ITEM 1	BUSINESS
The Company
Patriot Scientific Corporation (the “Company”, “PTSC”, “we”, “us”, or “our”) is an intellectual-property licensing company with several patents (described below) covering the design of microprocessor chips. Chips with our patented technology are used throughout the world in products ranging from computers and cameras to printers, automobiles and industrial devices. Through our joint venture, Phoenix Digital Solutions, LLC (“PDS”), we pursue the commercialization of our patented microprocessor technologies through broad and open licensing and by litigating against those who may be infringing on our patents.
Our business address is 701 Palomar Airport Road, Suite 170, Carlsbad, California 92011; our main telephone number is (760) 547-2700. Our internet website page is located at http://www.ptsc.com. All of our reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available free of charge on our internet website. The information on, or that can be accessed through, our website is not part of this Annual Report.
PTSC is a corporation organized under Delaware law on March 24, 1992, and is the successor by merger to Patriot Financial Corporation, a Colorado corporation, incorporated on June 10, 1987. In June 2005, we entered into a joint venture agreement with Technology Properties Limited, Inc. (“TPL”) to form PDS. In September 2008, we acquired Patriot Data Solutions Group, Inc. formerly known as Crossflo Systems, Inc. (“PDSG”) which engaged in data-sharing services and products primarily in the public safety/government sector. During April 2012, we sold substantially all of the assets of PDSG.
PDSG was a segment of our business prior to the quarter ended February 29, 2012 and it is now classified as discontinued operations in our consolidated financial statements.
Our Technology
The global semiconductor (or silicon “chip”) market has many segments and categories. The best-known - and most profitable - of these is the microprocessor segment. Microprocessor chips are the “brains” of most electronic and electrical devices throughout the world. Although microprocessors are often closely associated with personal computers (“PCs”), PCs account for only a small fraction of the microprocessor chips made and sold every year. The vast majority of microprocessors are used in everyday items like automobiles, digital cameras, cell phones, video game players, data networks, industrial flow-control valves, sensors, medical devices, weapons, home appliances, robots, security systems, televisions, and much more. These “embedded microprocessors” (so called because they’re embedded into another product) are far more ubiquitous than the chips inside personal computers. This is the market that our technology serves.
Phoenix Digital Solutions, LLC
On June 7, 2005, we entered into a Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore, an individual (“Moore”). We, TPL and Moore were parties to certain lawsuits filed by us alleging infringement (the “Infringement Litigation”) of seven U.S. patents issued dating back to 1989 on our microprocessor technology (the “Microprocessor Patents”) and a lawsuit also filed by us alleging claims for declaratory judgment for determination and correction of inventorship of the Microprocessor Patents (the “Inventorship Litigation”). The transactions described in the Master Agreement and related agreements (the “Transactions”) included the settlement or dismissal of the Inventorship Litigation.
Pursuant to the Master Agreement we caused certain of our respective interests in the Microprocessor Patents to be licensed to PDS, a joint venture limited liability company owned 50% by us and 50% by TPL, and PDS engaged TPL to commercialize the Microprocessor Patents pursuant to a Commercialization Agreement among PDS, TPL and us (the “Commercialization Agreement”). Under the Commercialization Agreement, PDS granted to TPL the exclusive right to grant licenses and sub-licenses of the Microprocessor Patents and to pursue claims against violators of the Microprocessor Patents, in each case, on behalf of PDS, us, TPL and Moore, and TPL agreed to use reasonable best efforts to commercialize the Microprocessor Patents in accordance with a mutually agreed business plan. Pursuant to the Commercialization Agreement, PDS agreed to a reimbursement policy with regard to TPL’s expenses incurred in connection with the commercialization of the Microprocessor Patents. All proceeds generated by TPL in connection with the commercialization of the Microprocessor Patents were paid directly to PDS. From the inception of the Commercialization Agreement to May 31, 2015, gross license revenues to PDS totaled $308,364,535.
Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (“LLC Agreement”). We and TPL each own 50% of the membership interests of PDS, and each have the right to appoint one member of the not to exceed three (3) member management committee. The TPL and PDS appointees are required to select a mutually acceptable third member of the management committee. While there had not been a third management committee member since May 2010, as a result of our initiation of arbitration seeking the appointment of a third member, on December 16, 2014, an independent manager to the PDS management committee was selected by the arbitrator. Pursuant to the LLC Agreement, we and TPL must each contribute to the working capital of PDS and at the discretion of PDS’s management committee we may be obligated to make future contributions in equal amounts in order to maintain a working capital fund. The LLC Agreement provides that PDS shall indemnify its members, managers, officers and employees, to the fullest extent permitted by applicable law, for any liabilities incurred as a result of their involvement with PDS, if the person seeking indemnification acted in good faith and in a manner reasonably believed to be in the best interest of PDS.
On July 11, 2012, we entered into a Licensing Program Services Agreement (the “Program Agreement”) with PDS, TPL, and Alliacense Limited, LLC (“Alliacense”, an affiliate of TPL) creating an amendment to the Commercialization Agreement, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement, PDS engaged Alliacense to negotiate Moore Microprocessor Patent (“MMP”) portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of PDS, TPL, and the Company. The Program Agreement extended through the useful life of the MMP portfolio patents. Pursuant to the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense. On July 24, 2014, the Program Agreement was amended with PDS and Alliacense entering into the Amended Alliacense Services and Novation Agreement (the “Novation Agreement”). Pursuant to the Novation Agreement certain performance goals and incentives were established for Alliacense. The Novation Agreement also provided for the addition of a second licensing company, which was engaged on October 10, 2014, to complement the MMP licensing commercialization. However, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015 Alliacense was terminated by PDS. On July 17, 2012, we entered into an Agreement with PDS, TPL, and Alliacense whereby we agreed to certain additional allocations of obligations relating to the Program Agreement.
The July 2012 and 2014 agreements facilitate an aggressive litigation strategy which currently includes actions in U.S. District Court against multiple companies alleged to be infringers of the MMP portfolio. We believe that the significant investment in legal effort and costs incurred to date at PDS is necessary for the protection of our interests in the MMP portfolio and its future success.
On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. We have been appointed to the creditors’ committee and have been closely monitoring the progress in this matter as it relates to our interest in PDS. On July 18, 2014, TPL and the creditors’ committee announced that a term sheet serving as the basis for a Joint Plan of Reorganization (the “Plan”) had been agreed to with the expectation that the Plan would be presented to the Bankruptcy Court for approval on September 17, 2014. The Joint Plan was confirmed by the Bankruptcy Court on February 11, 2015 with the entered confirmation order becoming final on April 2, 2015. The Joint Plan provides that the Effective Date, which remains pending, will be the later of (i) the first business day that is at least 30 days after the entry of the confirmation order or (ii) the first Business Day on which the reorganized TPL has sufficient cash to make all payments required under the Plan on the Effective Date.
In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.
Licenses, Patents, Trade Secrets and Other Proprietary Rights
We rely on a combination of patents, copyright and trademark laws, trade secrets, software security measures, license agreements and nondisclosure agreements to protect our proprietary technologies. Our policy is to seek the issuance of patents that we consider important to our business to protect inventions and technology that support our microprocessor technology.
As of the date of this filing, we have one unexpired U.S. patent issued in 1998 on our microprocessor technology. This patent will expire in September 2015. We also have three European and two Japanese patents all expiring in October 2016. We also have six U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and July 21, 2015. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration dates.
There can be no assurance that our patents will provide meaningful commercial advantages to us. Although we intend to protect our rights vigorously, there can be no assurance that these measures will be successful.
We generally require all of our employees and consultants, including our management, to sign a non-disclosure and invention assignment agreement upon employment with us.
Products and Services
On April 30, 2012 substantially all of the assets of PDSG were sold in exchange for a royalty on PDSG revenues for a period of three years. Accordingly, our investment in the MMP portfolio represents virtually all of our business interests at this time.
Employees
At May 31, 2015, we have three employees. All employees are full time. We also engage consultants and part-time persons, as needed.
Our future success depends in significant part upon the continued services of our key personnel. The competition for highly qualified personnel is intense, and there can be no assurance that we will be able to retain key employees. None of our employees are represented by a labor union, and we consider our relations with our employees to be good. None of our employees are covered by key man life insurance policies.
Available Information
We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Materials filed with the SEC can be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, on official business days during the hours of 10 a.m. to 3 p.m. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet web site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Our filings are available to the public at the website maintained by the SEC, http://www.sec.gov. We also make available, free of charge, through our web site at www.ptsc.com, our reports on Forms 10-K, 10-Q, and 8-K, and amendments to those reports, as soon as reasonably practicable after they are filed with or furnished to the SEC. The information on, or that can be accessed through, our website is not part of this Annual Report.
ITEM 1A.
ITEM 1A. RISK FACTORS
We urge you to carefully consider the following discussion of risks as well as other information contained in this Form 10-K. We believe the following to be our most significant risk factors as of the date this report is being filed. The risks and uncertainties described below are not the only ones we face.
Delays In Deploying A Licensing Agent Are Adversely Effecting Us.
PDS’s sole licensing agent implementing the MMP licensing program is Dominion Harbor Group, LLC (“Dominion”), which was appointed in October 2014. Since PDS’s previous licensing agent did not cooperate with the appointment of Dominion, Dominion has been redeveloping information and strategies that should have been transferred from the previous licensing agent. Accordingly, it has taken a significant amount of time for Dominion to develop such information and strategies. As a result, Dominion has not been able to commence revenue generating activities under the licensing program, which is having an adverse effect on our ability to generate revenues from the MMP portfolio. We do not know when Dominion will complete the development of information and strategies. Until such development is completed, we do not expect to be able to generate significant licensing revenues.
We May Be Required To Fund Our Joint Venture’s Legal Costs.
On March 20, 2013 TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. While TPL’s bankruptcy and reorganization does not at present affect the licensing agreement between PDS and Alliacense, PDS has incurred significant legal costs in ongoing matters before the U.S. District Court. If PDS does not receive sufficient licensing revenues to pay these expenses, we may be required to pay these expenses. In the event the cost of legal actions exceeds our ability to fund these efforts, our options for additional sources of financing may be limited.
The Impact Of TPL’s Bankruptcy And Reorganization On PDS And The Future Success Of The Licensing Program Is Uncertain.
While TPL’s bankruptcy and reorganization does not appear to affect the licensing agreement between PDS and Alliacense, the consequences should the reorganization under Chapter 11 be unsuccessful, which could include lawsuits from creditors or a motion to convert the case to Chapter 7, would be uncertain and potentially adverse to PDS and the licensing program. For example, if the case is converted, a trustee may propose the sale of TPL’s interest in PDS to be sold to an unknown third party if allowed by applicable law and approved by the bankruptcy court. It is unclear how that may affect the operation of PDS or the licensing program, but it may be adverse.
We Have Reported Licensing Income In Prior Fiscal Years Which May Not Be Indicative Of Our Future Income.
We have entered into license agreements through our joint venture with TPL and have reported income from the joint venture for the fiscal years 2006 to 2011 and 2013 to 2014. However, the joint venture has not generated significant licensing revenues since September 2013 and the joint venture has recorded a loss for the fiscal year ended May 31, 2015. Because of the uncertain nature of the negotiations that lead to license revenues, pending litigation with companies which we allege have infringed on our patent portfolio, the possibility of legislative action regarding patent rights, the possible effect of new judicial interpretations of patent laws, and delays in obtaining information necessary for the successful deployment of licensing companies to represent the MMP Portfolio, we may not receive revenues from such agreements in the future consistent with amounts received in the past, and we may not receive future revenues from license agreements at all.
We Are Dependent Upon A Joint Venture For Substantially All Of Our Income.
In June 2005, we entered into the PDS joint venture with TPL, which as a result of agreements entered into in June 2005, July 2012 and July 2014, TPL and its licensing company affiliate Alliacense had been responsible for the licensing and enforcement of our microprocessor patent portfolio. This joint venture has been the source of substantially all of our income since June 2005. While the joint venture remains in place, Alliacense was terminated by PDS on May 11, 2015. Therefore, in light of the absence of significant revenue from other sources and until one or more replacement licensing entities have been successfully deployed and demonstrate an ability to generate significant cash flows, we should be regarded as highly dependent on the success or failure of licensing and settlements occurring in conjunction with existing litigation efforts.
We Have Been Involved In Multiple Disputes With Our Joint Venture Partner.
We have been involved in multiple disputes with our joint venture partner TPL and its affiliate Alliacense. During times when there are only two appointed managers of the joint venture, a deadlock can exist on important issues that may not be resolved quickly. In the event of a protracted deadlock, the joint venture may not be able to take actions when appropriate or necessary. Previously we have had to initiate formal arbitration proceedings seeking the appointment of an independent manager to the management committee of the joint venture (see footnote 6). Although an independent manager is currently in place, we have concluded that any future absences of an independent manager may have a negative impact on the licensing program and PDS’s business.
Our Joint Venture Is At Risk For Going Concern And An Inability To Meet Certain Obligations.
PDS, our joint venture with TPL, which received a going concern opinion since its May 31, 2011 financial statements, has experienced significant declines in revenues while at the same time incurring significant legal costs associated with pending litigation with companies which we allege have infringed on our patent portfolio.
PDS’s licensing revenues have declined over recent years to a point where PDS’s ability to make future payments is in substantial doubt unless licensing revenues substantially increase in the near term. In the event that PDS does not have the funds to pay one or more of the aforementioned costs, we and TPL must decide whether to contribute additional capital to PDS to fund such payments and due to TPL’s bankruptcy and reorganization, we may be required to pay these expenses without any contribution from TPL.
Our Microprocessor Patents Are In The Process Of Expiring.
We have one unexpired U.S. patent, that will expire in September 2015, and three European and two Japanese patents expiring in October 2016. We also have six U.S. patents, six European, and one Japanese patent that expired between August 2009 and July 21, 2015. While expired patents may have certain retrospective statutory benefits, their value as assets for licensing and cash generation is significantly diminished.
A Successful Challenge To Our Intellectual Property Rights Could Have A Significant And Adverse Effect On Us.
A successful challenge to our ownership of our technology or the proprietary nature of our intellectual property could materially damage our business prospects. We rely on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. With respect to our core technologies, we currently have one unexpired U.S., three European and two Japanese patents issued. Any issued patent may be challenged and invalidated. Any claims allowed from existing patents may not be of sufficient scope or strength to provide significant protection. Our competitors may also be able to design around our patents.
Vigorous protection and pursuit of intellectual property rights or positions characterize the fiercely competitive semiconductor industry, which has resulted in significant and often protracted and expensive litigation. Therefore, our competitors and others may assert that our technologies infringe on their patents or proprietary rights. Persons we believe are infringing our patents are likely to vigorously defend their actions and assert that our patents are invalid. Problems with patents or other rights could result in significant costs, and limit future license revenue. If infringement claims against us are deemed valid or if our infringement claims are successfully opposed, we may not be able to obtain appropriate licenses on acceptable terms or at all. Litigation could be costly and time-consuming but may be necessary to protect our future patent and/or technology license positions or to defend against infringement claims. From time to time parties have petitioned the USPTO to re-examine certain of our patents. An adverse decision in litigation or in the re-examination process could have a very significant and adverse effect on our business.
We are party to multiple lawsuits regarding the MMP portfolio and have had mixed results in our litigation efforts to date. See footnote 9 to our consolidated financial statements and Part I, Item 3. “Legal Proceedings” in this Report on Form 10-K for more information.
In the event that one or more of these lawsuits regarding the MMP portfolio is not resolved in our favor, such outcome (or lack of an outcome) could weaken the MMP portfolio which would have a negative effect on PDS's ability to procure future license revenues and, therefore, adversely affect PDS’s and our cash flows.
A New Law Firm Has Recently Been Engaged To Defend And Enforce Our Intellectual Property Rights.
On April 13, 2015, PDS engaged a law firm to replace the former law firm in connection with the defense and enforcement of our intellectual property rights. The new law firm has been required to spend time and resources to understand our intellectual property rights and status of the lawsuits currently in progress. The new law firm may not make the same recommendations as our former law firm and our strategies with respect to the lawsuits may change. The inability of the new law firm to quickly understand our intellectual property rights and status of the lawsuits currently in progress and implement a cohesive strategy with respect thereto could have a material adverse effect on our ability to defend and prosecute such lawsuits and, therefore, have a material adverse effect on our business, financial condition and result of operations.
We Are Dependent On A Single Law Firm To Defend And Enforce Our Intellectual Property Rights.
PDS has recently engaged a new law firm to defend and enforce our intellectual property rights. Any significant interruption in their services, or the loss of their services for any reason, would have a material adverse effect on our ability to defend and prosecute such lawsuits and, therefore, have a material adverse effect on our business, financial condition and result of operations. The law firm’s services could be disrupted for a variety of reasons, and any disruption would have a material adverse effect on our business. Our inability to engage the services of a new law firm in a timely manner could have a substantial negative effect on our business.
A Change In Our Relationship With PDS Could Change The Way We Account For Our Interest In The Future.
Our investment in PDS is accounted for under the equity method, we record as part of other income or expense our share of the increase or decrease in the equity of this company in which we have invested. It is possible that, in the future, our relationships and/or our interests in or with this equity method investee could change. Such potential future changes could result in consolidation of such entity which could result in changes in our reported results.
We May Issue Preferred Stock, And The Terms Of Such Preferred Stock May Reduce The Value Of Our Common Stock.
We are authorized to issue up to a total of 5,000,000 shares of preferred stock in one or more series. Our Board of Directors may determine whether to issue shares of preferred stock without further action by holders of our Common Stock. If we issue shares of preferred stock, it could affect the rights or reduce the value of our Common Stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with or sell our assets to a third party. These terms may include voting rights, preferences as to dividends and liquidation, conversion and redemption rights, and sinking fund provisions. If we seek capital for our business, such capital may be raised through the issuance of preferred stock.
If A Large Number Of Our Shares Are Sold All At Once Or In Blocks, The Market Price Of Our Shares Would Most Likely Decline.
Most of our shareholders are not restricted in the price at which they can sell their shares. Shares sold at a price below the current market price at which our Common Stock is trading may cause the market price of our Common Stock to decline.
The Market For Our Stock Is Subject To Rules Relating To Low-Priced Stock (“Penny Stock”) Which May Limit Our Ability To Raise Capital.
Our Common Stock is currently listed for trading in the OTCQB operated by OTC Markets, Inc. and is subject to the “penny stock rules” adopted pursuant to Section 15(g) of the Exchange Act. In general, the penny stock rules apply to non-NASDAQ or non-national stock exchange companies whose common stock trades at less than $5.00 per share or which have tangible net worth of less than $5,000,000 ($2,000,000 if the company has been operating for three or more years). Such rules require, among other things, that brokers who trade “penny stock” on behalf of persons other than “established customers” complete certain documentation, make suitability inquiries of investors and provide investors with certain information concerning trading in the security, including a risk disclosure document, quote information, broker’s commission information and rights and remedies available to investors in penny stocks. Many brokers have decided not to trade “penny stock” because of the requirements of the penny stock rules, and as a result, the number of broker-dealers willing to act as market makers in such securities is limited. The “penny stock rules,” therefore, may have an adverse impact on the market for our Common Stock and may affect our ability to raise additional capital if we decide to do so.
Our Share Price Could Decline As A Result Of Short Sales.
When an investor sells stock that he does not own, it is known as a short sale. The seller, anticipating that the price of the stock will go down, intends to buy stock to cover his sale at a later date. If the price of the stock goes down, the seller will profit to the extent of the difference between the price at which he originally sold it less his later purchase price. Short sales enable the seller to profit in a down market. Short sales could place significant downward pressure on the price of our Common Stock. Penny stocks which do not trade on an exchange, such as our Common Stock, are particularly susceptible to short sales.
Our Future Success Depends In Significant Part Upon The Continued Services Of Our Key Senior Management.
Our future success depends in significant part upon the continued services of our senior management. The competition for highly qualified personnel is intense, and we may not be able to retain our key employees or attract and retain additional highly qualified personnel in the future. None of our employees are represented by a labor union, and we consider our relations with our employees to be good. None of our employees are covered by key man life insurance policies.
ITEM 1B.
ITEM 1B. 	UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.	PROPERTIES
We currently lease 1,371 square feet of office space located at 701 Palomar Airport Road, Suite 170, Carlsbad, California. The lease expires March 31, 2016.
The current floor space provides adequate and suitable facilities for all of our corporate functions.
ITEM 3.
ITEM 3.	LEGAL PROCEEDINGS
Litigation
Patent Litigation
On February 8, 2008, we, TPL and Alliacense Ltd. were named as defendants in separate lawsuits filed in the United States District Court for the Northern District of California by HTC Corporation, and Acer, Inc., and affiliated entities of each of them. (Those cases were deemed related and are referred to herein as the “N.D. Cal. Case”). HTC and Acer sought declaratory relief that their products did not infringe enforceable claims of the '336 patent. We alleged counterclaims for patent infringement of the '336 and '890 patents as to certain of their products.
The Court issued a first claim construction ruling in the N.D. Cal. Case on June 12, 2012, which preserved our ability to proceed on our infringement claims against Acer and HTC. Thereafter, Chief District Judge James Ware retired and the N.D. Cal. Case was reassigned to Magistrate Judge Paul S. Grewal, who held a supplemental claim construction hearing on November 30, 2012. Judge Grewal then issued a supplemental claim construction ruling on December 5, 2012, which preserved our ability to proceed with our infringement claims. On September 6, 2013 Acer entered into an MMP portfolio license agreement that also provided for the dismissal of all claims in the N.D. Cal Case, as well as the filing of a joint motion to terminate Acer as a respondent in the ITC 853 Investigation (described more fully below). On September 19, 2013 the ‘890 patent was dropped from the N.D. Cal Case pursuant to stipulation by all parties. A jury trial was held in the N.D. Cal. Case against HTC, beginning on September 23, 2013. On October 3, 2013, the jury returned a verdict in favor of us and TPL, finding that HTC had infringed the ‘336 patent with damages of $958,560. HTC appealed the jury verdict and we filed cross appeals regarding the period available for infringement damages related to the ‘890 patent. On January 7, 2015, the parties filed a stipulated motion to voluntarily dismiss the HTC appeal and our cross appeals on the basis of having reached a settlement agreement. The Federal Circuit granted that motion and dismissed the appeals the same day.
On July 24, 2012 complaints were filed on behalf of us, TPL, and PDS (collectively referred to as “Plaintiffs”) against Acer, Inc., Amazon.com, Inc., Barnes & Noble, Inc., Garmin, Ltd., HTC Corporation, Huawei Technologies Co., Ltd., Kyocera Corporation, LG Electronics, Nintendo Co., Ltd., Novatel Wireless, Inc., Samsung Electronics Co., Ltd., Sierra Wireless, Ltd. and ZTE Corporation with the U.S. International Trade Commission ("ITC") (ITC Investigation No. 337-TA-853, or the “853 Investigation”) alleging infringement of the ‘336 patent. We also filed new parallel proceedings in the U.S. District Court for the Northern District of California alleging infringement of the US 5,440,749 patent (the “‘749 patent”), and the ‘890 and ‘336 patents against Amazon.com Inc., Barnes & Noble Inc., Garmin Ltd., Huawei Technologies Co. Ltd., Kyocera Corporation, LG Electronics, Nintendo Co. Ltd., Novatel Wireless Inc., Samsung Electronics Co. Ltd., Sierra Wireless Inc., and ZTE Corporation. We subsequently reached a settlement with Sierra Wireless, Inc. Trial proceedings before the ITC began on June 3, 2013 and concluded the following week. Settlements were subsequently reached with Kyocera Corporation, Amazon.com, Inc., and Acer, Inc. An Initial Determination (“ID”) was rendered on September 6, 2013 finding that none of the remaining Respondents had infringed the ‘336 patent. We filed a petition for review of the ID with the full ITC on September 23, 2013. On February 20, 2014, the ITC provided notice affirming the September 6, 2013 ID. We have chosen not to file an appeal of the ITC decision to the United States Court of Appeals for the Federal Circuit. All of the district court actions against the new parties (i.e., all respondents other than Acer and HTC) that have not previously settled and which had been stayed pending resolution of the 853 Investigation are proceeding in front of Judge Vince Chhabria, with Judge Grewal handling all pretrial matters.
On February 4, 2015 Barnes & Noble, Inc. filed a motion asserting that our cause of action on the ‘336 patent was barred by the Kessler doctrine because of the ITC’s finding of non-infringement. A hearing was held on March 17, 2015 in the U.S. District Court for the Northern District of California regarding the matter. On May 31, 2015 Judge Grewal denied this motion. Barnes & Noble asked Judge Chhabria to reconsider this ruling but on July 22, 2015, Plaintiffs and Barnes & Noble filed a notice of settlement stating that Plaintiffs and Barnes & Noble had reached a settlement in principle. This mooted a hearing in front of Judge Chhabria regarding Barnes & Noble’s motion.
On April 10, 2015 multiple defendants in the District Court action filed a motion arguing for invalidity of the ‘749 patent. A hearing was held on May 19, 2015 regarding this matter and on July 28, 2015, Judge Grewal denied this motion as moot.
On June 30, 2015 a hearing was held on Samsung and LG’s motion to strike Plaintiffs’ infringement contentions. On July 11, 2015 Judge Grewal granted in part Samsung and LG’s motion and ordered Plaintiffs to provide amended infringement contentions in accordance with the Court’s order.
On July 1, 2015 the parties in the Novatel Wireless, Inc. action filed a stipulated motion to voluntarily dismiss all claims and counterclaims on the basis of a settlement agreement having been reached. The California district court granted that motion on July 14, 2015.
On July 27, 2015 Plaintiffs and Defendants filed a stipulation whereby each party withdrew their claims regarding the ‘749 and ‘890 patents with prejudice.
On August 26, 2015 Plaintiffs and Garmin entered into a settlement and license agreement.
Alliacense Disputes
PDS and Alliacense had been involved in multiple disputes regarding amounts asserted by Alliacense as owed by PDS. The disputed amounts included sums for past services and advances. On July 24, 2014, PDS and Alliacense entered into the Novation Agreement, which included provisions for resolving all of the claims in dispute for $623,000. Of that amount, $300,000 was paid by PDS to Alliacense in November 2013, with the balance paid by PDS to Alliacense in two payments of $161,500 each on June 20, 2014 and July 25, 2014. The Novation Agreement also provided for the addition of a second licensing company, however, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company despite our repeated demands and on May 11, 2015 Alliacense was terminated by PDS.
PDS Arbitration- Independent Managing Member
In January 2014, our representative to the PDS management committee filed with the American Arbitration Association (“AAA”) a demand for arbitration pursuant to the terms of the LLC Agreement. The demand sought the appointment of a third member, referred to as the independent manager member to the PDS management committee. On December 16, 2014, the AAA appointed arbitrator selected an independent managing member from one of the nominees submitted by Patriot, thereby filling the open management committee seat.
PDS Arbitration - Alliacense Performance
In June 2015, our representative to the PDS management committee filed with the Judicial Arbitration and Mediation Services (“JAMS”) a demand for arbitration pursuant to Alliacense’s non-performance under terms of the Novation Agreement. The demand seeks a declaration of the respective rights and obligations of the parties under the Novation Agreement.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our Common Stock is currently listed for trading in the OTCQB operated by OTC Markets, Inc. under the symbol PTSC. Prices reported represent prices between dealers, do not include markups, markdowns or commissions and do not necessarily represent actual transactions. The market for our shares has been sporadic and at times very limited.
The following table sets forth the high and low closing bid quotations for our Common Stock for the fiscal years ended May 31, 2015 and 2014.
On August 24, 2015, the closing price of our stock was $0.04 per share and we had approximately 680 stockholders of record. Because most of our Common Stock is held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of beneficial owners represented by these record holders.
Dividend Policy
On February 22, 2007, our Board of Directors adopted a semi-annual dividend payment policy, subject to determination by our Board of Directors in light of our financial condition, other possible applications of our available resources, and relevant business considerations. We paid no dividends during the fiscal years ended May 31, 2015 and 2014.
Equity Compensation Plan Information
Our stockholders previously approved our 2006 Stock Option Plan. The following table sets forth certain information concerning aggregate stock options authorized for issuance under our 2006 Stock Option Plan as of May 31, 2015. For a narrative description of the material features of the plan, refer to footnote 7 of our consolidated financial statements.
Plan Category
Number of securities
to be issued
upon exercise of outstanding
options
Weighted-average
exercise price of outstanding
options
Number of securities remaining available for future issuance under equity compensation plan
Equity compensation plan approved by security holders
3,335,000
$ 0.06
6,590,000
As of May 31, 2015, there are 6,590,000 shares available for future issuance under our 2006 Stock Option Plan.
Recent Sale of Unregistered Securities
None.
Issuer Purchases of Equity Securities
None.
ITEM 6.
ITEM 6.	SELECTED FINANCIAL DATA
As a “smaller reporting company” as defined in Rule 12b-2 of the Exchange Act, we are not required to provide the information called for by this item.
ITEM 7.
ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS CONCERNING FUTURE EVENTS AND PERFORMANCE OF OUR COMPANY. YOU SHOULD NOT RELY ON THESE FORWARD-LOOKING STATEMENTS, BECAUSE THEY ARE ONLY PREDICTIONS BASED ON OUR CURRENT EXPECTATIONS AND ASSUMPTIONS. MANY FACTORS COULD CAUSE OUR ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED IN THESE FORWARD-LOOKING STATEMENTS. YOU SHOULD REVIEW CAREFULLY THE RISK FACTORS IDENTIFIED IN THIS REPORT AS SET FORTH BELOW AND UNDER THE CAPTION “RISK FACTORS.” WE DISCLAIM ANY INTENT TO UPDATE ANY FORWARD-LOOKING STATEMENTS TO REFLECT SUBSEQUENT ACTUAL EVENTS OR DEVELOPMENTS.
Overview
In June 2005, we entered into a series of agreements with TPL and others to facilitate the pursuit of unlicensed users of our intellectual property. In October 2011 we settled litigation with TPL that was initiated by us over matters related to the management of the MMP portfolio. In July 2012 we entered into additional agreements with TPL, PDS and the TPL affiliate, Alliacense, including the Licensing Program Services Agreement (the “Program Agreement”) in furtherance of the management and commercialization of the MMP portfolio. On July 24, 2014, the Program Agreement was amended with PDS and Alliacense entering into the Amended Alliacense Services and Novation Agreement (the “Novation Agreement”). The July 2012 and 2014 agreements facilitate an aggressive licensing and litigation strategy which currently includes actions in the U.S. District Court against multiple companies alleged to be infringers of the MMP portfolio. We continue to believe that the significant investment in legal effort and costs incurred to date at PDS is necessary for the protection of our interests in the MMP portfolio and its future success, although to date it has generated mixed results.
To the extent MMP portfolio license proceeds are insufficient; we expect working capital contributions may need to be made to PDS in the future. Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. To date, we have determined that it is in the best interests of the MMP licensing program that we contribute our 50% share of additional capital to PDS in the event license revenues received by PDS are insufficient.
On August 24, 2015 PDS’s cash balance was $628,528. Management’s plans for the continued operation of PDS rely on the ability of PDS to obtain license agreements to cover its operational costs. PDS has experienced a decline in licensing revenues and has not obtained significant license revenues since September 2013 and it is unclear when any additional licensing revenues may be generated.
The Novation Agreement, which amended the Program Agreement, provides for the utilization of a second licensing agent, which was engaged on October 10, 2014, in order to complement the MMP licensing commercialization, and increase the opportunity for the successful licensing of the MMP portfolio. However, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015 Alliacense was terminated by PDS. PDS has entered into arbitration with Alliacense to seek a declaration of rights and obligations of the parties under the Novation Agreement.
In January 2014, our representative to the PDS management committee filed with the American Arbitration Association (“AAA”) a demand for arbitration seeking the appointment of a third member, referred to as the independent manager member, to the PDS management committee in an effort to eliminate potential deadlock on issues important to PDS. On December 16, 2014, the AAA appointed arbitrator selected an independent managing member from one of the nominees submitted by Patriot, thereby filling the open management committee seat.
Management expects to continue to incur significant legal expenses for the continued operation of PDS. PDS has been incurring significant third-party costs for expert testimony, depositions and other related legal costs pursuant to litigation in U.S. District Court and previously actions with the ITC Investigation No. 337-TA-853 which concluded in fiscal 2014. We could be required to make capital contributions to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.
On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. A Joint Plan of Reorganization (the “Joint Plan”) between TPL and the creditor’s committee was confirmed by the Bankruptcy Court on February 11, 2015 with the entered confirmation order becoming final on April 2, 2015. The Joint Plan provides that the Effective Date, which remains pending, will be the later of (i) the first business day that is at least 30 days after the entry of the confirmation order or (ii) the first Business Day on which the reorganized company has sufficient cash to make all payments required under the Plan on the Effective Date. We have been appointed to the creditors’ committee and have been closely monitoring the progress in this matter as it relates to our interest in PDS. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.
Agility IP Law, LLP (patent litigation counsel for Phoenix Digital Solutions/Patriot for the assertion of the ‘336, ‘890 and ‘749 patents) dissolved their firm effective April 17, 2015. The attorneys at Agility who have worked on the assertion of the patents moved to other law firms, and are not able to continue to represent PDS/Patriot in the pending cases in the Northern District of California. However, PDS hired the firm of Nelson Bumgardner, P.C. to take over as lead trial counsel in the Northern California cases to continue protecting our intellectual property rights.
Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and judgments that significantly affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods. We believe the following critical accounting policies affect our most significant estimates and judgments used in the preparation of our consolidated financial statements.
1. 	Investments in Marketable Securities
We classify our investments in marketable securities in certificates of deposit at the time of purchase as held-to-maturity and reevaluate such classifications at each balance sheet date. Held-to-maturity investments consist of securities that we have the intent and ability to retain until maturity. These securities are recorded at cost and adjusted for the amortization of premiums and discounts, which approximates fair value. Cash inflows and outflows related to the sale and purchase of investments are classified as investing activities in our consolidated statements of cash flows.
2. 	Investment in Affiliated Company
We have a 50% interest in PDS. We account for our investment using the equity method of accounting since the investment provides us the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the investee and is recognized in the consolidated statements of operations in the caption “Equity in earnings (loss) of affiliated company” and also is adjusted by contributions to and distributions from PDS.
PDS, as an unconsolidated equity investee, recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. PDS may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.
At May 31, 2015, our share of loss in PDS exceeds our investment in PDS by $69,342. This amount is recorded as “Cumulative losses in excess of investment in affiliated company” on our consolidated balance sheet at May 31, 2015, due to our intent to fund the working capital requirements of PDS.
At May 31, 2015, our investment in PDS is presented as a liability pursuant to accounting principles generally accepted in the United States of America. In the event our investment in PDS was to reflect an asset balance, we would review our investment in PDS to determine whether events or changes in circumstances indicate that an asset carrying amount may not be recoverable. The primary factors we would consider in our determination are the financial condition, operating performance and near term prospects of the investee. If the decline in value is deemed to be other than temporary, we would recognize an impairment loss.
3.	Share-Based Compensation
Share-based compensation expense recognized during the period is based on the grant date fair value of the portion of share-based payment awards ultimately expected to vest during the period. As share-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeiture rates are based on historical forfeiture experience and estimated future employee forfeitures.
4.	Income Taxes
We follow authoritative guidance in accounting for uncertainties in income taxes. This authoritative guidance prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under this guidance we may only recognize tax positions that meet a “more likely than not” threshold.
We follow authoritative guidance to evaluate whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. We are assessing our deferred tax assets under more likely than not scenarios in which they may be realized through future income.
We have determined that it was more likely than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses. As a result of this determination we have placed a full valuation allowance against our deferred tax assets.
5.	Assessment of Contingent Liabilities
We are involved in various legal matters, disputes, and patent infringement claims which arise in the ordinary course of our business. We accrue for any estimated losses at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which we have recorded our estimated exposure is appropriate.
RESULTS OF OPERATIONS
Comparison of fiscal 2015 and 2014
Selling, general and administrative expenses decreased from approximately $1,660,000 for the fiscal year ended May 31, 2014 to approximately $1,438,000 for the fiscal year ended May 31, 2015. The decrease consisted primarily of approximately $163,000 in legal fees; approximately $92,000 of which was recovery of legal fees for PDS cases that were previously written off and approximately $7,000 of which was for PDS third member arbitration fees recovered. The remaining decrease is due to reductions in legal fees as PDS cases with the International Trade Commission were concluded in fiscal 2014. Other decreases consisted of approximately $19,000 in non-cash stock based compensation expense.
Our other income and expense for the fiscal years ended May 31, 2015 and 2014 included equity in the earnings (loss) of PDS of approximately $(107,000) and $105,000, respectively. Our investment in PDS is accounted for in accordance with the equity method of accounting for investments. The change in the earnings of PDS is due to the decrease in licensing revenues during fiscal 2015 as compared to the prior fiscal year.
Loss from continuing operations before income taxes of approximately $(1,550,000) for the fiscal year ended May 31, 2014 decreased to a loss from continuing operations before income taxes of approximately $(1,535,000) for the fiscal year ended May 31, 2015 primarily due to the decrease in our equity in earnings of PDS and approximately $163,000 in reimbursement of legal fees for PDS cases that were previously written off for the fiscal year ended May 31, 2015.
Provision for income taxes
During the fiscal years ended May 31, 2015 and 2014, we recorded a provision for income taxes related to federal and California taxes of approximately $1,600 and $6,000, respectively.
Results of Discontinued Operations
Comparison of fiscal 2015 and 2014
Royalty income decreased from approximately $89,000 to approximately $7,000 for the fiscal years ended May 31, 2015 and 2014, respectively. On April 30, 2015, the three year period during which PDSG earned royalties from the April 30, 2012 sale of PDSG assets expired. The fiscal year 2015 loss on sale of Vigilys amount of $(9,000) represents PDSG’s write-off of the uncollectible balance due on the sale of the Vigilys assets.
Income (loss) from discontinued operations, net
We recorded a net loss from discontinued operations for the fiscal year ended May 31, 2015 of $(1,873) and net income from discontinued operations for the fiscal year ended May 31, 2014 of $89,060.
Net loss
We recorded a net loss for the fiscal years ended May 31, 2015 and 2014 of $(1,538,028) and $(1,466,867), respectively.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Our cash, cash equivalents and short-term marketable securities balances decreased from approximately $6,418,000 as of May 31, 2014 to approximately $5,134,000 as of May 31, 2015. We also have a restricted cash balance amounting to approximately $21,000 as of May 31, 2015 and 2014. Total current assets decreased from approximately $6,700,000 as of May 31, 2014 to approximately $5,176,000 as of May 31, 2015. Total current liabilities amounted to approximately $96,000 and approximately $290,000 as of May 31, 2015 and May 31, 2014, respectively. The change in our working capital position as of May 31, 2015 as compared with May 31, 2014 results primarily from the fact that we did not receive sufficient distributions from PDS to cover our operating expenses and utilized cash on hand to pay such expenses.
Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. To date we have determined that it is in the best interests of the MMP licensing program that we provide our 50% share of capital to provide for PDS expenses including legal retainers and litigation related payments in the event license revenues received by PDS are insufficient to meet these needs. We believe it is likely that contributions to PDS to fund working capital will continue to be required.
PDS had been incurring significant third-party costs for expert testimony, depositions and other related litigation costs. We could be required to make capital contributions to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.
On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. A Joint Plan of Reorganization (the “Joint Plan”) between TPL and the creditor’s committee was confirmed by the Bankruptcy Court on February 11, 2015 with the entered confirmation order becoming final on April 2, 2015. The Joint Plan provides that the Effective Date, which remains pending, will be the later of (i) the first business day that is at least 30 days after the entry of the confirmation order or (ii) the first Business Day on which the reorganized company has sufficient cash to make all payments required under the Plan on the Effective Date. We have been appointed to the creditors’ committee and have been closely monitoring the progress in this matter as it relates to our interest in PDS. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.
Cash Flows From Operating Activities
Cash used in operating activities of continuing operations for the fiscal years ended May 31, 2015 and 2014 was approximately $1,400,000 and $1,577,000, respectively. The principal components of the current fiscal year were the net loss from continuing operations of approximately $1,536,000 and changes in accounts payable of approximately $191,000 offset by the equity in loss of affiliated company of approximately $107,000 and changes in prepaid expenses of approximately $188,000. The principal component of the prior fiscal year was the loss from continuing operations of approximately $1,556,000 and the equity in earnings of affiliated company of approximately $105,000.
Cash provided by operating activities of discontinued operations for the fiscal years ended May 31, 2015 and 2014 was approximately $56,000 and $72,000, respectively. Cash provided by discontinued operations activities relates to royalty revenue received during the periods.
Cash Flows From Investing Activities
Cash used in investing activities for the fiscal years ended May 31, 2015 and 2014 was approximately $692,000 and approximately $1,131,000, respectively. Cash activities for the current and prior fiscal years were primarily attributable to purchases and sales of marketable securities and distributions from PDS.
Cash Flows From Financing Activities
Cash used in financing activities for the fiscal year ended May 31, 2014 was approximately $221,000 which was used to purchase our common stock for treasury.
Capital Resources
Our current liquid cash resources as of May 31, 2015, are expected to provide the funds necessary to support our operations through at least the next twelve months. The cash flows from our interest in PDS represent our primary significant source of cash generation. In the event of a continued decrease or interruption in MMP portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash, cash equivalents and short-term investment position of $5,134,466 at May 31, 2015.
RECENT ACCOUNTING PRONOUNCEMENTS
In August 2014, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) No. 2014-15, "Presentation of Financial Statements - Going Concern." ASU 2014-15 provides guidance in generally accepted accounting principles about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. ASU 2014-15 is effective for annual reporting periods ending after December 15, 2016 and for annual periods and interim periods thereafter (fiscal year 2017 for the Company). Early adoption is permitted. We have not yet determined the potential effects of the adoption of ASU 2014-15 on our consolidated financial statements.
ITEM 7A.
ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a “smaller reporting company” as defined in Rule 12b-2 of the Exchange Act, we are not required to provide the information called for by this item.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data required by this item are included in Part IV, Item 15 of this Report and begin on page with the index to consolidated financial statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.	CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Interim Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) of the Exchange Act, as of the end of the period covered by this report. Based on this evaluation, our Interim Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and is accumulated and communicated to our management, including our Interim Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Management’s Report on Internal Control Over Financial Reporting
Our 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). Under the supervision and with the participation of our management, including our Interim Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of May 31, 2015 based on the criteria set forth in Internal Control - Integrated Framework - 2013 update issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of May 31, 2015.
This Annual Report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by our independent registered public accounting firm pursuant to the rules of the SEC that permit us to provide only management's report in this Annual Report.
Changes in Internal Controls over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the fourth fiscal quarter ended May 31, 2015, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Inherent Limitations on Internal Control
A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
In addition, projections of any evaluation of effectiveness to future periods are subject to risks that controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Director Qualifications - We believe that individuals who serve on our Board should possess the requisite education and experience to make a significant contribution to the Board and bring a range of skills, diverse perspectives and backgrounds to its deliberations; and should have the highest ethical standards, a strong sense of professionalism and dedication to serving the interests of our stockholders. The following are qualifications, experience and skills for Board members which are important to our business:
·Leadership Experience - We seek directors who demonstrate extraordinary leadership qualities. Strong leaders bring vision, diverse perspectives, and broad business insight to the company. They demonstrate practical management experience, skills for managing change, and knowledge of industries, geographies and risk management strategies relevant to the company.
·Finance Experience - We believe that all directors should possess an understanding of finance and related reporting processes. We also seek directors who qualify as “audit committee financial experts” as defined in rules of the SEC for service on the Audit Committee.
·Industry Experience - We seek directors who have relevant industry experience including: existing and new technologies, new or expanding businesses and a deep understanding of the Company’s business environments.
The following table and biographical summaries set forth information, including principal occupation, business experience, other directorships and director qualifications concerning the members of our Board of Directors and our executive officer as of May 31, 2015. There is no blood or other familial relationship between or among our directors or executive officer.
CARLTON M. JOHNSON, JR. Carlton Johnson has served as a director of the Company since 2001, and is Chairman of the Executive Committee of the Board of Directors. From June 1996 through March 2013, Mr. Johnson served as in-house legal counsel for Roswell Capital Partners, LLC and related entities. Mr. Johnson has been admitted to the practice of law in Alabama since 1986, Florida since 1988 and Georgia since 1997. He has been a shareholder in the Pensacola, Florida AV- rated law firm of Smith, Sauer, DeMaria Johnson and was President-Elect of the 500 member Escambia-Santa Rosa Bar Association. He also served on the Florida Bar Young Lawyers Division Board of Governors. Mr. Johnson earned a degree in History/Political Science at Auburn University and a Juris Doctor at Samford University - Cumberland School of Law. Since 1999, Mr. Johnson has served on the board of directors of Peregrine Pharmaceuticals, Inc., a publicly held emerging bio-tech company, and currently serves as chairman of Peregrine’s board of directors. Mr. Johnson serves as chairman of Peregrine’s audit committee and is a member of Peregrine’s compensation and nominating committees. From May 2009 to March 2012, Mr. Johnson served on the board of directors of Cryoport, Inc. a publicly held company providing cost-efficient frozen shipping to biopharmaceutical and biotechnology industries. Mr. Johnson served as chairman of Cryoport’s compensation committee and as a member of its audit committee and nomination and governance committee. From November 2009 to December 2011, Mr. Johnson served on the board of directors of ECOtality, Inc. a leader in clean electric transportation and storage technologies. Mr. Johnson served on the audit committee and nominating committee of ECOtality.
The Board of Directors concluded that Mr. Johnson should serve as a director in light of the extensive public company finance and corporate governance experience that he has obtained through serving on the boards and audit committees of Peregrine Pharmaceuticals, Inc., Cryoport, Inc., and ECOtality, Inc.
GLORIA H. FELCYN. Gloria Felcyn has served as a director of the Company since October, 2002 and is the Chairman of the Audit Committee of the Board of Directors. Since 1982, Ms. Felcyn has been the principal in her own certified public accounting firm, during which time she represented Helmut Falk Sr. and nanoTronics, along with other major individual and corporate clients in Silicon Valley. Following Mr. Falk’s death, Ms. Felcyn represented his estate and family trust as Executrix and Trustee of the Falk Estate and The Falk Trust. Prior to establishing her firm, Ms. Felcyn worked for the national accounting firm of Hurdman and Cranston from 1969 through 1970 and Price Waterhouse & Co. in San Francisco and New York City from 1970 through 1976, during which period, she represented major Fortune 500 companies. Subsequent to that, Ms. Felcyn worked in the field of international tax planning with a major real estate syndication company in Los Angeles until 1982 when she decided to start her own practice in Northern California. A major portion of Ms. Felcyn’s current practice is “Forensic Accounting”, which involves valuation of business entities and investigation of assets. Ms. Felcyn has published tax articles for “The Tax Advisor” and co-authored a book published in 1982, “International Tax Planning”. Ms. Felcyn has a degree in Business Economics from Trinity University and is a member of the American Institute of CPAs.
The Board of Directors concluded that Ms. Felcyn should serve as a director and the chairperson of the Audit Committee in light of the extensive financial and accounting experience that she has obtained over her career.
CLIFFORD L. FLOWERS. Cliff Flowers became our Chief Financial Officer and Secretary on September 17, 2007. On October 5, 2009 Mr. Flowers was named Interim CEO and was elected a director of the Company on January 19, 2011. From May 2007 to September 17, 2007, Mr. Flowers was the interim CFO for BakBone Software Inc., working as a consultant on behalf of Resources Global Professionals, Inc. From June 2004 through December 2006, Mr. Flowers was the senior vice president of finance and operations and CFO for Financial Profiles, Inc. a developer and marketer of software for the financial planning industry. Prior to joining Financial Profiles, Mr. Flowers served as CFO of Xifin, Inc., a provider of hosted software services to the commercial laboratory marketplace. Prior to Xifin, Mr. Flowers served for nine years in positions of increasing responsibility at Previo, Inc., a developer and marketer of various PC and server-based products, including back up and business continuity offerings. As CFO of Previo, Mr. Flowers’ global responsibilities included all financial operations and legal affairs. He earlier served as an audit manager with Price Waterhouse, LLP. Mr. Flowers is a graduate of San Diego State University with a B.S. summa cum laude in Business Administration with an emphasis in accounting.
The Board of Directors concluded that Mr. Flowers should serve as a director due to his leadership and financial experience combined with the perspective and experience he brings as our current Chief Financial Officer and interim Chief Executive Officer.
Board Leadership Structure
Our bylaws provide that the Chairman of the Board shall preside over all meetings of the Board of Directors. Our bylaws also state that the Chairman of the Board shall serve as the Chief Executive Officer unless determined otherwise by our Board. Since October 5, 2009 our Chief Financial Officer has served as our interim CEO and our Board has not appointed a Chairman of the Board. During meetings of our Board of Directors, Mr. Johnson, an independent director, acts as Chairman of the Board.
Our independent directors meet in executive sessions without management present to evaluate whether management is performing its responsibilities in a manner consistent with the direction of the Board. Additionally, all Board committee members are independent directors. The committee chairs have authority to hold executive sessions without management present. The Board has determined that its current structure is in the best interests of the Company and its stockholders. We believe the independent nature of the Audit Committee and the Compensation Committee as well as the practice of regular meetings of the independent directors in executive session without Mr. Flowers present ensures that the Board maintains a level of independent oversight of management that is appropriate for the Company.
Board Risk Oversight
Our Board oversees and maintains our governance and compliance processes and procedures to promote the conduct of our business in accordance with applicable laws and regulations and with the highest standards of responsibility, ethics and integrity. As part of its oversight responsibility, our Board is responsible for the oversight of risks facing the Company and seeks to provide guidance with respect to the management and mitigation of those risks. Our board also delegates specific areas of risk to the Audit Committee which is responsible for the oversight of risk policies and processes relating to our financial statements and financial reporting processes. The Audit Committee reviews and discusses with management and the independent auditors significant risks and exposures to the Company and steps management has taken or plans to take to minimize or manage such risks. The Audit Committee meets in executive session with our Chief Financial Officer and our independent auditor at each regular meeting of the Audit Committee.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires our directors, executive officers and persons who beneficially own 10% or more of a class of securities registered under Section 12 of the Exchange Act to file reports of beneficial ownership and changes in beneficial ownership with SEC. Directors, executive officers and greater than 10% stockholders are required by the rules and regulations of the SEC to furnish us with copies of all reports filed by them in compliance with Section 16(a).
Based solely on our review of the copies of such forms received by us, or written representations from reporting persons, we believe that our insiders complied with all applicable Section 16(a) filing requirements during fiscal year 2015.
Code of Ethics
We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. Our Code of Ethics is available on our website at www.ptsc.com under the link “Investors” and “Management Team”.
Audit Committee
We have an audit committee established in accordance with Section 3(a)(58)(A) of the Exchange Act, currently comprised of: Gloria H. Felcyn (Committee Chair) and Carlton M. Johnson, Jr. Each member of our Audit Committee (the “Audit Committee”) is independent as defined under the applicable rules of the SEC and NASDAQ Stock Market LLC (“NASDAQ”) listing standards. The Board of Directors has determined that Gloria H. Felcyn, who serves on the Audit Committee, is an “audit committee financial expert” as defined in applicable SEC rules.
Director Legal Proceedings
During the past ten years, no director, executive officer or nominee for our Board of Directors has been involved in any legal proceedings that are material to an evaluation of their ability or integrity to become our director or executive officer.
ITEM 11.
ITEM 11.	EXECUTIVE COMPENSATION
The following table summarizes the compensation of the named executive officers for the fiscal years ended May 31, 2015 and 2014. For fiscal 2015 and 2014, the named executive officers are our Interim Chief Executive Officer and our Chief Financial Officer.
Summary Compensation Table
For Fiscal Years Ended May 31, 2015 and
1. Represents the aggregate grant date fair value of grants awarded in fiscal 2015 and 2014 computed in accordance with authoritative guidance issued by the Financial Accounting Standards Board.
2. See the All Other Compensation Table below for details of the total amounts represented.
All Other Compensation Table
For Fiscal Years Ended May 31, 2015 and
The following table shows the number of shares covered by exercisable and un-exercisable options held by our named executive officers as of May 31, 2015.
Outstanding Equity Awards
As of May 31, 2015
Employment Contracts
In connection with Mr. Flowers’ appointment as Chief Financial Officer on September 17, 2007, we entered into an Employment Agreement (the “Flowers Agreement”) with Mr. Flowers for an initial 120-day term if not terminated pursuant to the Flowers Agreement, with an extension period of one year and on a day-to-day basis thereafter. Pursuant to the Flowers Agreement, Mr. Flowers’ initial base salary was $225,000 per year and he is eligible to receive an annual merit bonus of up to 50% of his base salary, as determined in the sole discretion of the Board of Directors. Effective October 1, 2008, October 5, 2009 and December 15, 2011, Mr. Flowers’ base salary was increased to $231,750, $291,750 and $327,750, respectively. Also pursuant to the Flowers Agreement and on the date of the Flowers Agreement, Mr. Flowers received a fully vested grant of non-qualified stock options to purchase 150,000 shares of our Common Stock and a grant of non-qualified stock options to purchase 600,000 shares of our Common Stock vesting over four years. Mr. Flowers’ right to exercise the foregoing stock options became fully vested on October 9, 2009, in connection with his appointment as Interim CEO. The Flowers Agreement also provides for Mr. Flowers to receive customary employee benefits, including health, life and disability insurance.
Pursuant to the Flowers Agreement, if Mr. Flowers is terminated without cause or resigns with good reason any time after two years of continuous employment, he is entitled to receive an amount equal to 12 months of his annual base salary. Mr. Flowers is also entitled to certain payments upon a change of control of the Company if the surviving corporation does not retain him. All such payments are conditional upon the execution of a general release.
Director Compensation
As described more fully below, this table summarizes the annual cash compensation for our non-employee directors during the fiscal year ended May 31, 2015.
Director Compensation
For Fiscal Year Ended May 31, 2015
1. Consists of $28,800 board fee, $36,000 Phoenix Digital Solutions, LLC management committee fee, $28,800 Compensation Committee Chair fee and $28,800 Executive Committee Chair fee.
2. Consists of $28,800 board fee and $67,200 Audit Committee Chair fee.
3. Represents the aggregate grant date fair value of grants awarded in fiscal 2015 computed in accordance with authoritative guidance issued by the Financial Accounting Standards Board.
Director Outstanding Equity Awards
As of May 31, 2015
Directors who are not our employees are compensated for their service as a director as shown in the table below:
Schedule of Director Fees
May 31, 2015
All retainers are paid in monthly installments.
Other
We reimburse all directors for travel and other necessary business expenses incurred in the performance of their services for us.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth, as of August 24, 2015, the stock ownership of each of our officers and directors, of all our officers and directors as a group, and of each person known to us to be a beneficial owner of 5% or more of our Common Stock. The number of shares of Common Stock outstanding as of August 24, 2015, was 401,392,948. Except as otherwise noted, each person listed below is the sole beneficial owner of the shares and has sole investment and voting power over such shares. Each individual’s address is 701 Palomar Airport Road, Suite 170, Carlsbad, California 92011-1045.
*Less than 1%
(1) Includes 800,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 24, 2015.
(2) Includes 800,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 24, 2015.
(3) Includes 700,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 24, 2015.
(4) Includes 2,300,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 24, 2015.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Transactions With Directors, Executive Officers and Principal Stockholders
There were no transactions, or series of transactions during the fiscal years ended May 31, 2015 or 2014, nor are there any currently proposed transactions, or series of transactions, to which we are a party, in which the amount exceeds $120,000, and in which to our knowledge any director, executive officer, nominee, five percent or greater stockholder, or any member of the immediate family of any of the foregoing persons, has or will have any direct or indirect material interest other than as described below.
Director Independence
Our Board of Directors has determined that a majority of the members of, and nominees to, our Board of Directors qualify as “independent,” as defined by the listing standards of NASDAQ. Consistent with these considerations, after review of all relevant transactions and relationships between each director and nominee, or any of his or her family members, and us, our senior executive management and our independent auditors, the Board of Directors has determined further that all of our directors and nominees are independent under the listing standards of NASDAQ. In making this determination, the Board of Directors considered that there were no new transactions or relationships between its current independent directors and the Company, its senior management and its independent auditors since last making this determination. Each member of our Audit Committee, and each member of the Compensation Committee of our Board of Directors, is independent as defined by the listing standards of NASDAQ.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Pursuant to the Policy on Engagement of Independent Auditor, the Audit Committee is directly responsible for the appointment, compensation and oversight of the independent auditor. The Audit Committee pre-approves all audit services and non-audit services to be provided by the independent auditor and has approved 100% of the audit, audit-related and tax fees listed below. The Audit Committee may delegate to one or more of its members the authority to grant the required approvals, provided that any exercise of such authority is presented at the next Audit Committee meeting for ratification.
Each audit, non-audit and tax service that is approved by the Audit Committee will be reflected in a written engagement letter or writing specifying the services to be performed and the cost of such services, which will be signed by either a member of the Audit Committee or by one of our officers authorized by the Audit Committee to sign on our behalf.
The Audit Committee will not approve any prohibited non-audit service or any non-audit service that individually or in the aggregate may impair, in the Audit Committee’s opinion, the independence of the independent auditor.
In addition, our independent auditor may not provide any services to our officers or Audit Committee members, including financial counseling or tax services.
Audit Fees
During the fiscal years ended May 31, 2015 and 2014, the aggregate fees billed by our principal accountants for professional services rendered for the audit of our annual consolidated financial statements, and reviews of quarterly consolidated financial statements included in our reports on Form 10-Q, and audit services provided in connection with other statutory or regulatory filings were $91,850 and $103,400, respectively.
Audit-Related Fees
None.
Tax Fees
During the fiscal years ended May 31, 2015 and 2014, the aggregate fees billed by our principal accountants for tax compliance, tax advice and tax planning rendered on our behalf were $12,525 and $12,200, respectively, which are related to the preparation of federal and state income tax returns.
All Other Fees
Our principal accountants billed no other fees for the fiscal years ended May 31, 2015 and 2014, except as disclosed above.
PART IV
ITEM 15.
ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)The following documents are filed as a part of this report:
1.Financial Statements. The following consolidated financial statements and Report of Independent Registered Public Accounting Firm are included starting on page of this Report:
Patriot Scientific Corporation
Report of KMJ Corbin & Company LLP, Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of May 31, 2015 and 2014
Consolidated Statements of Operations for the Years Ended May 31, 2015 and 2014
Consolidated Statements of Stockholders’ Equity for the Years Ended May 31, 2015 and 2014
Consolidated Statements of Cash Flows for the Years Ended May 31, 2015 and 2014
Notes to Consolidated Financial Statements
Phoenix Digital Solutions, LLC
Report of KMJ Corbin & Company LLP, Independent Registered Public Accounting Firm
Balance Sheets as of May 31, 2015 and 2014
Statements of Operations for the Years Ended May 31, 2015 and 2014
Statements of Members’ Equity (Deficit) for the Years Ended May 31, 2015 and 2014
Statements of Cash Flows for the Years Ended May 31, 2015 and 2014
Notes to Financial Statements
2. Financial Statement Schedules. All financial statement schedules have been omitted since the information is either not applicable or required or is included in the consolidated financial statements or notes thereof.
3. Exhibits. Those exhibits marked with a (*) refer to exhibits filed herewith. The other exhibits are incorporated herein by reference, as indicated in the following list. Those exhibits marked with a (†) refer to management contracts or compensatory plans or arrangements.
Exhibit No.
Document
2.1
Agreement and Plan of Merger dated August 4, 2008, among the Company, PTSC Acquisition 1 Corp, Crossflo Systems, Inc. and the Crossflo principal officers, incorporated by reference to Exhibit 99.1 to Form 8-K filed August 11, 2008 (Commission file No. 000-22182)
3.1
Original Articles of incorporation of the Company’s predecessor, Patriot Financial Corporation, incorporated by reference to Exhibit 3.1 to registration statement on Form S-18, (Commission file No. 33-23143-FW)
3.2
Articles of Amendment of Patriot Financial Corporation, as filed with the Colorado Secretary of State on July 21, 1988, incorporated by reference to Exhibit 3.2 to registration statement on Form S-18, (Commission file No. 33-23143-FW)
3.3
Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on March 24, 1992, incorporated by reference to Exhibit 3.3 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.3.1
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on April 18, 1995, incorporated by reference to Exhibit 3.3.1 to Form 10-KSB for the fiscal year ended May 31, 1995 (Commission file No. 000-22182)
3.3.2
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on June 24, 1997, incorporated by reference to Exhibit 3.3.2 to Form 10-KSB for the fiscal year ended May 31, 1997, filed July 18, 1997 (Commission file No. 000-22182)
3.3.3
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on April 28, 2000, incorporated by reference to Exhibit 3.3.3 to Registration Statement on Form S-3 filed May 5, 2000 (Commission file No. 333-36418)
3.3.4
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on May 6, 2002, incorporated by reference to Exhibit 3.3.4 to Form 10-Q for the quarterly period ended February 28, 2009, filed April 9, 2009 (Commission file No. 000-22182)
3.3.5
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on October 16, 2003, incorporated by reference to Exhibit 3.3.5 to Registration Statement on Form SB-2 filed May 21, 2004 (Commission file No. 333-115752)
3.3.6
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on April 29, 2005, incorporated by reference to Exhibit 3.3.6 to Form 10-Q for the quarterly period ended February 28, 2009, filed April 9, 2009 (Commission file No. 000-22182)
3.3.7
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on November 14, 2005, incorporated by reference to Exhibit 3.3.7 to Form 10-Q for the quarterly period ended February 28, 2009, filed April 9, 2009 (Commission file No. 000-22182)
3.3.8
Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on March 18, 2009, incorporated by reference to Exhibit 3.3.8 to Form 10-K for the fiscal year ended May 31, 2009, filed August 14, 2009 (Commission file No. 000-22182)
3.4
Articles and Certificate of Merger of Patriot Financial Corporation into the Company dated May 1, 1992, with Agreement and Plan of Merger attached thereto as Exhibit A, incorporated by reference to Exhibit 3.4 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.5
Certificate of Merger issued by the Delaware Secretary of State on May 8, 1992, incorporated by reference to Exhibit 3.5 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.6
Certificate of Merger issued by the Colorado Secretary of State on May 12, 1992, incorporated by reference to Exhibit 3.6 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.7
Bylaws of the Company, incorporated by reference to Exhibit 3.7 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.7.1
Amendment to bylaws of the Company, incorporated by reference to Exhibit 3.7.1 to our Current Report on Form 8-K dated November 4, 2010 (Commission file No. 000-22182)
4.1
Specimen common stock certificate, incorporated by reference to Exhibit 4.1 Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
4.2†
2006 Stock Option Plan of the Company as amended and restated, incorporated by reference to Appendix C to the Company Proxy Statement filed September 22, 2008 (Commission file No. 000-22182)
10.1
Master Agreement, dated as of June 7, 2005, by and among the Company, Technology Properties Limited Inc., a California corporation and Charles H. Moore, an individual, incorporated by reference to Exhibit 10.40 to Form 8-K filed June 15, 2005 (Commission file No. 000-22182)
10.2
Commercialization Agreement dated as of June 7, 2005 by and among the JV LLC, Technology Properties Limited Inc., a California corporation, and the Company, incorporated by reference to Exhibit 10.41 to Form 8-K filed June 15, 2005 (Commission file No. 000-22182)
10.3
Limited Liability Company Operating Agreement of JV LLC, a Delaware limited liability company, dated as of June 7, 2005, incorporated by reference to Exhibit 10.42 to Form 8-K filed June 15, 2005 (Commission file No. 000-22182)
10.4†
Employment Agreement dated September 17, 2007 by and between the Company and Clifford L. Flowers, incorporated by reference to Exhibit 10.1 to Form 8-K filed September 19, 2007 (Commission file No. 000-22182)
10.5
Form of Indemnification Agreement by and between the Company and the Board of Directors, incorporated by reference to Exhibit 10.6 to Form 10-K filed August 29, 2011 (Commission file No. 000-22182)
10.6
Licensing Program Services Agreement effective July 11, 2012 among Phoenix Digital Solutions, LLC, Alliacense Limited, LLC, Technology Properties Limited, LLC and the Company, incorporated by reference to Exhibit 10.7 to Form 8-K filed July 17, 2012 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)
10.7
Agreement effective July 11, 2012 between Technology Properties Limited, LLC and the Company, incorporated by reference to Exhibit 10.8 to Form 8-K filed July 17, 2012 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)
10.8
Agreement effective July 17, 2012 among Phoenix Digital Solutions, LLC, Alliacense Limited, LLC, Technology Properties Limited, LLC and the Company, incorporated by reference to Exhibit 10.9 to Form 8-K filed July 17, 2012 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)
10.9
Agreement effective July 24, 2014 among Phoenix Digital Solutions, LLC and Alliacense Limited, LLC, incorporated by reference to Exhibit 10.10 to Form 8-K filed July 30, 2014 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)
10.10
Letter agreement dated October 10, 2014 between Phoenix Digital Solutions, LLC and Dominion Harbor Group, LLC, incorporated by reference to Exhibit 10.10 to Form 10-Q filed April 14, 2015 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)
14.1
Code of Ethics for Senior Financial Officers incorporated by reference to Exhibit 14.1 to Form 10-K for the fiscal year ended May 31, 2003, filed August 29, 2003 (Commission file No. 000-22182)
21*
List of subsidiaries of the Company
23.1*
Consent of Independent Registered Public Accounting Firm
31.1*
Certification of Clifford L. Flowers, Interim CEO, pursuant to Rule 13a-15(e) or Rule 15d-15(e)
31.2*
Certification of Clifford L. Flowers, CFO, pursuant to Rule 13a-15(e) or Rule 15d-15(e)
32.1*
Certification of Clifford L. Flowers, Interim CEO and CFO, pursuant to 18 U.S.C. Section 1350
99.1
Form of Incentive Stock Option Agreement to the Company’s 2006 Stock Option Plan incorporated by reference to Exhibit 99.10 on Form 10-K for the fiscal year ended May 31, 2009, filed August 14, 2009 (Commission file No. 000-22182)
99.2
Form of Non-Qualified Stock Option Agreement to the Company’s 2006 Stock Option Plan incorporated by reference to Exhibit 99.11 on Form 10-K for the fiscal year ended May 31, 2009, filed August 14, 2009 (Commission file No. 000-22182)
101.INS** XBRL Instance Document
101.SCH** XBRL Schema Document
101.CAL** XBRL Calculation Linkbase Document
101.DEF** XBRL Definition Linkbase Document
101.LAB** XBRL Label Linkbase Document
101.PRE** XBRL Presentation Linkbase Document
** Pursuant to Rule 406T of Regulation S-T, these interactive data files are not deemed filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act or Section 18 of the Securities Exchange Act and otherwise not subject to liability
Patriot Scientific Corporation
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Board of Directors
Patriot Scientific Corporation
We have audited the accompanying consolidated balance sheets of Patriot Scientific Corporation and subsidiaries (the “Company”) as of May 31, 2015 and 2014, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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 audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit on its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Patriot Scientific Corporation and subsidiaries as of May 31, 2015 and 2014, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ KMJ Corbin & Company LLP
Costa Mesa, California
August 31, 2015
Patriot Scientific Corporation
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements
Patriot Scientific Corporation
Consolidated Statements of Operations
See accompanying notes to consolidated financial statements.
Patriot Scientific Corporation
Consolidated Statements of Stockholders’ Equity
See accompanying notes to consolidated financial statements.
Patriot Scientific Corporation
Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements
1. Organization and Business
Patriot Scientific Corporation (the “Company”, “PTSC”, “we”, “us”, or “our”), was organized under Delaware law on March 24, 1992 and is the successor by merger to Patriot Financial Corporation, a Colorado corporation, incorporated on June 10, 1987. In June 2005, we entered into a joint venture agreement with Technology Properties Limited, Inc. (“TPL”) to form Phoenix Digital Solutions, LLC (“PDS”). In September 2008, we acquired Patriot Data Solutions Group, Inc. formerly known as Crossflo Systems, Inc. (“PDSG”) which engaged in data-sharing services and products primarily in the public safety/government sector. In January 2010, we sold the assets of Verras Medical, Inc. and in August 2010 we sold the Vigilys business line both formerly associated with PDSG. During April 2012, we sold substantially all of the assets of PDSG.
Through our joint venture PDS we pursue the commercialization of our patented microprocessor technologies through broad and open licensing and by litigating against those who may be infringing on our patents.
Liquidity and Management’s Plans
Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. To date, we have determined that it is in the best interests of the Moore Microprocessor Patent (“MMP”) licensing program that we provide our 50% share of capital to provide for PDS expenses including legal retainers and litigation related payments in the event license revenues received by PDS are insufficient to meet these needs. We believe it is likely that contributions to PDS to fund working capital will continue to be required.
PDS had been incurring significant third-party costs for expert testimony, depositions and other related litigation costs. We could be required to make capital contributions to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.
Our current liquid cash resources as of May 31, 2015, are expected to provide the funds necessary to support our operations through at least the next twelve months. The cash flows from our interest in PDS represent our only significant source of cash generation. In the event of a continued decrease or interruption in MMP portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and cash equivalents and short-term investment position of $5,134,466 at May 31, 2015.
On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. We have been appointed to the creditors’ committee and have been closely monitoring the progress in this matter as it relates to our interest in PDS. A Joint Plan of Reorganization (the “Joint Plan”) between TPL and the creditor’s committee was confirmed by the Bankruptcy Court on February 11, 2015 with the entered confirmation order becoming final on April 2, 2015. The Joint Plan provides that the Effective Date, which remains pending, will be the later of (i) the first business day that is at least 30 days after the entry of the confirmation order or (ii) the first Business Day on which the reorganized TPL has sufficient cash to make all payments required under the Plan on the Effective Date. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
2. Summary of Significant Accounting Policies
Basis of Consolidation
The consolidated balance sheets at May 31, 2015 and 2014 and consolidated statements of operations for the fiscal years ended May 31, 2015 and 2014 includes our accounts and those of our wholly owned subsidiary PDSG which includes Crossflo Systems, Inc. (“Crossflo”), and our inactive subsidiary Plasma Scientific Corporation. All significant intercompany accounts and transactions have been eliminated.
PDSG is being presented as discontinued operations in the consolidated statements of operations for all periods presented. See “Discontinued Operations” below for additional information.
Discontinued Operations
On February 17, 2012 our board of directors authorized management to sell the assets of PDSG due to the inability of PDSG to meet its business plan and continuing projected negative cash flows. In accordance with authoritative guidance we have classified the assets, liabilities, operations and cash flows of PDSG as discontinued operations for all periods presented. During March 2012, we entered into an interim agreement with the purchaser of the assets of PDSG which required the purchaser to pay PDSG $93,450 to subsidize the April 2012 expenses of PDSG during the sale transaction negotiations. On April 30, 2012, we negotiated a sale transaction in which we sold substantially all of the assets of PDSG in exchange for a royalty on PDSG revenues for a period of three years. From April 30, 2012 to May 31, 2015, the gain on the asset sale of PDSG is approximately $101,000.
Summarized operating results of discontinued operations for the fiscal years ended May 31, 2015 and 2014 are as follows:
PDSG activity for the fiscal year ended May 31, 2015 and 2014 consists of PDSG royalty revenues of $7,127 and $89,060, respectively. Additional activity for the fiscal year ended May 31, 2015 includes a $9,000 write-off of the receivable due to PDSG on the balance of the sale of Vigilys assets.
The following table summarizes the carrying amount of the major classes of assets and liabilities of PDSG classified as discontinued operations at May 31, 2015 and May 31, 2014:
Financial Instruments and Concentrations of Credit Risk
Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, cash equivalents, and investments in marketable securities.
We invest our cash and cash equivalents primarily in money market mutual funds and certificates of deposit. Cash and cash equivalents are maintained with high quality financial institutions, the composition and maturities of which are regularly monitored by management. At times, deposits held with financial institutions may exceed the amount of insurance provided by the Federal Deposit Insurance Corporation and the Securities Investor Protection Corporation. We perform ongoing evaluations of these financial institutions to limit our concentration of risk exposure.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Fair Value of Financial Instruments
Our financial instruments consist principally of cash and cash equivalents, investments in marketable securities, accounts payable and accrued expenses and other. The carrying value of these financial instruments approximates fair value because of the immediate or short-term maturity of the instruments. The fair value of our cash equivalents is determined based on quoted prices in active markets for identical assets or Level 1 inputs. The fair value of our investments in marketable securities is determined based on quoted prices in non-active markets for identical assets or Level 2 inputs. We believe that the carrying values of all other financial instruments approximate their current fair values due to their nature and respective durations.
Cash Equivalents, Restricted Cash, and Short-Term Marketable Securities
We consider all highly liquid investments acquired with a maturity of three months or less to be cash equivalents.
Restricted cash and cash equivalents at May 31, 2015 and 2014 consist of a savings account held as collateral for our corporate credit card account.
At May 31, 2015 and 2014 our short-term marketable securities in the amount of $2,455,106 and $1,701,647 consist of certificates of deposit with various financial institutions, with maturity dates of twelve months or less.
Investments in Marketable Securities
We determine the appropriate classification of our investments at the time of purchase and reevaluate such designation at each balance sheet date. Our investments in marketable securities have been classified and accounted for as held-to-maturity based on management’s investment intentions relating to these securities. Held-to-maturity marketable securities are stated at amortized cost. Unrealized gains and losses, net of deferred taxes, are recorded as a component of other comprehensive income (loss). We follow the authoritative guidance to assess whether our investments with unrealized loss positions are other than temporarily impaired. Realized gains and losses and declines in fair value judged to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the consolidated statements of operations.
Property, Equipment and Depreciation
Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to five years. Major betterments and renewals are capitalized, while routine repairs and maintenance are charged to expense when incurred.
Investment in Affiliated Company
We have a 50% interest in PDS. We account for our investment using the equity method of accounting since the investment provides us the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the investee and is recognized in the consolidated statements of operations in the caption “Equity in earnings (loss) of affiliated company” and also is adjusted by contributions to and distributions from PDS.
PDS, as an unconsolidated equity investee, recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. PDS may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Investment in Affiliated Company (continued)
At May 31, 2015, our share of loss in PDS exceeds our investment in PDS by $69,342. This amount is recorded as “Cumulative losses in excess of investment in affiliated company” on our consolidated balance sheet at May 31, 2015, due to our intent to fund the working capital requirements of PDS.
At May 31, 2015, our investment in PDS is presented as a liability pursuant to accounting principles generally accepted in the United States of America. In the event our investment in PDS was to reflect an asset balance, we would review our investment in PDS to determine whether events or changes in circumstances indicate that an asset carrying amount may not be recoverable. The primary factors we would consider in our determination are the financial condition, operating performance and near term prospects of the investee. If the decline in value is deemed to be other than temporary, we would recognize an impairment loss.
Treasury Stock
We account for treasury stock under the cost method and include treasury stock as a component of stockholders’ equity.
Income Taxes
We follow authoritative guidance in accounting for uncertainties in income taxes. This authoritative guidance prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under this guidance we may only recognize tax positions that meet a “more likely than not” threshold.
We follow authoritative guidance to evaluate whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. We assess our deferred tax assets annually under more likely than not scenarios in which they may be realized through future income.
We have determined that it was more likely than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses. As a result of this determination we have placed a full valuation allowance against our deferred tax assets.
We follow authoritative guidance to adjust our effective tax rate each quarter to be consistent with the estimated annual effective tax rate. We are also required to record the tax impact of certain discrete items, unusual or infrequently occurring, including changes in judgment about valuation allowances and effects of changes in tax laws or rates, in the interim period in which they occur. In addition, jurisdictions with a projected loss for the year or a year-to-date loss where no tax benefit can be recognized are excluded from the estimated annual effective tax rate. The impact of such an exclusion could result in a higher or lower effective tax rate during a particular quarter, based upon the mix and timing of actual earnings or losses versus annual projections.
Assessment of Contingent Liabilities
We are involved in various legal matters, disputes, and patent infringement claims which arise in the ordinary course of our business. We accrue for any estimated losses at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which we have recorded our estimated exposure is appropriate.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Earnings (Loss) Per Share
Basic earnings per share for continuing and discontinued operations includes no dilution and is computed by dividing earnings available to common stockholders by the weighted average number of common shares outstanding for the period.
Diluted earnings per share for continuing and discontinued operations reflect the potential dilution of securities that could share in the earnings of an entity.
For the fiscal years ended May 31, 2015 and 2014 potential common shares of 3,335,000 and 1,335,000, respectively, related to our outstanding options were not included in the calculation of diluted loss per share for continuing and discontinued operations as we recorded a loss. Had we reported net income for the years ended May 31, 2015 and 2014 2,000,000 and no additional shares, respectively, of common stock would have been included in the calculation of diluted income per share for continuing and discontinued operations. For the fiscal years ended May 31, 2015 and 2014, we excluded the PDSG escrow shares of 2,844,630 in the calculation of diluted loss per share for continuing and discontinued operations as we recorded a loss.
In connection with our acquisition of Crossflo, which became a part of PDSG, we issued escrow shares that are contingent upon certain representations and warranties made by Crossflo at the time of the merger agreement (see Note 9). We exclude these escrow shares from the basic income (loss) per share calculations and include the escrowed shares in the diluted income per share calculations.
Use of Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities in the consolidated financial statements and accompanying footnotes. Actual results could differ from those estimates. On an ongoing basis we evaluate our estimates, including, but not limited to: fair values of investments in marketable securities, the use, recoverability, and /or realizability of certain assets, including investments in affiliated companies, deferred tax assets, and share-based compensation.
Share-Based Compensation Share-based compensation expense recognized during the year is based on the grant date fair value of the portion of share-based payment awards ultimately expected to vest during the year. As share-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeiture rates are based on historical forfeiture experience and estimated future employee forfeitures.
Intellectual Property Rights
PDS, our investment in affiliated company, relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. We have one unexpired U.S. patent issued in 1998 on our microprocessor technology. This patent will expire in September 2015. We also have three European and two Japanese patents all expiring in October 2016. We also have six U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and July 21, 2015. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration date. The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to the ownership of the technology or the proprietary nature of the intellectual property would materially damage business prospects. Any issued patent may be challenged and invalidated.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Recent Accounting Pronouncements
In August 2014, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) No. 2014-15, "Presentation of Financial Statements - Going Concern." ASU 2014-15 provides guidance in generally accepted accounting principles about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. ASU 2014-15 is effective for annual reporting periods ending after December 15, 2016 and for annual periods and interim periods thereafter (fiscal year 2017 for the Company). Early adoption is permitted. We have not yet determined the potential effects of the adoption of ASU 2014-15 on our consolidated financial statements.
3. Cash, Cash Equivalents, Restricted Cash and Marketable Securities
We consider all highly liquid investments with original maturities of three months or less to be cash equivalents.
Restricted cash and cash equivalents at May 31, 2015 and 2014 consist of deposits in a savings account required to be held as collateral for our corporate credit card.
At May 31, 2015 and 2014, our current portion of marketable securities in the amount of $2,455,106 and $1,701,647, respectively, consists of the par value plus accrued interest of our time deposits. These marketable securities are classified as held-to-maturity and are reported at amortized cost, which approximates fair market value.
We follow authoritative guidance to account for our marketable securities as held-to-maturity. Under this authoritative guidance we are required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. We determine fair value based on quoted prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment or valuations by third party professionals. The three levels of inputs that we may use to measure fair value are:
Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2: Quoted prices in markets that are not active or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; and
Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).
The following tables detail the fair value measurements within the fair value hierarchy of our cash, cash equivalents and investments in marketable securities:
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Cash, Cash Equivalents, Restricted Cash and Marketable Securities (continued)
We purchase certificates of deposit with varying maturity dates greater than three months. The following table summarizes the maturities, gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2015:
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Cash, Cash Equivalents, Restricted Cash and Marketable Securities (continued)
We purchase certificates of deposit with varying maturity dates greater than three months. The following table summarizes the maturities, gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2014:
4. Property and Equipment
Property and equipment consisted of the following at May 31, 2015 and 2014:
Depreciation expense related to property and equipment was $2,054 and $2,303 for the years ended May 31, 2015 and 2014, respectively.
5. Investment in Affiliated Company
Phoenix Digital Solutions, LLC
On June 7, 2005, we entered into a Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore (“Moore”), the co-inventor of the technology which is the subject of the MMP portfolio of microprocessor patents, pursuant to which the parties resolved all legal disputes between them. Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (the “LLC Agreement”) into which we and Moore contributed our rights to certain of our technologies.
We and TPL each own 50% of the membership interests of PDS, and each member has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. There had not been a third management committee member since May 2010, however, as a result of our initiation of arbitration seeking the appointment of a third member, on December 16, 2014, an independent manager to the PDS management committee was selected by the arbitrator (see Note 9). Pursuant to the LLC Agreement, we and TPL initially agreed to establish a working capital fund for PDS of $4,000,000, of which our contribution was $2,000,000. The working capital fund was increased to a maximum of $8,000,000 as license revenues are achieved. We and TPL are obligated to fund future working capital requirements at the discretion of the management committee of PDS in order to maintain working capital of not more than $8,000,000. If the management committee determines that additional capital is required, neither we nor TPL are required to contribute more than $2,000,000 in any fiscal year. No such contributions were made during the fiscal years ended May 31, 2015 and 2014. Distributable cash and allocation of profits and losses have been allocated to the members in the priority defined in the LLC Agreement.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Investment in Affiliated Company (continued)
PDS previously reimbursed TPL for payment of all legal and third-party expert fees and other related third-party costs and expenses, although the majority of third-party costs are now paid directly by PDS. During the fiscal years ended May 31, 2015 and 2014, PDS expensed $1,247,969 and $2,300,323, respectively, pursuant to the agreement. These expenses are recorded in the accompanying PDS statements of operations presented below net of $20,546 and $400,708, for fiscal 2015 and 2014, respectively, of legal fee reversals previously expensed and recorded as accounts payable to TPL as the statute of limitations had expired.
On July 11, 2012, we entered into the Program Agreement with PDS, TPL, and Alliacense, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement, PDS engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of PDS, TPL, and the Company. The Program Agreement continued through the useful life of the MMP portfolio patents. Pursuant to the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense. On July 24, 2014, the Program Agreement was amended with PDS and Alliacense entering into the Amended Alliacense Services and Novation Agreement (the “Novation Agreement”). Pursuant to the Novation Agreement certain performance goals and incentives were established for Alliacense. The Novation Agreement also provided for the addition of a second licensing company, which was engaged on October 10, 2014, to complement the MMP licensing commercialization. However, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015, Alliacense was terminated by PDS.
On July 17, 2012, we entered into an Agreement with PDS, TPL, and Alliacense whereby we agreed to certain additional allocations of obligations relating to the Program Agreement.
Pursuant to the Program Agreement, PDS had committed to Alliacense a quarterly amount of $500,000 which represented the licensing services fees due Alliacense, subject to a contingency arrangement which provided for a percentage on future revenues, for its efforts to secure licensing agreements on behalf of PDS. During fiscal 2014, PDS discontinued these payments which were formally eliminated by terms of the Novation Agreement. These payments had replaced the quarterly amounts previously paid to TPL pursuant to the Commercialization Agreement. During the fiscal year ended May 31, 2014 PDS expensed $956,353 pursuant to this contractual obligation. These expenses are recorded in the accompanying PDS statement of operations for the fiscal year ended May 31, 2014 presented below.
Pursuant to the Program Agreement, PDS was contractually obligated to pay Alliacense litigation support fees relating to Alliacense’s special work and effort regarding internal costs related to MMP maintenance and litigation support including support in the U.S. District Court and the complaints filed on behalf of TPL, PDS and us with the ITC. During the fiscal years ended May 31, 2015 and 2014, PDS reversed $(24,598) and expensed $184,435, respectively, pursuant to this contractual obligation. Future litigation support payments to Alliacense relating to the ITC litigation had been subject to a contingency arrangement which provided for a percentage of future recoveries in these actions. The Novation Agreement eliminated the Program Agreement’s litigation support activity by Alliacense. These reversals and expenses are recorded in the accompanying PDS statements of operations for the fiscal years ended May 31, 2015 and 2014 presented below.
Pursuant to the Novation Agreement, the PDS paid Alliacense licensing fees of $155,600 during the fiscal year ended May 31, 2015.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Investment in Affiliated Company (continued)
During the fiscal years ended May 31, 2015 and 2014, PDS paid Alliacense $323,000 and $300,000, respectively, against multiple outstanding disputed items in connection with a settlement of these items (see Note 9).
During January 2013, TPL and Moore settled their litigation. Terms of the settlement include the payment by PDS to Moore of a consulting fee of $250,000 for four years or until the completion of all outstanding MMP litigation whichever comes first. Per terms of the agreement PDS paid Moore $150,000 on the settlement date and will pay Moore $16,667 per month from August 2013 through January 2014 and $20,833 per month beginning February 2014 through January 2017. During the fiscal years ended May 31, 2015 and 2014, PDS paid Moore $249,996 and $183,334, respectively, pursuant to this contractual obligation. These expenses are recorded in the accompanying PDS statements of operations for the fiscal years ended May 31, 2015 and 2014 presented below.
During the fiscal year ended May 31, 2014, we expensed $92,050 of legal fees on behalf of PDS.
We are accounting for our investment in PDS under the equity method of accounting, and accordingly have recorded our share of PDS’s net loss during the fiscal year ended May 31, 2015 of $106,923 as a decrease in our investment. We have recorded our share of PDS’s net income during the fiscal year ended May 31, 2014 of $104,677 as an increase in our investment. Cash distributions of $58,400 and $375,000 received from PDS during the years ended May 31, 2015 and 2014, respectively, have been recorded as a reduction in our investment. We have recorded our share of PDS’s net income and loss as “Equity in earnings (loss) of affiliated company” in the accompanying consolidated statements of operations for the years ended May 31, 2015 and 2014, respectively.
During the fiscal years ended May 31, 2015 and 2014, PDS entered into licensing agreements with third parties, pursuant to which PDS recognized revenues of $1,820,000 and $5,022,000, respectively.
On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. A Joint Plan of Reorganization (the “Joint Plan”) between TPL and the creditor’s committee was confirmed by the Bankruptcy Court on February 11, 2015 with the entered confirmation order becoming final on April 2, 2015. The Joint Plan provides that the Effective Date, which remains pending, will be the later of (i) the first business day that is at least 30 days after the entry of the confirmation order or (ii) the first Business Day on which the reorganized company has sufficient cash to make all payments required under the Plan on the Effective Date. We have been appointed to the creditors’ committee and have been closely monitoring the progress in this matter as it relates to our interest in PDS. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements. If we determine that it is appropriate to consolidate PDS, we would measure the assets, liabilities and noncontrolling interests of PDS at their fair values at the date that we have the controlling financial interest.
PDS’s balance sheets at May 31, 2015 and 2014 and statements of operations for the years ended May 31, 2015 and 2014 are as follows:
Balance Sheets
Assets:
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Investment in Affiliated Company (continued)
Liabilities and Members’ Equity (Deficit):
Statements of Operations
We review our investment in PDS to determine whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider in our determination are the financial condition, operating performance and near term prospects of PDS. If a decline in value is deemed to be other than temporary, we would recognize an impairment loss.
6. Accrued Expenses and Other
At May 31, 2015 and 2014, accrued expenses and other consisted of the following:
7. Stockholders’ Equity
Share Repurchases
During July 2006, we commenced our Board of Director approved stock buyback program in which we repurchase our outstanding common stock from time to time on the open market. The repurchase plan has no maximum number of shares and is solely at the discretion of the Board of Directors. The repurchase plan has no set expiration date.
There were no share repurchases during the year ended May 31, 2015.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Stockholders’ Equity (continued)
The following table summarizes share repurchases during the year ended May 31, 2014:
Share-based Compensation Summary of Assumptions and Activity
The fair value of share-based awards to employees and directors is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from our stock options. The Black-Scholes model also requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the pricing term of the grant effective as of the date of the grant. The expected volatility is based on the historical volatilities of our common stock. These factors could change in the future, affecting the determination of stock-based compensation expense in future periods.
A summary of option activity for the year ended May 31, 2015 is presented below:
The weighted average grant date fair value of options granted during the fiscal year ended May 31, 2015 was $0.02 per option.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Stockholders’ Equity (continued)
The aggregate intrinsic value in the table above represents the differences in market price at the close of the fiscal year ($0.03 per share on May 31, 2015) and the exercise price of outstanding, in-the-money options (those options with exercise prices below $0.03) on May 31, 2015.
The following table summarizes employee and director stock-based compensation expense for the fiscal years ended May 31, 2015 and 2014, which was recorded as follows:
2006 Stock Option Plan
The 2006 Stock Option Plan, as amended, which expires in March 2016, provides for the granting of options to acquire up to 10,000,000 shares, with a limit of 8,000,000 Incentive Stock Option (“ISO”) shares of our common stock to either full or part time employees, directors and our consultants at a price not less than the fair market value on the date of grant. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2006 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal years ended May 31, 2015 and 2014, we granted options to employees and directors to purchase 2,000,000 and 760,000 shares, respectively, of our common stock under this plan, none of which were ISOs. As of May 31, 2015, options to purchase 3,335,000 shares of common stock are outstanding under the 2006 Stock Option Plan.
8. Income Taxes
The provision for income taxes from continuing operations is as follows for the years ended May 31:
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Income Taxes (continued)
The reconciliation of the effective income tax rate to the Federal statutory rate is as follows for the years ended May 31:
Deferred tax assets and liabilities reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of our deferred tax assets from continuing operations are as follows as of May 31:
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Income Taxes (continued)
We have federal and state net operating loss carryforwards available to offset future taxable income of approximately $22,744,000 and $22,365,000, respectively, at May 31, 2015. These carryforwards begin to expire in the years ending May 31, 2025 and 2015, respectively.
We follow authoritative guidance which defines criteria that an individual tax position must meet for any part of the benefit of that position to be recognized in a company’s financial statements and also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Interest and penalties, if any, related to unrecognized tax benefits are recorded in income tax expense. Interest and penalties relating to underpayment of income taxes are recorded in general and administrative expense. As of May 31, 2015, we are subject to U.S. Federal income tax examinations for the tax years May 31, 2003 through May 31, 2015, and we are subject to state and local income tax examinations for the tax years May 31, 2003 through May 31, 2015 due to the carryover of net operating losses related to PDSG from previous years.
We have no liability relating to unrecognized tax benefits under the authoritative guidance for the fiscal years ended May 31, 2015 and 2014.
Our continuing practice is to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. We do not expect our unrecognized tax benefits to change significantly over the next twelve months.
9. Commitments and Contingencies
Patent Litigation
On February 8, 2008, we, TPL and Alliacense Ltd. were named as defendants in separate lawsuits filed in the United States District Court for the Northern District of California by HTC Corporation, and Acer, Inc., and affiliated entities of each of them. (Those cases were deemed related and are referred to herein as the “N.D. Cal. Case”). HTC and Acer sought declaratory relief that their products did not infringe enforceable claims of the '336 patent. We alleged counterclaims for patent infringement of the '336 and '890 patents as to certain of their products.
The Court issued a first claim construction ruling in the N.D. Cal. Case on June 12, 2012, which preserved our ability to proceed on our infringement claims against Acer and HTC. Thereafter, Chief District Judge James Ware retired and the N.D. Cal. Case was reassigned to Magistrate Judge Paul S. Grewal, who held a supplemental claim construction hearing on November 30, 2012. Judge Grewal then issued a supplemental claim construction ruling on December 5, 2012, which preserved our ability to proceed with our infringement claims. On September 6, 2013 Acer entered into an MMP portfolio license agreement that also provided for the dismissal of all claims in the N.D. Cal Case, as well as the filing of a joint motion to terminate Acer as a respondent in the ITC 853 Investigation (described more fully below). On September 19, 2013 the ‘890 patent was dropped from the N.D. Cal Case pursuant to stipulation by all parties. A jury trial was held in the N.D. Cal. Case against HTC, beginning on September 23, 2013. On October 3, 2013, the jury returned a verdict in favor of us and TPL, finding that HTC had infringed the ‘336 patent with damages of $958,560. HTC appealed the jury verdict and we filed cross appeals regarding the period available for infringement damages related to the ‘890 patent. On January 7, 2015, the parties filed a stipulated motion to voluntarily dismiss the HTC appeal and our cross appeals on the basis of having reached a settlement agreement. The Federal Circuit granted that motion and dismissed the appeal the same day.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Commitments and Contingencies (continued)
On July 24, 2012 complaints were filed on behalf of us, TPL, and PDS (collectively referred to as “Plaintiffs”) against Acer, Inc., Amazon.com, Inc., Barnes & Noble, Inc., Garmin, Ltd., HTC Corporation, Huawei Technologies Co., Ltd., Kyocera Corporation, LG Electronics, Nintendo Co., Ltd., Novatel Wireless, Inc., Samsung Electronics Co., Ltd., Sierra Wireless, Ltd. and ZTE Corporation with the U.S. International Trade Commission ("ITC") (ITC Investigation No. 337-TA-853, or the “853 Investigation”) alleging infringement of the ‘336 patent. We also filed new parallel proceedings in the U.S. District Court for the Northern District of California alleging infringement of the US 5,440,749 patent (the “‘749 patent”), and the ‘890 and ‘336 patents against Amazon.com Inc., Barnes & Noble Inc., Garmin Ltd., Huawei Technologies Co. Ltd., Kyocera Corporation, LG Electronics, Nintendo Co. Ltd., Novatel Wireless Inc., Samsung Electronics Co. Ltd., Sierra Wireless Inc., and ZTE Corporation. We subsequently reached a settlement with Sierra Wireless, Inc. Trial proceedings before the ITC began on June 3, 2013 and concluded the following week. Settlements were subsequently reached with Kyocera Corporation, Amazon.com, Inc., and Acer, Inc. An Initial Determination (“ID”) was rendered on September 6, 2013 finding that none of the remaining Respondents had infringed the ‘336 patent. We filed a petition for review of the ID with the full ITC on September 23, 2013. On February 20, 2014, the ITC provided notice affirming the September 6, 2013 ID. We have chosen not to file an appeal of the ITC decision to the United States Court of Appeals for the Federal Circuit. All of the district court actions against the new parties (i.e., all respondents other than Acer and HTC) that have not previously settled and which had been stayed pending resolution of the 853 Investigation are proceeding in front of Judge Vince Chhabria, with Judge Grewal handling all pretrial matters.
On February 4, 2015 Barnes & Noble, Inc. filed a motion asserting that our cause of action on the ‘336 patent was barred by the Kessler doctrine because of the ITC’s finding of non-infringement. A hearing was held on March 17, 2015 in the U.S. District Court for the Northern District of California regarding the matter. On May 31, 2015 Judge Grewal denied this motion. Barnes & Noble asked Judge Chhabria to reconsider this ruling but on July 22, 2015, Plaintiffs and Barnes & Noble filed a notice of settlement stating that Plaintiffs and Barnes & Noble had reached a settlement in principle. This mooted a hearing in front of Judge Chhabria regarding Barnes & Noble’s motion.
On April 10, 2015 multiple defendants in the District Court action filed a motion arguing for invalidity of the ‘749 patent. A hearing was held on May 19, 2015 regarding this matter and on July 28, 2015, Judge Grewal denied this motion as moot.
On June 30, 2015 a hearing was held on Samsung and LG’s motion to strike Plaintiffs’ infringement contentions. On July 11, 2015, Judge Grewal granted in part Samsung and LG’s motion and ordered Plaintiffs to provide amended infringement contentions in accordance with the Court’s order.
On July 1, 2015 the parties in the Novatel Wireless, Inc. action filed a stipulated motion to voluntarily dismiss all claims and counterclaims on the basis of a settlement agreement having been reached. The California district court granted that motion on July 14, 2015.
On July 27, 2015 Plaintiffs and Defendants filed a stipulation whereby each party withdrew their claims regarding the ‘749 and ‘890 patents with prejudice.
On August 26, 2015 Plaintiffs and Garmin entered into a settlement and license agreement.
Alliacense Disputes
PDS and Alliacense had been involved in multiple disputes regarding amounts asserted by Alliacense as owed by PDS. The disputed amounts included sums for past services and advances. On July 24, 2014, PDS and Alliacense entered into the Novation Agreement, which included provisions for resolving all of the claims in dispute for $623,000. Of that amount, $300,000 was paid by PDS to Alliacense in November 2013, with the balance paid by PDS to Alliacense in two payments of $161,500 each on June 20, 2014 and July 25, 2014. The Novation Agreement also provided for the addition of a second licensing company, however, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015 Alliacense was terminated by PDS.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Commitments and Contingencies (continued)
PDS Arbitration- Independent Managing Member
In January 2014, our representative to the PDS management committee filed with the American Arbitration Association (“AAA”) a demand for arbitration pursuant to the terms of the LLC Agreement. The demand sought the appointment of a third member, referred to as the independent manager member to the PDS management committee. On December 16, 2014, the AAA appointed arbitrator selected an independent managing member from one of the nominees submitted by Patriot, thereby filling the open management committee seat.
PDS Arbitration - Alliacense Performance
In June 2015, our representative to the PDS management committee filed with the Judicial Arbitration and Mediation Services (“JAMS”) a demand for arbitration pursuant to Alliacense’s non-performance under terms of the Novation Agreement. The demand seeks a declaration of the respective rights and obligations of the parties under the Novation Agreement.
401(k) Plan
We have a retirement plan that complies with Section 401(k) of the Internal Revenue Code. All employees are eligible to participate in the plan. We match 100% of elective deferrals subject to a maximum of 4% of the participant’s eligible earnings. Our participants vest 33% per year over a three year period in their matching contributions. Our matching contributions during the fiscal years ended May 31, 2015 and 2014 were $15,935 and $10,610, respectively.
Employment Contracts
In connection with Mr. Flowers’ appointment as the Chief Financial Officer, and commencing on September 17, 2007, we entered into an employment agreement with Mr. Flowers for an initial 120-day term if not terminated pursuant to the agreement, with an extension period of one year and on a continuing basis thereafter. Pursuant to the agreement, if Mr. Flowers is terminated without cause or resigns with good reason any time after two years of continuous employment, he is entitled to receive an amount equal to twelve months of his annual base salary. Mr. Flowers is also entitled to certain payments upon a change of control of the Company if the surviving corporation does not retain him. All such payments are conditional upon the execution of a general release.
Guarantees and Indemnities
We have made certain guarantees and indemnities, under which we may be required to make payments to a guaranteed or indemnified party. We indemnify our directors, officers, employees and agents to the maximum extent permitted under the laws of the State of Delaware. In connection with our facility lease, we have indemnified our lessor for certain claims arising from the use of the facility. The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments we could be obligated to make. Historically, we have not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying consolidated balance sheets.
Patriot Scientific Corporation
Notes to Consolidated Financial Statements (Continued)
Commitments and Contingencies (continued)
Escrow Shares
On August 31, 2009 we gave notice to the former shareholders of Crossflo and Union Bank of California (the “Escrow Agent”) under Section 2.5 of the Agreement and Plan of Merger between us and Crossflo (the “Agreement”), outlining damages incurred by us in conjunction with the acquisition of Crossflo, and seeking the return of 2,844,630 shares of our common stock held by the Escrow Agent. Subsequently, former shareholders of Crossflo representing a majority of the escrowed shares responded in protest to our claim, delaying the release of the escrowed shares until a formal resolution is reached. In the event we fail to prevail in our claim against the escrowed shares, we may be obligated to deposit into escrow approximately $256,000 of cash consideration due to the decline in our average stock price over the one year escrow period, calculated in accordance with the Section 2.5 of the Agreement. We have evaluated the potential for loss regarding our claim and believe that it is probable that the resolution of this issue will not result in a material obligation to the Company, although there is no assurance of this. Accordingly, we have not recorded a liability for this matter.
Operating Lease
We lease our facility through an operating lease that expires in March 2016. Rental expense is presented in the following table:
Future minimum payments under our operating lease commitment as of May 31, 2015 amount to $32,219.
10. Subsequent Events
We have evaluated subsequent events after the balance sheet date and based on our evaluation, management has determined that no subsequent events have occurred that would require recognition in the accompanying consolidated financial statements or disclosure in the notes thereto other than as disclosed herein and in the accompanying notes.
Phoenix Digital Solutions, LLC
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Members
Phoenix Digital Solutions, LLC
We have audited the accompanying balance sheets of Phoenix Digital Solutions, LLC (the "Company") as of May 31, 2015 and 2014, and the related statements of operations, members' equity (deficit) and cash flows for the years then ended. These financial statements 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. 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 financial position of Phoenix Digital Solutions, LLC as of May 31, 2015 and 2014, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As more fully described in Note 1 to the financial statements, because of the uncertain nature of the negotiations that lead to license revenues, there is no assurance that the Company will receive any future revenues from license agreements, or if it does, that such license revenues in the future will be consistent with amounts received in the past. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.
/s/ KMJ Corbin & Company LLP
Costa Mesa, California
August 31, 2015
Phoenix Digital Solutions, LLC
Balance Sheets
See accompanying notes to financial statements.
Phoenix Digital Solutions, LLC
Statements of Operations
See accompanying notes to financial statements.
Phoenix Digital Solutions, LLC
Statements of Members’ Equity (Deficit)
Years Ended May 31, 2015 and 2014
See accompanying notes to financial statements.
Phoenix Digital Solutions, LLC
Statements of Cash Flows
See accompanying notes to financial statements.
Phoenix Digital Solutions, LLC
Notes to Financial Statements
1. Organization and Business
Phoenix Digital Solutions, LLC (the “Company” or “PDS”) is a Delaware limited liability company organized on June 7, 2005. Through a commercialization agreement dated June 7, 2005 as amended in July 2012, the Company holds the rights to certain patents of its members. The Company receives license fees from license agreements entered into between licensees and the Company and distributes license fee proceeds to its members.
Basis of Presentation
The Company’s financial statements have been prepared using the accrual method of accounting in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities in the normal course of business.
Going Concern and Management’s Plans
At August 24, 2015, the Company’s cash balance was $628,528. The ability of PDS to continue as a going concern is dependent on its ability to generate or obtain sufficient cash to meet its obligations on a timely basis. The Company will need to generate proceeds from new license agreements or obtain equity or debt financing from its members to fund its planned operating expenses and working capital requirements for the foreseeable future. Currently, the Company has no commitments to obtain additional capital from sources outside of that which may be contributed by the members, and there can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all.
Because of the uncertain nature of the negotiations that lead to license revenues, pending litigation with companies which the members believe have infringed on their patent portfolio, the possibility of legislative action regarding patent rights, and the possible effect of new judicial interpretations of patent laws, there is no assurance that the Company will receive any future revenues from license agreements, or if it does, that such license revenues in the future will be consistent with amounts received in the past.
In the event the Company is unable to successfully generate proceeds from license agreements at historical levels or obtain additional capital, it is unlikely that the Company will have sufficient cash flows and liquidity to finance its business operations as currently contemplated. Accordingly, in the event new financing is not obtained, the Company will likely reduce general and administrative expenses, including legal fees, litigation activity and other licensing costs, until it is able to obtain sufficient financing to do so.
On March 20, 2013, Technology Properties Limited Inc. (“TPL”) filed a petition under Chapter 11 of the United States Bankruptcy Code. Patriot Scientific Corporation (“PTSC”) has been appointed to the creditors’ committee and has been closely monitoring the progress in this matter as it relates to PTSC’s interest in PDS. A Joint Plan of Reorganization (the “Joint Plan”) between TPL and the creditor’s committee was confirmed by the Bankruptcy Court on February 11, 2015 with the entered confirmation order becoming final on April 2, 2015. The Joint Plan provides that the Effective Date, which remains pending, will be the later of (i) the first business day that is at least 30 days after the entry of the confirmation order or (ii) the first Business Day on which the reorganized TPL has sufficient cash to make all payments required under the Plan on the Effective Date.
Phoenix Digital Solutions, LLC
Notes to Financial Statements (Continued)
Organization and Business (continued)
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed, the above conditions raise sufficient doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
2. Summary of Significant Accounting Policies
Limited Liability Company Operating Agreement
As a limited liability company, each member’s liability is limited to the capital invested. Allocation of profits, losses and distributions is in accordance with the terms as defined in the operating agreement.
The Company is treated as a partnership for federal income tax purposes. Consequently, federal income taxes are not payable by the Company. The Company’s net income or loss is allocated among the members in accordance with the operating agreement of the Company and members are taxed individually on their share of the Company’s earnings. The State of California assesses a limited liability company fee based on the Company’s income in addition to a flat limited liability company tax. Accordingly the financial statements reflect a provision for these California taxes.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts and disclosures. Accordingly, actual results could differ from those estimates.
Revenue Recognition
The Company recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. The Company may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.
Financial Instruments and Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash.
Cash is maintained with high quality financial institutions. At times, deposits held with financial institutions may exceed the amount of insurance provided by the Federal Deposit Insurance Corporation. The Company performs ongoing evaluations of these financial institutions to limit its concentration of risk exposure.
Legal Fees
For the years ended May 31, 2015 and 2014, one legal service provider accounted for $1,195,269 and $1,599,199, respectively, of legal costs associated with the litigation of the Moore Microprocessor Patent (“MMP”) portfolio. These amounts are included in general and administrative expense in the accompanying statements of operations.
Phoenix Digital Solutions, LLC
Notes to Financial Statements (Continued)
Summary of Significant Accounting Policies (continued)
Intellectual Property Rights
The Company relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. The Company currently licenses one unexpired U.S. patent issued in 1998 on PTSC’s microprocessor technology in addition to three European and two Japanese patents. The U.S. patent will expire in September 2015 and the European and Japanese patents will expire in October 2016. The Company also licenses six U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and July 21, 2015. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration date. The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to its ownership of the technology or the proprietary nature of the intellectual property would materially damage the Company’s business prospects. Any issued patent may be challenged and invalidated.
3. Fair Value of Financial Instruments
The Company’s financial instruments consist of cash and certain of its accounts payable and accrued expenses. The carrying value of these financial instruments approximates fair value because of the immediate or short-term maturity of the instruments.
4. Prepaid Expenses
At May 31, 2015 and 2014, prepaid expenses consist of:
At May 31, 2015, prepaid expenses in the table above consist of the balance of a directors and officers’ insurance premium for the period June 2015 to March 2016.
At May 31, 2015, other current assets consist of amounts receivable from a consultant and from the state of Delaware.
At May 31, 2014, prepaid expenses in the table above consist of the balance of a directors and officers’ insurance premium for the period June 2014 to March 2015.
Retainers in the table above consist of the amount the Company advanced to its former patent litigation firm for the ITC and U.S. District Court cases.
Phoenix Digital Solutions, LLC
Notes to Financial Statements (Continued)
5. Formation of Joint Venture and Commercialization Agreement
The Company, a joint venture has two members: TPL, and PTSC. Each member owns 50% of the membership interests of the Company. Each member has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. There had not been a third management committee member since May 2010, however, as a result of PTSC’s initiation of arbitration seeking the appointment of a third member, on December 16, 2014, an independent manager to the PDS management committee was selected by the arbitrator.
Contribution Requirements
Pursuant to the Company’s Limited Liability Company Operating Agreement (the “LLC Agreement”), the members agreed to establish a working capital fund for the Company of $4,000,000, of which each member contributed $2,000,000. The working capital fund increases to a maximum of $8,000,000 as license revenues are achieved. The members are obligated to fund future working capital requirements at the discretion of the management committee of the Company in order to maintain working capital of not more than $8,000,000. If the management committee determines that additional capital is required, neither member is required to contribute more than $2,000,000 in any fiscal year. No contributions were made during the fiscal years ended May 31, 2015 and 2014. Distributable cash and allocation of profits and losses are allocated to the members in the priority defined in the LLC Agreement.
Joint Venture Contractual Agreements
On June 7, 2005, the Company entered into a Commercialization Agreement (the “Commercialization Agreement”) with TPL and PTSC. This Commercialization Agreement allows TPL to commercialize the patent portfolio by entering into settlement and/or license agreements, litigating in the name of TPL, PTSC, the Company and Charles Moore (“Moore”), and manage the use of the patent portfolio by third parties.
On July 11, 2012, the Company entered into a Licensing Program Services Agreement (the “Program Agreement”) with PTSC, TPL, and Alliacense creating an amendment to the Commercialization Agreement, and an Agreement (the “TPL Agreement”) between TPL and PTSC. Pursuant to the Program Agreement, the Company engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of the Company, TPL, and PTSC. The Program Agreement continued through the useful life of the MMP portfolio patents. On July 24, 2014, the Program Agreement was amended with the Company and Alliacense entering into the Amended Alliacense Services and Novation Agreement (the “Novation Agreement”). Pursuant to the Novation Agreement certain performance goals and incentives were established for Alliacense. The Novation Agreement also provided for the addition of a second licensing company, which was engaged on October 10, 2014, to complement the MMP licensing commercialization. However, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015, Alliacense was terminated by PDS.
On July 17, 2012, the Company entered into an Agreement with PTSC, TPL, and Alliacense whereby the parties agreed to certain additional allocations of obligations relating to the Program Agreement.
During the fiscal years ended May 31, 2015 and 2014, the Company paid Alliacense $323,000 and $300,000, respectively, against multiple outstanding disputed items in connection with a settlement of these items (see Note 7).
Phoenix Digital Solutions, LLC
Notes to Financial Statements (Continued)
Formation of Joint Venture and Commercialization Agreement (continued)
During January 2013, TPL and Moore settled their litigation. Terms of the settlement include payment by the Company to Moore of a consulting fee of $250,000 for four years or until the completion of all outstanding MMP litigation whichever comes first. Per terms of the agreement the Company paid Moore $150,000 on the settlement date and will pay Moore $16,667 per month from August 2013 through January 2014 and $20,833 per month beginning February 2014 through January 2017 (see Note 8).
Significant Contractual Legal Relationship
The Company had incurred legal fees from an unrelated law firm and legal subcontractors to provide substantial legal services for the commercialization of the MMP portfolio of microprocessor patents. This law firm dissolved in April 2015 and the Company has retained replacement counsel.
Accounts payable balances due this law firm and legal subcontractors as of May 31, 2014 were $92,289.
Transactions with this law firm and legal subcontractors for the fiscal years ended May 31, 2015 and 2014 were as follows:
6. Delinquent Accounts Payable
During the fiscal years ended May 31, 2015 and 2014, the Company reversed approximately $20,500 and $401,000, respectively, of legal fees and other expenses previously expensed and recorded as accounts payable as the statute of limitations had expired. These reversals are recorded as a reduction of legal and other expenses in general and administrative expense in the accompanying statements of operations.
7. Commitments and Contingencies
Licensing Fee Dispute
The Company and Alliacense had been involved in multiple disputes regarding amounts asserted by Alliacense as owed by the Company. The disputed amounts included sums for past services and advances. On July 24, 2014, the Company and Alliacense entered into the Amended Alliacense Services and Novation Agreement, which included provisions for resolving all of the claims in dispute for $623,000. Of that amount, $300,000 was paid by the Company to Alliacense in November 2013, with the balance paid by the Company to Alliacense in two payments of $161,500 each on June 20, 2014 and July 25, 2014. The Novation Agreement also provided for the addition of a second licensing company, however, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015, Alliacense was terminated by PDS.
Management Committee Arbitration
In January 2014, PTSC’s representative to the Company’s management committee filed with the American Arbitration Association (“AAA”) a demand for arbitration pursuant to the terms of the LLC Agreement. The demand sought the appointment of a third member, referred to as the independent manager member, to the Company’s management committee. On December 16, 2014, the AAA appointed arbitrator selected an independent managing member from one of the nominees submitted by PTSC, thereby filling the open management committee seat.
Phoenix Digital Solutions, LLC
Notes to Financial Statements (Continued)
Commitments and Contingencies (continued)
Alliacense Performance Arbitration
In June 2015, PTSC’s representative to the Company’s management committee filed with the Judicial Arbitration and Mediation Services (“JAMS”) a demand for arbitration pursuant to Alliacense’s non-performance under terms of the Novation Agreement. The demand seeks a declaration of the respective rights and obligations of the parties under the Novation Agreement.
Guarantees and Indemnities
Under the LLC Operating Agreement, the Company indemnifies its members, managers, officers and employees from any damages and liabilities by reason of their management or involvement in the affairs of the Company as long as the indemnitee acted in good faith and in the best interests of the Company.
Under the Commercialization Agreement, the Company and PTSC hold harmless TPL and its representatives with respect to all claims of any nature by or on behalf of the Company and PTSC related to the preparation, execution and delivery of duties and responsibilities under the Commercialization Agreement.
The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make.
Historically, the Company has not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying balance sheets.
Contractual Commitments
In January 2013, the Company entered into a contractual commitment with a related party entity to provide consulting services at a cost of $250,000 per year for duration of four years or the completion of all outstanding MMP litigation, whichever comes first.
For the fiscal years ended May 31, 2015 and 2014, the Company expensed $249,996 and $183,334, respectively, related to this agreement.
In connection with the Program Agreement, the Company was required to make payments to Alliacense of $500,000 no later than three days prior to the start of each calendar quarter. Such payments were non-accountable and non-recoupable, but were offset against the licensing fees owed to Alliacense pursuant to the Program Agreement. During fiscal 2014, the Company discontinued these payments. During the fiscal year ended May 31, 2014 the Company expensed $956,353 pursuant to this contractual obligation.
Phoenix Digital Solutions, LLC
Notes to Financial Statements (Continued)
8. Related Party Transactions
A summary of related party transactions described above is as follows:
9. Subsequent Events
The Company has evaluated subsequent events after the balance sheet date and based on its evaluation, management has determined that no subsequent events have occurred that would require recognition in the accompanying financial statements or disclosure in the notes thereto other than as disclosed herein and in the accompanying notes.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
DATED: August 31, 2015 PATRIOT SCIENTIFIC CORPORATION
/S/ CLIFFORD L. FLOWERS
Clifford L. Flowers
Interim Chief Executive Officer and Chief Financial Officer
(Duly Authorized and Principal Financial Officer)