007 and 2008, respectively, represent collateral for the landlords under various leases. The Company has approximately $2.2 million and $2.1 million recorded as deferred rent as of December 31, 2007 and 2008, respectively. These
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amounts principally represent the difference between straight-line rent expense recorded and the rent payments and lease incentives as of the balance sheet date.
The Company leases certain equipment under capital leases, which expire at various dates through 2008. Borrowings under capital leases bear interest at 10.83% per annum. Amounts charged to interest expense related to capital leases were immaterial for the years ended December 31, 2006, 2007 and 2008, respectively.
The Company has an agreement with one of its equipment vendors, which obligates the Company to purchase certain equipment and services for approximately $1.0 million in 2009 and $1.0 million in 2010. The Company has made purchases from this vendor of approximately $1.5 million, $1.2 million, and $2.0 million in 2006, 2007 and 2008, respectively.
The Company has several employment offer letters with officers of the Company. These offer letters provide for an annual base compensation and the issuance of stock options. These stock options were granted at fair market value. These offer letters generally contain provisions for severance payouts in the event of termination of employment of the officers.
The balance of goodwill was $2,196 and $0 at December 31, 2007 and 2008, respectively. The Company performed its annual impairment test at the beginning of the fourth quarter of 2008 which indicated there was no impairment to the Company’s goodwill and other intangible assets. However, business conditions worsened during the fourth quarter of 2008, and the market’s perception of the value of the Company’s common stock resulted in a reduction in the Company’s market capitalization below its book value. These factors caused the Company to perform additional impairment testing as of December 31, 2008. As a result of this additional testing, the Company determined that its goodwill and certain of its intangible assets were impaired. Accordingly, the Company recorded a $3.0 million non-cash impairment charge of which $1.6 million related to goodwill and $1.3 million pertained to other intangible assets. Additionally, the change in the carrying amounts is also related to the difference in exchange rate in effect at December 31, 2007 and 2008. The goodwill balances are recorded using local currency (British Pounds Sterling) as the functional currency and are translated into US dollars at the exchange rate in effect at year-end.
The following table summarizes the Company’s intangible assets subject to amortization at the dates indicated:
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Amortization expense for intangibles totaled approximately $272 and $311 for the years ended December 31, 2008 and 2007, respectively. Aggregate amortization expense for intangible assets is estimated to be:
The Company entered into two Non-Qualified Stock Option Agreements dated July 31, 2007 and February 7, 2008 with a member of its Board of Directors, Alex Mashinsky, in connection with consulting services beyond the scope of his services rendered as a member of Board of Directors. The Company recognized a total of $244 and $143 in stock based compensation expense pursuant to these agreements during the years ended December 31, 2007 and 2008.
The Chief Financial Officer is also a Partner in Tatum LLC (“Tatum”), an executive services and consulting firm. The Company entered into an agreement with Tatum to hire a Controller on an interim basis. The Company recognized a total of $86 and $264 in expense pursuant to this agreement during the years ended December 31, 2007 and 2008, respectively.
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Net loss for third quarter 2008 includes a pre-tax charge to earnings of $1.3 million for severance costs and an impairment charge of approximately $0.5 million to adjust the carrying value of certain decommissioned fixed assets to their estimated fair market value. In the fourth quarter of 2008, the Company recorded a pre-tax charge to earnings of $3.0 million for a non-cash impairment charge related to goodwill and other intangible assets.
Net loss for the first quarter 2007 included a provision for litigation of $1,150. Net loss for second quarter 2007 includes a pre-tax charge to earnings of $1,021 for severance costs and a provision for litigation of $790. Fourth quarter 2007 includes a pre-tax impairment charge of $2.3 million to write down Broad Street Digital’s intangible and other long-lived assets to their estimated fair value. In addition, fourth quarter 2007 results include the reversal of $0.1 million in interest expense related to a liability recorded upon adoption of FIN 48, which was reversed against retained earnings due to the finalization of the related tax study.
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