As filed with the Securities and Exchange Commission on July 21, 2006

Reg. No. 333-135415

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Amendment No. 1

to

Form SB-2

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

Save the World Air, Inc.

(Name of Small Business Issuer in its Charter)

5125 Lankershim Boulevard

North Hollywood, California 91601

(818) 487-8000

(Address and Telephone Number of Principal Executive Offices and Principal Place of Business)

 

 

Eugene E. Eichler

Chief Executive Officer

5125 Lankershim Boulevard

North Hollywood, California 91601

(818) 487-8000

(Name, Address and Telephone Number of Agent For Service)

 

 

Copy to:

 

Lance Jon Kimmel, Esq.

SEC Law Firm

11693 San Vicente Boulevard, Suite 357

Los Angeles, California 90049

(310) 557-3059

 

 

Approximate date of proposed sale to the public:  From time to time after the date this registration statement becomes effective.

 

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this form is a post-effective amendment filed pursuant to Rule 462^© under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box.  o

 

CALCULATION OF REGISTRATION FEE

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

SUBJECT TO COMPLETION. DATED JULY 21, 2006

 

PROSPECTUS

 

SAVE THE WORLD AIR, INC.

 

5,443,313 Shares of Common Stock

 

This prospectus relates to the reoffer and resale, from time to time, of up to 2,408,733 shares of our common stock and up to 3,034,580 shares of our common stock issuable upon the exercise of warrants held by the same selling security holders. The prices at which the selling shareholder may sell these shares will be determined by the prevailing market price for shares of our common stock or in negotiated transactions. For a list of selling security holders, please see “Selling Security Holders” on page 40 of this prospectus.

 

We are not selling any shares of common stock in this offering and therefore will not receive any proceeds from this offering. We will, however, receive the exercise price of the warrants if and when those warrants are exercised. None of the warrants have yet been exercised as of the date of this prospectus.

 

We will pay the expenses of registering the shares registered in this prospectus.

 

Our common stock is traded in the over-the-counter market and is quoted on the OTC Bulletin Board under the symbol ZERO.OB. On June 23, 2006, the last bid price of our common stock was $2.20 per share.

 

The shares included in this prospectus may be reoffered and resold directly by the selling security holders in accordance with one or more of the methods described in the plan of distribution, which begins on page 45 of this prospectus. We will not control or determine the price at which a selling security holder decides to sell its shares. Brokers or dealers effecting transactions in these shares should confirm that the shares are registered under applicable state law or that an exemption from registration is available.

 

Investing in our common stock involves a high degree of risk. You should understand the risks associated with investing in our common stock. Before making an investment, read the “Risk Factors,” which begin on page 3 of this prospectus.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

 

The date of this prospectus is          , 2006.

TABLE OF CONTENTS

 

 

You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that which is contained in this prospectus. This prospectus may be used only where it is legal to sell these securities. The information in this prospectus may only be accurate on the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of securities.

 

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. This document contains forward-looking statements, which reflect the views of our management with respect to future events and financial performance. These forward-looking statements are subject to a number of uncertainties and other factors that could cause actual results to differ materially from such statements. Forward-looking statements are identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “projects,” “targets” and similar expressions. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on the information available to management at this time and which speak only as of this date. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For a discussion of some of the factors that may cause actual results to differ materially from those suggested by the forward-looking statements, please read carefully the information under “Risk Factors” beginning on page 3.

 

The identification in this document of factors that may affect future performance and the accuracy of forward-looking statements is meant to be illustrative and by no means exhaustive. All forward-looking statements should be evaluated with the understanding of their inherent uncertainty. You may rely only on the information contained in this prospectus.

 

We have not authorized anyone to provide information different from that contained in this prospectus. Neither the delivery of this prospectus nor the sale of common stock means that information contained in this prospectus is correct after the date of this prospectus. This prospectus is not an offer to sell or solicitation of an offer to buy these securities in any circumstances under which the offer or solicitation is unlawful.

 

PROSPECTUS SUMMARY

Common stock offered by the selling security holders		2,408,733 shares held by the selling security holders and 3,034,580 shares issuable upon exercise of the warrants
Common stock currently outstanding as of June 21, 2006		37,141,264 shares(1)
Common stock to be outstanding after the offering, assuming exercise of all the warrants for the shares covered by this prospectus		40,175,844 shares(1)(2)
OTC Bulletin Board Trading Symbol		ZERO.OB
Risk Factors		An investment in our common stock involves significant risks. See “Risk Factors” beginning on page   .

(1)		Does not include 7,181,257 shares of common stock issuable upon the exercise of outstanding options (with exercise prices ranging from $0.10 per share to $1.69 per share) and 22,075,058 shares of common stock issuable upon the exercise of warrants (with exercise prices ranging from $0.40 to $2.70 per share).
(2)		Includes 3,034,580 shares of common stock issuable upon the exercise of currently outstanding warrants (with exercise prices ranging from $1.00 to $2.70) covered by this prospectus. Excludes (i) an additional 19,040,478 shares of common stock issuable upon the exercise of currently outstanding warrants (with exercise prices ranging from $0.40 to $2.60) and (ii) an additional 1,839,512 shares of common stock issuable upon the conversion of outstanding convertible notes, or investor notes, at $.70 per share, none of which are covered by this prospectus.

 

 

Investing in our common stock involves a high degree of risk, and you should be able to bear the complete loss of your investment. You should carefully consider the risks described below, the other information in this Prospectus, the documents incorporated by reference herein and the risk factors discussed in our other filings with the Securities and Exchange Commission, including our Annual Reported on Form 10-KSB for the year ended December 31, 2005, when evaluating our company and our business. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known by us or that we currently deem immaterial also may impair our business operations. If any of the following risks actually occur, our business could be harmed. In such case, the trading price of our common stock could decline and investors could lose all or a part of the money paid to buy our common stock.

 

RISKS RELATED TO OUR BUSINESS

 

We have never generated any revenues, have a history of losses, and cannot assure you that we will ever become or remain profitable. As a result, you may lose your entire investment.

 

We have not yet generated any revenue from operations and, accordingly, we have incurred net losses every year since our inception in 1998. For the three-month periods ended March 31, 2006 and March 31, 2005, we had net losses of $2,998,105 and $1,065,056, respectively. For the fiscal years ended December 31, 2005 and 2004, we had net losses of $3,115,186 and $6,803,280, respectively. To date, we have dedicated most of our financial resources to research and development, general and administrative expenses and initial sales and marketing activities. We have funded all of our activities through sales of our securities. Although we expect to generate revenue beginning in 2006 from sales of our ZEFS and CAT-MATE devices, we anticipate net losses and negative cash flow to continue for the foreseeable future until such time as our products are brought to market in sufficient amounts to offset operating losses. As planned, we have significantly expanded both our research and development efforts, and our sales and marketing efforts, during the past year. Consequently, we will need to generate significant additional revenue to fund our operations. This has put a proportionate corresponding demand on capital. Our ability to achieve profitability is entirely dependent upon our research and development efforts to deliver a viable product and the company’s ability to successfully bring it to market. Although our management is optimistic that we will succeed with marketing the ZEFS and CAT-MATE devices, there can be no assurance that we will ever generate any revenues or that any revenues that may be generated will be sufficient for us to become profitable or thereafter maintain profitability. If we cannot generate any revenues or become or remain profitable, we may have to cease our operations and liquidate our business and you may lose your entire investment.

 

Our independent auditors have expressed doubt about our ability to continue as a going concern, which may hinder our ability to obtain future financing.

 

In their report dated March 22, 2006, our independent auditors stated that our financial statements for the year ended December 31, 2005 were prepared assuming that we would continue as a going concern. Our ability to continue as a going concern is an issue raised as a result of our recurring negative cash flows from operations and accumulated deficit. We had an accumulated deficit of approximately $20,246,074 and $23,244,179 as of December 31, 2005 and March 31, 2006, respectively. Our ability to continue as a going concern is subject to our ability to obtain significant additional capital to fund our operations and to generate revenue from sales, of which there is no assurance. The going concern qualification in the auditor’s report could materially limit our ability to raise additional capital. If we fail to raise sufficient capital, we may have to liquidate our business and you may lose your investment.

 

We may need additional capital to repay certain short-term debt as it matures during 2006.

 

In August and September 2005, we sold an aggregate of $1,501,378 of our 9% convertible subordinated notes due July 31, 2006, which we refer to as investor notes, to certain investors. The noteholders may voluntarily convert their investor notes into shares of our common stock at a conversion price of $.70 per share at any time prior to the maturity date of the investors notes. In addition, we may, at our option, require that the investor notes be converted into shares of our common stock if we raise or obtain firm commitments to raise at least $5,000,000 in new

financing in one or more debt or equity offerings subsequent to the issuance of the investor notes. We have not satisfied this condition and therefore at present we cannot require the conversion of the investor notes on or prior to their maturity date. As of June 21, 2006, noteholders holding $213,720 aggregate principal amount of the investor notes voluntarily converted their investor notes into 305,314 shares of our common stock.

 

Management cannot predict with certainty that the remaining noteholders will voluntarily convert their investor notes into shares of our common stock, eliminating the need for us to repay the investor notes when they mature on July 31, 2006. If the noteholders do not voluntarily convert the investor notes, or if we have not raised or obtained firm commitments to raise sufficient additional capital to require the conversion of the investor notes, we would either have to use a significant portion of our cash on hand to repay the investor notes or may be unable to repay the investor notes in full when they mature on July 31, 2006, and, in addition, we would have to curtail many of our business activities.

 

We will need additional capital to meet our operating needs, and we cannot be sure that additional financing will be available.

 

As of March 31, 2006 our expenses ran at a “burn rate” of approximately $350,000 per month, and since that time, due to expanded activities, our expenses have run and are expected to continue to run, at a “burn rate” of approximately $400,000 per month. Even assuming that we will not be required to repay the investor notes at maturity because they have been converted into shares of our common stock, our current capital resources will be sufficient to fund operations only through October 2006, and we will require additional capital in order to operate beyond this date. Management anticipates that at least portion of our cash flow needs will be satisfied by the exercise of outstanding warrants to purchase our common stock, at variable prices, which are coming due at various times this year. In addition, management is actively pursuing other financing alternatives. However, no assurance can be given at this time that any such sources of capital will be available to us, or available to us on favorable terms. If we cannot obtain needed capital, when and as we need it, our continuing research and development efforts, sales and marketing plans, business and financial condition and our ability to reduce losses and generate profits are likely to be materially and adversely affected.

 

If we obtain additional financing, you may suffer significant dilution.

 

Any additional issuance of our common stock, or securities convertible into or exercisable for our common stock, would dilute the percentage ownership of our existing stockholders. This dilution could also have an adverse impact on our earnings per share, if and when we become profitable, and reduce the price of our common stock. In addition, the new securities may have rights, preferences or privileges senior to those of our common stock.

 

As a company with an unproven business strategy, our limited history of operations makes evaluation of our business and prospects difficult.

 

Our business prospects are difficult to predict because of our limited operating history, early stage of development and unproven business strategy. Since our incorporation in 1998, we have been and continue to be involved in development of products using our technology, establishing manufacturing and marketing of these products to consumers and industry partners. Although we believe our technology and products in development have significant profit potential, we may not attain profitable operations and our management may not succeed in realizing our business objectives.

 

If we are not able to devote adequate resources to product development and commercialization, we may not be able to develop our products.

 

Our business strategy is to develop, manufacture and market ZEFS and CAT-MATE products using our technology. We believe that our revenue growth and profitability, if any, will substantially depend upon our ability to:

 

 

 

Certain of our products are still under various stages of development. Because we have limited resources to devote to product development and commercialization, any delay in the development of one product or reallocation of resources to product development efforts that prove unsuccessful may delay or jeopardize the development of other product candidates. Although our management believes that it can finance our product development through private placements and other capital sources, if we do not develop new products and bring them to market, our ability to generate revenues will be adversely affected.

 

As we have not generated positive cash flow from operations, our ability to continue operations is dependent on our ability to either begin to generate positive cash flow from operations or our ability to raise capital from outside sources.

 

We have not generated positive cash flow from operations and have relied on external sources of capital to fund operations. We had $320,344 in cash at March 31, 2006 and negative cash flow from operations of $953,963 for the three-month period ended March 31, 2006.

 

We currently do not have credit facilities available with financial institutions or other third parties, and historically have relied upon best efforts third-party funding. Though we have been successful at raising capital on a best efforts basis in the past, we can provide no assurance that we will be successful in any future best-efforts financing endeavors. We may need to continue to rely upon financing from external sources to fund our operations for the foreseeable future. If we are unable to raise sufficient capital from external sources to fund our operations, we may need to curtail operations.

 

The commercial viability of the ZEFS and CAT-MATE devices remains largely unproven and we may not be able to attract customers.

 

Despite the fact that have entered into our first distribution agreements, to the best of our knowledge, no consumer, engine, carburetor or automobile manufacturer has used the ZEFS or CAT-MATE devices to reduce engine emissions, enhanced performance or fuel efficiency to date. Accordingly, the commercial viability of our devices are not known at this time. If commercial opportunities are not realized from the use of the ZEFS and CAT-MATE devices, our ability to generate revenue would be adversely affected. There can be no assurances that we will be successful in marketing our devices, or that customers will ultimately purchase our devices. Failure to have commercial success from the sale of these devices will significantly and negatively impact our financial condition.

 

If our products and services do not gain market acceptance, it is unlikely that we will become profitable.

 

The market for products that reduce harmful motor vehicle emissions is evolving and we have many successful competitors. Automobile manufacturers have historically used various technologies, including catalytic converters, to reduce exhaust emissions caused by their products. At this time, our technology is unproven, and the use of our technology by others is limited. The commercial success of our products will depend upon the adoption of our technology by auto manufacturers and consumers as an approach to reduce motor vehicle emissions. Market acceptance will depend on many factors, including:

 

 

If our products do not achieve a significant level of market acceptance, demand for our products will not develop as expected and it is unlikely that we will become profitable.

 

We need to outsource and rely on third parties for the manufacture, sales and marketing of our devices, and our future success will be dependent on the timeliness and effectiveness of the efforts of these third parties.

 

We do not have the required financial and human resources or capability to manufacture, market and sell our devices. Our business model calls for the outsourcing of the manufacture, and sales and marketing of our devices in order to reduce our capital and infrastructure costs as a means of potentially improving our financial position and the profitability of our business. Accordingly, we must enter into agreements with other companies that can assist us and provide certain capabilities that we do not possess. We have entered into certain distribution agreements, but we may not be successful in entering into additional such alliances on favorable terms or at all. Even if we do succeed in securing additional distribution agreements, we may not be able to maintain them. Furthermore, any delay in entering into agreements could delay the development and commercialization of our products and reduce their competitiveness even if they reach the market. Any such delay related to our existing or future agreements could adversely affect our business.

 

We do not currently have an agreement in place for the manufacture of our ZEFS devices. Although we presently intend to have our CAT-MATE devices manufactured by Kwong Kee (Qing Xin) Environmental Exhaust Systems Company, Ltd. in China , we do not yet have an agreement in place for the manufacture of our CAT-MATE devices.

 

If any party to which we have outsourced certain functions fails to perform its obligations under agreements with us, the development and commercialization of our devices could be delayed or curtailed.

 

To the extent that we rely on other companies to manufacture, sell or market our devices, we will be dependent on the timeliness and effectiveness of their efforts. If any of these parties do not perform its obligations in a timely and effective manner, the commercialization of our devices could be delayed or curtailed because we may not have sufficient financial resources or capabilities to continue such development and commercialization on our own.

 

Any revenues that we may earn in the future are unpredictable, and our operating results are likely to fluctuate from quarter to quarter.

 

We believe that our future operating results will fluctuate due to a variety of factors, including:

 

 

A large portion of our expenses, including expenses for our facilities, equipment and personnel, is relatively fixed and not subject to significant reduction. In addition, we expect our operating expenses will continue to increase significantly in 2006, as a result of our continuing research and development efforts, and increased production, and sales and marketing activities. Although we expect to generate revenues from sales of our products in the future, revenues may decline or not grow as anticipated and our operating results could be substantially harmed for a particular fiscal period. Moreover, our operating results in some quarters may not meet the expectations of stock market analysts and investors. In that case, our stock price most likely would decline.

Nondisclosure agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.

 

In order to protect our proprietary technology and processes, we rely in part on nondisclosure agreements with our employees, licensing partners, consultants, agents and other organizations to which we disclose our proprietary information. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information, and in such cases we could not assert any trade secret rights against such parties. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position. Since we rely on trade secrets and nondisclosure agreements, in addition to patents, to protect some of our intellectual property, there is a risk that third parties may obtain and improperly utilize our proprietary information to our competitive disadvantage. We may not be able to detect unauthorized use or take appropriate and timely steps to enforce our intellectual property rights.

 

The manufacture, use or sale of our current and proposed product candidates may infringe on the patent rights of others, and we may be forced to litigate if an intellectual property dispute arises.

 

If we infringe or are alleged to have infringed another party’s patent rights, we may be required to seek a license, defend an infringement action or challenge the validity of the patents in court. Patent litigation is costly and time consuming. We may not have sufficient resources to bring these actions to a successful conclusion. In addition, if we do not obtain a license, do not successfully defend an infringement action or are unable to have infringed patents declared invalid, we may:

 

 

Parties making such claims may be able to obtain injunctive relief that could effectively block the company’s ability to further develop or commercialize our current and proposed product candidates in the United States and abroad and could result in the award of substantial damages. Defense of any lawsuit or failure to obtain any such license could substantially harm the company. Litigation, regardless of outcome, could result in substantial cost to and a diversion of efforts by the company.

 

We may face costly intellectual property disputes.

 

Our ability to compete effectively will depend in part on our ability to develop and maintain proprietary aspects of our technology and either to operate without infringing the proprietary rights of others or to obtain rights to technology owned by third parties. Our pending patent applications, specifically patent rights of the ZEFS and CAT-MATE devices, may not result in the issuance of any patents or any issued patents that will offer protection against competitors with similar technology. Patents we receive may be challenged, invalidated or circumvented in the future or the rights created by those patents may not provide a competitive advantage. We also rely on trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.

 

We are involved in a patent infringement suit brought by our former sole director and executive officer.

 

In April 2005, Jeffrey A. Muller, the Company’s former sole director and executive officer, filed a complaint against us seeking declaratory and injunctive relief and alleging unfair competition in connection with a claimed prior patent interest in the ZEFS device. Mr. Muller is seeking to have the patent rights in the ZEFS device that were

previously transferred to us by Mr. Muller’s bankruptcy trustee declared null and void. This is but one of several claims that have been litigated over a number of years between Mr. Muller and us. While we believe that we have valid claims and defenses, there can be no assurance that an adverse result or outcome in the pending litigation would not have a material adverse effect on our business prospects, financial position and cash flow.

 

We may not be able to attract or retain qualified senior personnel.

 

We believe we are currently able to manage our current business with our existing management team. However, as we expand the scope of our operations, we will need to obtain the full-time services of additional senior management and other personnel. Competition for highly-skilled personnel is intense, and there can be no assurance that we will be able to attract or retain qualified senior personnel. Our failure to do so could have an adverse effect on our ability to implement our business plan. As we add full-time senior personnel, our overhead expenses for salaries and related items will increase from current levels and, depending upon the number of personnel we hire and their compensation packages, these increases could be substantial.

 

If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve profitability.

 

Our future success is substantially dependent on the efforts of our senior management, particularly Eugene Eichler, Bruce McKinnon and John Bautista. The loss of the services of members of our senior management may significantly delay or prevent the achievement of product development and other business objectives. Because of the scientific nature of our business, we depend substantially on our ability to attract and retain qualified marketing, scientific and technical personnel. There is intense competition among specialized automotive companies for qualified personnel in the areas of our activities. If we lose the services of, or do not successfully recruit key marketing, scientific and technical personnel, the growth of our business could be substantially impaired. At present, we maintain key man insurance only for Mr. McKinnon.

 

We may incur increased costs under the Sarbanes-Oxley Act of 2002.

 

As a public company, we incur significant legal, accounting and other expenses. In addition, the Sarbanes-Oxley Act of 2002, as well as related rules adopted by the Securities and Exchange Commission, have imposed substantial requirements on public companies, including certain corporate governance practices and requirements relating to internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. Although we will not be required to evaluate how to document and test our internal control procedures under Section 404 of the Sarbanes-Oxley Act and the related rules of the Securities and Exchange Commission until our Annual Report on Form 10-KSB for the year ended December 31, 2007, effective disclosure controls and procedures and internal controls are necessary for us to produce reliable financial reports and are important in helping prevent financial fraud generally. We must begin to implement proper procedures significantly in advance of this date and will incur significant up-front expenses to do so. If we are unable to achieve and maintain adequate disclosure controls and procedures and internal controls, our business and operating results could be harmed.

 

Changes in stock option accounting rules may adversely affect our reported operating results, our stock price, and our ability to attract and retain employees.

 

In December 2004, the Financial Accounting Standards Board published new rules that will require companies such as us to record all stock-based employee compensation as an expense. The new rules apply to stock options grants, as well as a wide range of other share-based compensation arrangements including restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Large public companies have had to apply the new financial accounting rules to the first fiscal year that began after June  15, 2005, while small business issuers such as this company have had to apply the new rules in their first fiscal year beginning after December 15, 2005. As a small company with limited financial resources, we have depended upon compensating our officers, directors, employees and consultants with such stock based compensation awards in the past in order to limit our cash expenditures and to attract and retain officers, directors, employees and consultants. Accordingly, if

we continue to grant stock options or other stock based compensation awards to our officers, directors, employees, and consultants after the new rules apply to us, our future earnings, if any, will be reduced (or our future losses will be increased) by the expenses recorded for those grants. These compensation expenses may be larger than the compensation expense that we would be required to record were we able to compensate these persons with cash in lieu of securities. Since we are a small company, the expenses we may have to record as a result of future options grants may be significant and may materially negatively affect our reported financial results. The adverse effects that the new accounting rules may have on our future financial statements should we continue to rely heavily on stock-based compensation may reduce our stock price and make it more difficult for us to attract new investors. In addition, reducing our use of stock plans as an incentive for and a reward to our officers, directors and employees, could result in a competitive disadvantage to us in the employee marketplace.

 

RISKS RELATED TO OUR COMMON STOCK

 

Currently, there is only very limited trading in our stock, so you may be unable to sell your shares at or near the quoted bid prices if you need to sell your shares.

 

The shares of our common stock are thinly-traded on the OTC Bulletin Board, meaning that the number of persons interested in purchasing our common shares at or near bid prices at any given time may be relatively small or non-existent. This situation is attributable to a number of factors, including the fact that we are a small company engaged in a high risk business which is relatively unknown to stock analysts, stock brokers, institutional investors and others in the investment community that can generate or influence daily trading volume and valuation. Should we even come to the attention of such persons, they tend to be risk-averse and would be reluctant to follow an unproven, early stage company such as ours or purchase or recommend the purchase of our shares until such time as we became more seasoned and viable. As a consequence, there may be periods of several days or more when trading activity in our shares is minimal or non-existent, as compared to a seasoned issuer which has a large and steady volume of trading activity that will generally support continuous trading without negatively impacting our share price. We cannot give you any assurance that a broader or more active public trading market for our common shares will develop or be sustained. Due to these conditions, we can give you no assurance that you will be able to sell your shares at or near bid prices or at all. As a result, you could lose all or part of your investment.

 

The market price of our stock is volatile.

 

The market price for our common stock has been volatile in recent months, ranging from a closing price of $0.65 on January 10, 2006 to a closing price of $4.74 on March 13, 2006, and $2.20 on June 23, 2006. Additionally, the price of our stock has been both higher and lower than those amounts on an intra-day basis in recent months. Because our stock is thinly traded, its price can change dramatically over short periods, even in a single day. An investment in our stock is subject to such volatility and, consequently, is subject to significant risk. The market price of our common stock could fluctuate widely in response to many factors, including:

 

 

Substantial sales of common stock could cause our stock price to fall.

 

As of June 23, 2006, we had 37,141,264 shares of common stock outstanding. In the past year, there have been times when average daily trading volume of our common stock has been extremely low, and there have been many days in which no shares were traded at all. At other times, the average daily trading volume of our common stock has been high. As a result of the registration of the shares included in this prospectus, an additional 5,443,313 shares of our common stock (assuming exercise of the warrants) will be able to be freely sold on the market. Because of the limited trading volume, the sudden release of up to 5,443,313 additional freely trading shares included in this prospectus onto the market, or the perception that such shares will or could come onto the market, could have an adverse affect on the trading price of our stock. No prediction can be made as to the effect, if any, that sales of the shares included in this prospectus, or the availability of such shares for sale, will have on the market prices prevailing from time to time. Nevertheless, the possibility that substantial amounts of common stock may be sold in the public market may adversely affect prevailing market prices for our common stock and could impair our ability to raise capital through the sale of our equity securities.

 

You may have difficulty selling our shares because they are deemed “penny stocks”.

 

Because our common stock is not quoted on the Nasdaq National Market or Nasdaq Capital Market or listed on a national securities exchange, if the trading price of our common stock remains below $5.00 per share, trading in our common stock will be subject to the requirements of certain rules promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which require additional disclosure by broker-dealers in connection with any trades involving a stock defined as a penny stock (generally, any non-Nasdaq equity security that has a market price of less than $5.00 per share, subject to certain exceptions). Such rules require the delivery, prior to any penny stock transaction, of a disclosure schedule explaining the penny stock market and the risks associated therewith and impose various sales practice requirements on broker-dealers who sell penny stocks to persons other than established customers and accredited investors (generally defined as an investor with a net worth in excess of $1,000,000 or annual income exceeding $200,000 individually or $300,000 together with a spouse). For these types of transactions, the broker-dealer must make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transaction prior to the sale. The broker-dealer also must disclose the commissions payable to the broker-dealer, current bid and offer quotations for the penny stock and, if the broker-dealer is the sole market-maker, the broker-dealer must disclose this fact and the broker-dealer’s presumed control over the market. Such information must be provided to the customer orally or in writing before or with the written confirmation of trade sent to the customer. Monthly statements must be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks. The additional burdens imposed upon broker-dealers by such requirements could discourage broker-dealers from effecting transactions in our common stock, which could severely limit the market liquidity of the common stock and the ability of holders of the common stock to sell their shares.

 

Potential issuance of additional shares of our common stock could dilute existing stockholders.

 

We are authorized to issue up to 200,000,000 shares of common stock. To the extent of such authorization, our Board of Directors has the ability, without seeking stockholder approval, to issue additional shares of common stock in the future for such consideration as the Board of Directors may consider sufficient. The issuance of additional common stock in the future will reduce the proportionate ownership and voting power of the common stock offered hereby.

 

We will not receive any proceeds from the sale of any of the common stock by the selling security holders pursuant to this prospectus. All proceeds from the sale of the shares will be for the account of the selling security holders. However, we will receive the proceeds from the exercise of warrants for 3,034,580 shares underlying such warrants, which are covered by this prospectus. If all of such warrants to purchase 3,034,580 shares of common stock are exercised for cash, the total amount of proceeds we would receive is approximately $3,925,062. We expect to use the proceeds, if any, that we receive from the exercise of warrants for general working capital purposes. We will pay the expenses of registration of these shares, including legal and accounting fees.

 

Overview

 

We are a development stage company that is transitioning to operations. We have not yet generated revenues. Historically, we devoted the bulk of our efforts on research and development of our proprietary and patented devices. Our devices are called “ZEFS” and “CAT-MATE.” Both the ZEFS and CAT-MATE technologies reduce carbon monoxide, hydrocarbon and oxides of nitrogen emissions in 2- and 4-stroke motorcycles, fuel-injection engines, generators and small engines. In addition, the ZEFS technology improves fuel efficiency and overall performance on equipment and vehicles driven by internal combustion engines.

 

During the past four years, we have acquired these technologies, developed products, conducted scientific tests and produced prototype products, and initiated sales and marketing efforts. In 2002, we acquired worldwide intellectual property, patent, manufacturing and marketing rights to the ZEFS technology. In late 2003, we acquired worldwide intellectual property and patent rights to the CAT-MATE technology. We have taken actions within the U.S. and internationally to secure our intellectual property rights.

 

During 2005, we also began to focus on the initial marketing of our devices. We entered into the first agreements for the distribution of our products in late 2005 and early 2006. We anticipate that we will begin delivering devices under these agreements commencing in the third quarter of 2006 and we currently believe that we will begin to generate revenue in late 2006. In April 2006, we entered into a product development agreement with a strategic partner relating our CAT-MATE devices.

 

In addition, we have initiated marketing efforts to international governmental entities in cooperation with the United Nations Environmental Programme (UNEP) and various original equipment manufacturers (OEMs), and the aftermarket to sell or license our ZEFS and CAT-MATE devices and technology.

 

Expenses to date have been funded through the sale of company stock and the issuance of debt. We will need to raise additional capital during 2006 to fund our sales and marketing efforts, continuing research and development, and certain other expenses.

 

Our company was incorporated on February 18, 1998, as a Nevada corporation under the name Mandalay Capital Corporation. We changed our name to Save the World Air, Inc. on February 11, 1999 following the acquisition of marketing and manufacturing rights of the ZEFS device. Our mailing address and executive offices are located at 5125 Lankershim Boulevard, North Hollywood, California, 91601. Our telephone number is (818) 487-8000. Our corporate website is www.stwa.com. Information contained on the website is not deemed part of this prospectus.

 

Governmental Mandates to Reduce Air Pollution

 

The incomplete and inefficient burning of fossil fuel in internal combustion engines results in unburned gases, such as hydrocarbons, carbon monoxide and oxides of nitrogen being expelled as harmful emission as a by-product of the engine’s exhaust. These emissions have contributed to significant air pollution and depletion of the ozone layer that protects the world’s atmosphere from harmful ultraviolet radiation. As a result, the world has experienced significant deterioration to its air quality since the beginning of the 20th century and the problem has gotten progressively worse with each passing year. Forecasts published by the World Resources Institute indicate that this trend will continue to accelerate.

 

Governments internationally recognize the serious effects caused by air pollution and have enacted legislation to mandate that engine manufacturers be required to reduce exhaust emissions caused by their products. As evidenced by the overwhelming participation in the establishment of the Kyoto Accord, most nations are moving towards tighter emissions control. The EU currently requires all member nations to adopt EURO3 emissions standards, and many Asian and Eastern European countries have also announced gradual phase-in of this standard. The cost of adding emissions control devices has always been a mitigating factor, shifting the cost burden to the consumer. In developing nations, where incomes are extremely low, economics and the lack of government resources have hampered progress. Nonetheless, we anticipate that the social and political realities of protecting our

environment may result in further government mandates that manufacturers adopt better cost effective solutions, such as our ZEFS and CAT-MATE devices, for reducing motor emissions.

 

Absent governmental mandates for emission controls, the primary appeal of our products is likely to be related to fuel efficiency and performance enhancement.

 

Our Business Strategy

 

Our Devices

 

Our principal business focus currently rests with development and distribution of devices designed to solve the complex problems caused by pollution from motorcycles, automobiles and other equipment driven by internal combustion engines and to improve the performance of those engines. We have designed and tested multiple versions of the ZEFS and CAT-MATE devices for use on 2- and 4-stroke carbureted and fuel injection gasoline engines and are currently in the process of adapting this technology to work on engines that use diesel fuels.

 

Historically, manufacturers of vehicles, motorcycles, power sports equipment, boats and small utility motors have had very few technological options to reduce emissions to the strictest levels of current and future government standards. The approach used by engine manufacturers to address this mandate has thus far generally taken the form of installing catalytic converters, which work on the principle of super heating gases within the exhaust manifold after the damaging gases have been created through internal combustion.

 

These traditional devices are expensive, and sensitive to the poor quality and adulterated fuel that is commonly found in developing nations. Bad fuel can permanently damage a catalytic converter with the first tank full, whereas the ZEFS device is unaffected by the problem of bad fuel. Catalytic converters also do not share the benefits of ZEFS technology of increased fuel efficiency and performance. In fact, in many cases catalytic converters are detrimental to mileage and power.

 

Our ZEFS devices contain permanent rare-earth magnets, which produce a very strong magnetic field. This field, when arranged in specific manner of shape and strength, causes a molecular change in the fuel as it passes through the field. As gasoline/diesel passes through the magnetic field, a molecular change in the fuel occurs facilitating a decline in both viscosity and surface tension. This allows for finer atomization, resulting in a more optimized mixture and therefore more efficient combustion, lower emissions, more horsepower and torque and improved fuel economy. Reductions have been recorded in the scale from 760 microns down to 140 microns in carburetion fuel systems and as low as 3 microns in fuel injection systems. The scientific theory behind the technology is explained in detail in the draft final report from the RAND Corporation, which oversaw our testing.

 

ZEFS devices have been developed for one-, two- and four- barrel carbureted and fuel injection engines. ZEFS devices are easily fitted to the base plates of carburetors and fuel injection systems; the devices are compact, there are no moving parts. They are also inexpensive to produce, extremely durable and unaffected by poor quality fuel.

 

Our CAT-MATE devices are specifically designed to work in conjunction with, and enhance the function of, common catalytic converters, when incorporated into their design. The device consists of a series of specifically shaped steel rings that, when placed in line with the exhaust flow before and/or after the catalytic substrate, facilitates acceleration in heat rise in the converter. This allows the converter to ignite quicker and easier on small displacement motors, which build heat much slower than do large displacement models. CAT-MATE also helps retain heat in the converter, allowing it to stay lit under idling and low RPM operation. Small motors, especially 2-stroke versions, are subject to low exhaust velocity and heat during idling, which causes most converters to extinguish and then become fouled with oil and contaminants eventually rendering them difficult to relight or useless.

 

CAT-MATE devices are not only designed to perform the functions stated above on both 2- and 4-stroke gasoline engines, along with diesel motors, but also perform as well as or better than an OEM catalytic converter, at a fraction of their cost. Specifically, CAT-MATE is designed for use on two- and four-stroke motorcycles, off-road and marine vehicles, generators, lawn mowers, on stationary implements and on “carbureted” and fuel injection motor vehicles.

Testing by the Company’s own research and development efforts, as well as by independent sources, has demonstrated that the use of ZEFS and CAT-MATE devices generate significant reductions in hydrocarbon, oxides of nitrogen and carbon monoxide emissions and, in the case of ZEFS devices, also improves fuel efficiency by lowering gas consumption and increases engine performance.

 

Research and Development

 

We are actively continuing our development of the ZEFS and CAT-MATE devices for use on gasoline and diesel powered engines and have taken steps to finalize devices to fit on carbureted, throttle body and multi-port fuel injection systems. We have used these prototype devices as demonstration units, during presentations, before manufacturers. It is our objective to facilitate the adoption of this technology by engine, carburetor, muffler and exhaust manufacturers.

 

Previously, we successfully developed multiple ZEFS devices for use on one-, two- and four-barrel carbureted engines and created production CAD drawings for these devices and produced multiple samples using aluminum housings and pre-production prototypes made of high temperature polymers. We have also created several prototype devices for use on fuel injection engines.

 

Because of the complexity and enormity of the task of designing variants of ZEFS and CAT-MATE devices to fit every make and model, we rely on the cooperation of manufacturers to support this function, including engineering, marketing, and installation of the devices. Additionally, we are cognizant that in order to preserve the integrity of the warranties provided by manufacturers, they must be involved in the process of designing and installing the ZEFS and CAT-MATE devices on legacy vehicles.

 

We are also engaged in limited research and development of ZEFS and CAT-MATE devices for use on diesel engines, such as those used on trucks, buses, heavy equipment and generators. Because these types of vehicles use engines provided from Cummins, Caterpillar, or Detroit Diesel almost exclusively, the number of ZEFS and CAT-MATE variants needed to service these fleets is considerably less than the number required to satisfy other markets. This fact alone makes entry into the diesel engine market potentially attractive for our business, offering potential customers with a minimum of expense for research and development of product variants.

 

In late 2005, we established a state-of-the-art research and product development facility in Morgan Hill, California, to complement our research and development center in Queensland, Australia. We have completed testing of ZEFS and CAT-MATE devices for multiple automobiles, trucks, motorcycles, off-road vehicles and stationary engines, the results of which were provided to RAND for evaluation. RAND was responsible for overseeing our research and development when that effort was based in Queensland. In connection with the establishment of our Morgan Hill facility, we transitioned the major focus of our R&D from Queensland to Morgan Hill. RAND assisted us in setting up our testing protocols at Morgan Hill. In addition, we are engaged in research and development of additional products, including other magnetic devices, at our Morgan Hill facility.

 

Our Queensland facility now focuses on novel technology research under the direction of our senior engineer and consultant, Adrian Menzell. RAND has now completed the majority of its work for us and is focusing on finalizing its report to us on the theoretical and technical issues relating to magnetism and fuels. In early 2005, we phased out the use of our third party R&D and testing facility in Los Angeles, California.

 

In April 2006, we entered into a product development agreement with Kwong Kee (Qing Xin) Environmental Exhaust Systems Company, Ltd. in China. Kwong Kee, a manufacturer of mufflers and catalytic converters, will collaborate with us on product development of our CAT-MATE technology. As part of our strategic alliance, Kwong Kee will make available its research and development facilities, testing equipment and product design and development support team.

 

We spent $1,873,464 in fiscal year 2004 and $1,150,361 in fiscal 2005 on research and development. Please see “Management’s Discussion and Analysis of Financial Condition and Results of Operation — Results of Operations” and Note 9 to Notes to Financial Statements for a more complete understanding of our research and development expense in 2005.

Independent Laboratory and Scientific Testing

 

The four internationally recognized emissions standards testing agencies for the certification of motor vehicles, parts, systems and aftermarket devices are the United States Environmental Protection Agency (EPA), California Air Resources Board (CARB), United Kingdom Vehicle Certification Agency (VCA) and TUF (Germany/EU).

 

We have performed independent laboratory testing of our ZEFS and CAT-MATE devices in order to gain better market acceptance by manufacturers and governmental regulatory officials. Research and testing using government standard test equipment in the United States, Thailand, China and Hong Kong has demonstrated that the ZEFS device reduces engine emissions, such as carbon monoxide, oxides of nitrogen and hydrocarbons, while also improving fuel consumption and performance. Research and testing using government standard test equipment in the United States and Hong Kong has demonstrated that the CAT-MATE device reduces engine emissions, such as carbon monoxide, oxides of nitrogen and hydrocarbons.

 

In December 2002, we retained RAND to study the validity and market potential of our technology. In early 2003, RAND determined that sufficient theoretical basis exists to warrant entry into a comprehensive product-testing program. As a result, in May 2003, we entered into an arrangement in which RAND would coordinate and supervise both a theoretical scientific study of the concepts underlying the ZEFS device as well as an empirical study. In response to an request for proposal (RFP) that RAND sent to 14 universities in the US, Temple University in Philadelphia, Pennsylvania was chosen to research our technology. Draft reports have been provided by RAND and their final report is in the process clearing peer review. RAND’s other activities on our behalf concluded in December 2005.

 

Tests of our CAT-MATE device on a Honda 2-stroke NSR 150 motorcycle and a Warrior 2-stroke 63cc generator conducted by Hong Kong Exhaust Emissions Laboratory (HKEEL) in July and August 2004 showed that CAT-MATE devices significantly reduce emissions of carbon monoxide (CO), hydrocarbons (THC) and oxides of nitrogen (NOX). These results were certified by United Kingdom’s VCA in January 2005.

 

Emissions and fuel economy tests conducted in 2004 and 2005 at Automotive Testing and Development Services, Inc. in Ontario California and in 2005 at Northern California Diagnostics Laboratory in Napa, California, both EPA and CARB approved testing laboratories, on a CAT-MATE device within the OEM exhaust system of a 1995 Mexican fuel injected Volkswagen Beetle taxi, showed significant reductions of CO, NOX and THC emissions, compared to the in-place original OEM exhaust system. In 2006, testing on our ZEFS devices for Harley-Davidson style motors were conducted at the EPA and CARB certified testing facility Olson Ecologic Laboratories in Fullerton, California. These tests yielded results that would allow these motors to meet current and future EPA and CARB emissions standards without expensive fuel injection and catalytic converters.

 

Further testing of our ZEFS device was conducted in December 2005 on a used 4-stroke motorcycle in Bangkok, Thailand at Automotive Emission Laboratory, Pollution Control Department, Ministry of Natural Resources and Environment of Thailand, and was performed jointly with S.P. Suzuki of Thailand, the authorized distributor of Suzuki products in Thailand. These certified test results surpassed “hot start” EURO 2 standards in all three of the harmful exhaust emissions, CO, NOX and THC, by the following amounts:

 

 

In addition, during the testing horsepower increased at all ranges, peaking at 18.8% at 50km/h and fuel economy increased 33% over the baseline tests.

Additional testing was conducted in early March 2006 at HKEEL, a certified laboratory of the United Kingdom’s VCA. In multiple certified tests of our ZEFS device on a new Chinese-manufactured carbureted 4-stroke Suyijia SZK125 motorcycle. These certified test results surpassed “cold start” EURO3 standards for motorcycles of 150cc or less in all three of the harmful exhaust emissions, CO, NOX and THC, by the following amounts:

 

 

In addition, during the testing fuel economy increased 7% over the baseline tests.

 

Of further note of the recent HKEEL testing, is the fact that it is generally difficult for anyone to meet EURO3 guidelines because the testing includes a “cold start” phase. The “cold start” phase includes exhaust emissions created when a motor is started after an 8-hour cold soak. It is during this warm-up time that engines produce their highest level of emissions. This is also where many catalytic converters fail because they must be heated to about 300 degrees (Fahrenheit) to begin working effectively.

 

Marketing

 

In October 2004, we commenced initial marketing efforts for our emission control and performance-enhancing ZEFS and CAT-MATE technologies, and these efforts are continuing. We are focused on selling or licensing our technologies and devices domestically and internationally to motorcycle, automobile, carburetor, fuel-injection and diesel engine manufacturers as well as, exhaust and muffler original equipment manufacturers (OEMs) and the after-market. We have made presentations of our ZEFS and CAT-MATE technologies to OEMs in the United States, Asia and Europe.

 

We entered into our first distribution agreements for our products in late 2005 and early 2006. Our first two US distributorship agreements with Team Phantom of Alaska and Motorcycle Products Consulting of California, provides for the sale of our ZEFS devices in the North American OEM and after-market for motorcycles through the distributors to certain named prospective purchasers.

 

In January 2006, we entered into our first international distributorship agreement, with Golden Allied Enterprises (Group) Co., Ltd. (“GAE”). The agreement provides that GAE will serve as our exclusive distributor for our ZEFS and CAT-MATE devices in the People’s Republic of China. The agreement with GAE is conditioned upon our ZEFS device achieving EURO2 standards in tests to be conducted in Shanghai. These tests were successfully completed in April 2006, during which tests of our ZEFS device achieved EURO2 standards and the combination of our ZEFS and CAT-MATE devices achieved EURO3 standards.

 

Based on the success of recent testing of our ZEFS device meeting EURO3 standards, we now also intend to seek distribution opportunities for our devices in Europe, in addition to our marketing efforts in the United States and Asia. See “Independent Laboratory and Scientific Testing” above.

 

We also intend to pursue marketing of our products in developing nations of the world. Harmful exhaust emissions from motorcycles and automobiles in developing countries is at the highest levels because of the continued widespread use of older models with either no or malfunctioning catalytic converters. We intend to continue to work with governments worldwide at all levels, together with industry, to capitalize on our technology to achieve what we know to be common global environmental objectives.

 

In November 2004, management met with UNEP in New York to enlist its aid with this objective. By UNEP invitation, we participated in a UNEP-sponsored meeting in Bali, Indonesia in December 2004, which resulted in the initiation of informal negotiations with United Nations and government officials to explore the possibility of pilot programs using our technology in Indonesia, Kenya, Mexico, Thailand, Brazil and Sri Lanka.

 

We also participated in a United Nations sponsored Summit in Lake Toba, North Sumatra, Indonesia in March 2005. This resulted in an announcement by the Lake Toba Summit Chair, Nico Barito, endorsed by HRH Sri Sultan Hamengkubowono X of Yogyakarta and the late Governor of North Sumatra, Razil Nurdin, of two pilot programs

intended to minimize carbon monoxide emissions, hydrocarbons and oxides of nitrogen, by installing our ZEFS devices on 10,000 student motorcycles at universities in Yogyakarta and Medan in Indonesia. Recently, in consultation with the program sponsors, we modified the pilot programs, which are now being conducted in cooperation with the Honda distributor in Medan, C.V. Indako Trading Co. Under the revised program, we fitted 50 Honda motorcycles in Medan to study the impact of our ZEFS devices on fuel economy and performance enhancement. The results of this program are expected in July 2006. We do not currently believe that the recent seismic and other geologic events in Indonesia will adversely affect our ability to conduct and complete this program. While this project is not expected to generate any revenue for us, we believe that it will provide evidence of the utility of our low-cost, easy-to-install technologies in developing countries for fuel efficiency and performance enhancement.

 

Manufacturing

 

We have outsourced the manufacture of our ZEFS devices to Quadrant Technologies Limited in connection with our pilot program in Indonesia. In addition, at present, we intend to outsource the manufacture of all our ZEFS devices to Quadrant Technologies. The magnets used in our ZEFS devices will be manufactured by Quadrant in China. The ZEFS device itself and other magnetic devices that we may produce, market and sell will be manufactured by Quadrant in the United States. We do not currently have an agreement in place with Quadrant for the manufacture of our ZEFS devices.

 

The manufacture of the magnets used in our ZEFS devices requires a rare-earth metal, neodymium. Neodymium is readily available in China, at relatively stable prices.

 

We intend to outsource the manufacture of our CAT-MATE devices to Kwong Kee in China, or other contract manufacturers. We do not currently have an agreement in place with Kwong Kee for the manufacture of our CAT-MATE devices. If we are unable to enter into an agreement with Kwong Kee for the manufacture of our CAT-MATE devices, we believe that alternative third party manufacturers are readily available at competitive prices.

 

Key components in the manufacture of our CAT-MATE devices, as is the case with all catalytic converters manufactured by others, include the precious metals palladium, platinum and rhodium. The prices for these precious metals are highly volatile. However, supplies of such precious metals are not restricted.

 

Competition

 

The automotive and motor engine industry is highly competitive. We have many competitors in the United States and throughout the world developing technologies to make engines more environmentally friendly and fuel efficient. For instance, automobile manufacturers have already developed catalytic converters on automobiles, in order to reduce emissions.

 

We are not aware of any products that compete directly with our ZEFS devices, or other magnetic devices that are currently under research and development by us. ZEFS provides the benefits of all of emission reductions, fuel efficiency and engine performance enhancement. There are competing products which provide one or more of the beneficial attributes of our ZEFS devices, but not all three benefits. Additionally, we believe that those competing products that show benefit in more than one area demonstrate greater benefit in only one area and provide only minimal improvements in other areas. This contrasts with the testing of our ZEFS devices. Please see “Independent Laboratory and Scientific Testing” above.

 

Competing emissions reduction products are largely comprised of catalytic converters and alternative fuels. Catalytic converters are much more expensive than our products, and are sensitive and subject to damage caused by the poor quality or adulteration of fuel commonly used in developing nations. In addition, while catalytic converters reduce emissions, they do not improve fuel efficiency or engine performance. Domestically, there are a large number of manufacturers and distributors of catalytic converters, such as Engelhart Inc., Dow Corning Inc., Delphi Corporation and Car Sound Exhaust System, Inc., among others. Internationally, most catalytic converters are manufactured and distributed by Engelhart Inc., Delphi Corporation and a large number of smaller businesses in a fragmented industry.

Alternative fuels, such as hydrogen, electricity, liquid natural gas and ethanol, generally require more costly conversions and the fuels are not readily available, if at all, in most of the world.

 

We are not aware of any other magnetic fuel treatments or products based on such technology which have been proven to significantly improve fuel mileage. There are many products currently on the market that claim to increase fuel efficiency. We believe that the majority of these products have not undergone or provided independent validation from a recognized third party, such as RAND, or testing at a certified laboratory. Fuel injection does improve fuel efficiency and performance, but is extremely expensive from the perspective of the developing nations of the world. Major domestic and international manufacturers and distributors of fuel injection systems include Delphi Corporation, Robert Bosch Corporation, Siemens Corporation, and a large number of smaller businesses in a fragmented industry.

 

We are not aware of any other magnetic fuel treatments or products based on such technology which have been proven to significantly improve performance. There are many products which a consumer can purchase to increase overall performance. All of the most effective such products, including forced induction, nitrous oxide injection and exotic exhaust, are very expensive, increase emissions, reduce fuel efficiency and shorter the life of the engine. Major domestic and international manufacturers and distributors of performance-enhancing systems include Holley Performance Products, Inc., Nitrous Express Inc., Paxton Automotive Corporation, Eaton Corporation, Vortec Engineering LLC, Flowermaster, Inc., Hedman Manufacturing, Inc., Gibson Performance, Inc. and a large number of smaller businesses in a fragmented industry.

 

Our CAT-MATE device is an enhancement of the traditional catalytic converter. Therefore, while there are no products that compete directly with CAT-MATE, CAT-MATE may be regarding as competing with the rest of the catalytic converter market. Domestically, there are a large number of suppliers of catalytic converters, such as Engelhart, Inc., Dow Corning Inc., Delphi Corporation and Car Sound Exhaust System, Inc., among others. Internationally, most catalytic converters are supplied from China by Engelhart, Inc., Delphi Corporation and a large number of smaller manufacturers in a fragmented industry.

 

Nonetheless, many of our competitors have greater financial, research, marketing and staff resources than we do. While we believe that our technology has greater benefits, it may be unable to gain market acceptance. Furthermore, research and development throughout the world is constantly uncovering new technologies. Although we are unaware of any technologies that compete directly with ours, there can be no assurance that any existing or future technology is or will be superior to our ZEFS and CAT-MATE devices.

 

Government Regulation and Environmental Matters

 

Our activities and products to date are not subject to any governmental regulations that would have a significant impact on our business. We believe that we are in compliance with all applicable regulations that apply to our business as it is presently conducted. Our products, as such, are not subject to certification or approval by the U.S. Environmental Protection Agency or other governmental agencies domestically or internationally. Instead, such agencies test and certify a sample engine fitted with our devices

 

Depending upon whether we manufacture or license our devices in the future and in which countries such devices are manufactured or sold, we may be subject to regulations, including environmental regulations at such time.

 

Because we do not presently intend to manufacture our own products, we do not believe that we will have any special requirements to comply with environmental rules and regulations in the United States or other countries for the foreseeable future.

 

Intellectual Property

 

In December 1998, the Company acquired all of the marketing and manufacturing rights to the ZEFS technology from the purported inventor of the technology in exchange for 5,000,000 shares of our common stock, $500,000 and $10 royalty for each unit sold. In November 2002, under our settlement with the bankruptcy trustee for the estate of the purported inventor and his wife, the trustee transferred all ownership and legal rights to an existing international patent application for the ZEFS Mark I device to us. In exchange for these rights, we gave the bankruptcy trustee an option to purchase 500,000 shares of our common stock at $1.00 share and $0.20 royalty on each device we sell. See “Legal Proceedings” and Note 1 to “Notes to Financial Statements”.

In May 2002, we settled a dispute with Kevin “Pro” Hart, who claimed proprietary rights to the ZEFS technology. He assigned to us any and all of his rights to the ZEFS technology in exchange for an option to purchase 500,000 shares of our common stock at $1.00 share and a $0.20 royalty on each device we sell. Mr. Hart served as a member of our Advisory Board until his death in March 2006.

 

The CAT-MATE technology was created by Adrian Menzell, a member of our research team in Australia. On August 20, 2003, Mr. Menzell filed preliminary Australian patent application #2004900192 for the CAT-FLAP. This technology was enhanced and on June 4, 2004, Mr. Menzell filed preliminary Australian patent application No. 2004903000 for the CAT-MATE. During subsequent development of the invention, further patent applications were filed in which John Kostic and/or Patrick Baker, who are consultants to our company, may have had inventive input. On September 1, 2003, we entered into an Assignment Agreement with Mr. Menzell, pursuant to which this technology was assigned to us in exchange for 20,000 shares of our common stock and a royalty of $.25 for each CAT-MATE device sold. On June 26, 2004, we received a deed of assignment from Mr. Menzell and each pending patent application was transferred to our name. Mr. Menzell currently also serves as our senior engineer.

 

ZEFS Patent Applications

 

We obtained the patent application for the ZEFS MK1 device [PCT/AU1/00585] originally filed in Australia on May 19, 2000. The International Filing Application for our ZEFS MK1 technology was filed on May 21, 2001 (Official No. 10/275946) [PCT/AU1/00585] and modified as ZEFS MK2 on July 9, 2003. On November 4, 2003 we filed for our ZEFS MK3 (#2003906094). The United States Patent and Trademark Office issued a Notice of Allowance of Patent dated January 24, 2005. The duration of the patent is 20 years from the date the original application was filed. Prior to the issuance of such patent, we relied solely on trade secrets, proprietary know-how and technological innovation to develop our technology and the designs and specifications for the ZEFS technology. Overall, we have applied for a patent on an international basis in approximately 64 countries worldwide.

 

ZEFS MK1 — Device For Saving Fuel and Reducing Emissions.  This fuel saving device has a disk-like nonmagnetic body provided with a central opening and a number of permanent magnets having opposed polarities positioned about the central opening to provide multidirectional magnetic fields. The device is positioned in a fuel air mixture to reduce emissions.

 

The following table summarizes the status of the ZEFS MK1 patent application in the following countries:

 

 

 

 

ZEFS MK2 — Device for Saving Fuel and Reducing Emissions.  This fuel saving device similar to that of the MK1 except that a central magnet can be provided in the opening and the peripheral magnets extend only partially through the depth of the body and stop short of the top wall to provide the option of moving the magnetic field further away from the base of the carburetor to increase the area of magnetic influence between the point of fuel atomization and the point of cessation of magnetic influence.

 

The priority date is July 19, 2003 from Australian patent application 2003903626.

 

The following table summarizes the status of the ZEFS MK2 patent application in the following countries:

 

Approximately 125 countries are covered by the PCT. National Patent Applications were filed on or before January 15, 2006.

 

ZEFS MK3 — Emission Control Devices.  This emission control device is particularly suited for fuel injection systems which has an elongate body formed with one or more channels and a number of permanent magnets is positioned in the channels. The device sits on a fuel rail.

 

The priority date is November 4, 2003 from Australia patent application 2003906094.

 

The following table summarizes the status of the ZEFS MK3 patent application in the following countries:

 

 

Approximately 125 countries are covered by the PCT. National Patent Applications were filed by May 4, 2006.

 

CAT-MATE Patent Applications

 

CAT-FLAP (Afterburner) — Improvements in or Relating to Emission Control Systems.  A catalytic converter is provided in an engine exhaust flow to reduce emissions. A valve is provided downstream from the catalytic converter. The valve is in a closed position when the exhaust flow volume is low to keep the hot exhaust gas around the catalytic converter to keep the catalytic converter within its operational temperatures. When the exhaust flow volume is high (e.g. the engine is revving) the catalyst is kept at its operational temperature by normal gas flow and valve is opened to not impede exhaust flow. A simple hinge flap is one method by which this can be achieved.

 

 

The priority date is January 16, 2004 from Australian patent application 2004900192.

 

Approximately 125 countries are covered by the PCT. National Patent Applications are due by July 8, 2006.

 

CAT-MATE — Inline Exhaust Device to Improve Efficiency of a Catalytic Converter.  A set of rings is placed downstream from the catalytic converter to re-radiate heat to the catalytic converter to keep the converter working at a warmer temperature and therefore greater efficiency.

 

The priority date is June 4, 2004 from Australian patent application 2004903000.

 

This invention was incorporated into the specifications filed pursuant to the CAT-FLAP invention.

Method and Apparatus for Treatment of a Fluid (Temple University).  This is an apparatus for the magnetic treatment of oils to improve viscosity.

 

 

 

 

The priority date is May 14, 2004 from Australian patent application 2004902563.

 

Approximately 125 countries are covered by the PCT. National patent applications are due by November 14, 2006.

 

Other Patent Applications

 

Device for Saving Fuel and Reducing Emissions.  This device uses stacked magnets.

 

The priority date is June 21, 2005 from Australian patent application 2005903248.

 

Under the terms of the Paris Convention, the Australian patent application provides “cover note” type protection for 12 months (i.e. until June 21, 2006) in all countries that are party to the Paris Convention, and there are over 160 countries, including all the major economies.

 

An international patent application reserving rights in this invention was filed in June 2006, including the right to the priority date of 12 June 2005, in all 132 members of the PCT. The Company has also filed national applications in Malaysia, Thailand and Taiwan, countries which are not signatories to the PCT. Combined, these filings result in pending patent protection of the invention in 135 countries.

 

The international patent application will undergo a search and amendments to the claims are anticipated in the course of the International Search Report stage of the PCT process. At the International Preliminary Examination stage, the Company intends to make detailed submissions to more clearly distinguish the invention from those in the prior art. At the conclusion of these two stages, it will be necessary for the Company to decide in which specific countries it should proceed to National Phase.

 

Trademarks

 

We have also filed two applications for trademark protection for CAT-MATE, as follows:

 

Class 7: Devices to reduce noxious exhaust emissions from combustion engines; devices positioned in the exhaust flow of an exhaust of a combustion engine and to reduce pollutants in the exhaust; devices to radiate or transmit heat to a catalytic converter in an exhaust system; devices to radiate or transmit heat to a catalytic converter in an exhaust system and which absorbs the heat from the exhaust gasses and reradiates the heat to the catalytic converter in the exhaust system; all the foregoing being for petrol or diesel engines.

 

 

 

 

 

Non-Disclosure Agreements

 

To further protect our intellectual property, we have entered into agreements with certain employees and consultants, which limit access to, and disclosure or use of, our technology. There can be no assurance, however, that the steps we have taken to deter misappropriation of our intellectual property or third party development of our technology and/or processes will be adequate, that others will not independently develop similar technologies and/or processes or that secrecy will not be breached. In addition, although management believes that our technology has been independently developed and does not infringe on the proprietary rights of others, there can be no assurance that our technology does not and will not so infringe or that third parties will not assert infringement claims against us in the future. Management believes that the steps they have taken to date will provide some degree of protection, however, no assurance can be given that this will be the case.

 

Employees

 

As of June 1, 2006, we had nine full-time employees and six part-time employees. As of such date, we also utilized the services of two full-time paid consultants in our R&D facility in Queensland, Australia and two additional part-time paid consultants to assist us with various matters, including marketing. We intend to hire additional personnel to provide services when they are needed on a full-time basis. We recognize that our efficiency largely depends, in part, on our ability to hire and retain additional qualified personnel as and when needed and we have adopted procedures to assure our ability to do so.

 

Properties

 

Our principal executive offices consist of leased space in North Hollywood, California. We lease this space from KZ Golf, Inc. (“KZG”), pursuant to a lease we originally entered into on October 16, 2003 and which expired on October 16, 2005. We exercised an option to renew the lease, which renewal term was due to expire on October 15, 2007. Through October 16, 2005, the rent was $3,400 per month for approximately 1,225 square feet, and for comprehensive office support services, including reception, parking and conference facilities. During the extended lease term, the rent was $3,740 per month.

 

In connection with our need to acquire additional office space and expanded services as our business activities grow, we entered into a new lease dated as of January 1, 2006 with KZG, replacing the prior lease and the terms applicable under the extended term thereof. The new lease is for a term of 19 months, expiring July 31, 2007. The new rent is $6,208 per month for approximately 1,700 square feet of office space, and for additional common area use, expanded office support services, including a computer network, and additional parking spaces. We have the right to renew the lease for an additional term of two years at a 10% increase over the then-current rent.

 

Bruce H. McKinnon, our President and a director, is an owner of KZG. Management believes that the terms of the lease with KZG are no less favorable than what we would have had to pay for equivalent space and comparable services with an unaffiliated party. See “Certain Relationships and Related Transactions”.

 

Our research and development facility located in Queensland, Australia is leased. We entered into the lease for this facility on November 15, 2003 for a term of two years, and extended the lease on a month-to-month basis thereafter until March 14, 2006. The rent during this period was AUD $1,292 (approximately US $956) per month. On March 14, 2006, we entered into a new lease for this facility for a term of two years commencing March 15, 2006 at a rent of AUD $1462 (approximately US $1,082). Upon the termination of the term of the lease, we have the option to renew the lease up to two times, each for an additional two-year term, at an increase over the base rent of the greater of 5% or the increase in the annual consumer price index in Australia. We believe that our present research and development facility is adequate for our current and planned activities and that suitable additional or replacement facilities in the Queensland area are readily available on commercially reasonable terms should such facilities be needed in the future.

 

Our engineering, production and testing facility is located in Morgan Hill, California. The lease for this facility was entered into on September 1, 2005 and amended on February 1, 2006. The term is for two years, expiring on August 31, 2007. The base rent is $4,160 per month for approximately 5,600 square feet of office and industrial

usage space, and is renewable, at our option, for two additional years at the then prevailing market rate. We believe that this space is adequate for our current and planned engineering, production and testing activities.

 

Legal Proceedings

 

On December 19, 2001, the SEC filed civil charges in the United States Federal District Court, Southern District of New York, against us, our former President and then sole director Jeffrey A. Muller, and others, alleging that we and the other defendants were engaged in a fraudulent scheme to promote our stock. The SEC complaint alleged the existence of a promotional campaign using press releases, Internet postings, an elaborate website, and televised media events to disseminate false and materially misleading information as part of a fraudulent scheme to manipulate the market for stock in our corporation, which was then controlled by Mr. Muller. On March 22, 2002, we signed a Consent to Final Judgment of Permanent Injunction and Other Relief in settlement of this action as against the corporation only, which the court approved on July 2, 2002. Under this settlement, we were not required to admit fault and did not pay any fines or restitution. The SEC’s charges of fraud and stock manipulation continue against Mr. Muller and others.

 

On July 2, 2002, after an investigation by our newly constituted board of directors, we filed a cross-complaint in the SEC action against Mr. Muller and others seeking injunctive relief, disgorgement of monies and stock and financial restitution for a variety of acts and omissions in connection with sales of our stock and other transactions occurring between 1998 and 2002. Among other things, we alleged that Mr. Muller and certain others sold Company stock without providing adequate consideration to us; sold insider shares without making proper disclosures and failed to make necessary filing required under federal securities laws; engaged in self-dealing and entered into various undisclosed related-party transactions; misappropriated for their own use proceeds from sales of our stock; and entered into various undisclosed arrangement regarding the control, voting and disposition of their stock. On July 30, 2002, the U.S. Federal District Court, Southern District of New York, granted our application for a preliminary injunction against Mr. Muller and others, which prevented Mr. Muller and other cross-defendants from selling, transferring, or encumbering any assets and property previously acquired from us, from selling or transferring any of our stock that they may own or control, or from taking any action to injure us or our business and from having any direct contact with our shareholders. The injunctive order also prevents Mr. Muller from engaging in any effort to exercise control over our corporation and from serving as an officer or director of our company. While we believe that we have valid claims, there can be no assurance that an adverse result or settlement would not have a material adverse effect on our financial position or cash flow.

 

In the course of the litigation, we have obtained ownership control over Mr. Muller’s claimed patent rights to the ZEFS^tm device. Under a Buy-Sell Agreement between Mr. Muller and dated December 29, 1998, Mr. Muller, who was listed on the ZEFS devise patent application as the inventor of the ZEFS device, purported to grant us all international marketing, manufacturing and distribution rights to the ZEFS device. Those rights were disputed because an original inventor of the ZEFS device contested Mr. Muller’s legal ability to have conveyed those rights.

 

In Australia, Mr. Muller entered into a bankruptcy action seeking to overcome our claims for ownership of the ZEFS device. In conjunction with these litigation proceedings, a settlement agreement was reached with the bankruptcy trustee whereby the $10 per unit royalty previously due to Mr. Muller under his contested Buy-Sell Agreement was terminated and replaced with a $.20 per unit royalty payable to the bankruptcy trustee. On November 7, 2002, under a settlement agreement executed with Mr. Muller’s bankruptcy trustee, the trustee transferred to us all ownership and legal rights to this international patent application for the ZEFS device.

 

Both the SEC and we filed Motions for Summary Judgment contending that there are no material issues of fact in contention and as a matter of law, the Court should grant a judgment against Mr. Muller and the cross-defendants.

 

Mr. Muller and several of the defendants filed a Motion to Dismiss the complaint filed by us and moved for summary judgment in their favor. On December 28, 2004, Judge George B. Daniels, denied the cross-defendants’ motion to dismiss our cross-complaint, denied the defendants’ request to vacate the July 2, 2002 preliminary injunction and denied their request for damages against us. The court also refused to grant a summary judgment in favor of the cross-defendants and dismissed Mr. Muller’s claims against us for indemnification for his legal costs and for damages resulting from the litigation. Neither Mr. Muller nor any of the cross-defendants have filed any

cross-claims against us and we are not exposed to any liability as a result of the litigation, except for possibly incurring legal fees and expenses should we lose the litigation.

 

On November 16, 2005, the Court granted the SEC’s motion for summary judgment. In granting the motion, the Court has barred Mr. Muller from serving as an officer or director of a public company for a period of 20 years, ordered Mr. Muller to disgorge any shares of our stock that he still owns and directed the Company to cancel any issued and outstanding shares of our stock still owned by Mr. Muller. Mr. Muller was also ordered to disgorge to the SEC unlawful profits in the amount of $7.5 million and a pay a civil penalty in the amount of $100,000. Acting in accordance with the ruling and decision of the Court, we have canceled (i) 8,047,403 shares of its common stock held by Mr. Muller and/or his affiliates, (ii) options to acquire an additional 10,000,000 shares of our common stock held by Mr. Muller personally and (iii) $1,017,208 of debt which Mr. Muller claimed was owed to him by the Company.

 

In response to the November 16, 2005 decision by the Court, Muller filed a motion seeking to set aside the Decision and Order of the Court. On March 31, 2006, the Court issued a Decision and Order denying Muller’s Motion to set aside the Decision on Summary Judgment issued against Muller on November 16, 2005.

 

A final decision on the motion for summary judgment filed by us, which potentially would terminate the ongoing litigation, is still pending. Should the Court not grant summary judgment in our favor, the case will be scheduled for final disposition in a trial. Although the outcome of this litigation cannot be predicted with any degree of certainty, we are optimistic that, based upon previous developments in the litigation and the Court’s granting of the SEC’s motion for summary judgment, the Court’s ruling on our motion for summary judgment will either significantly narrow the issues for any later trial or will result in a final disposition of the case in a manner favorable to us.

 

In April 2005, Jeffrey A. Muller, the Company’s former sole director and executive officer, filed a complaint against us in the Federal District Court for the Central District of California, seeking declaratory and injunctive relief and alleging unfair competition in connection with a claimed prior patent interest in the ZEFS device and stock option rights. In seeking declaratory relief, Mr. Muller is seeking to have the patent rights in the ZEFS device that were previously transferred to us by Mr. Muller’s bankruptcy trustee declared null and void.

 

This lawsuit brought by Mr. Muller arose out of the same claims that are the subject of ongoing litigation in the Federal District Court for the Southern District of New York, in which we have previously obtained a preliminary injunction against Mr. Muller barring him from any involvement with the Company and preventing Mr. Muller, his agents or assigns, from exercising any claimed rights to our assets or stock. Mr. Muller previously filed the same complaint in the Federal District Court for the Southern District of New York, which claim is still pending. On December 28, 2004, Federal District Court Judge George B. Daniels issued a decision dismissing motions filed by Mr. Muller against our cross-claims. The dismissal of those motions involved similar causes of action as those contained in Mr. Muller’s recent lawsuit commenced in the Federal District Court for the Central District of California. Since the case in New York is still pending, we believe that the filing of the new lawsuit in California is subject to various defenses which should result in the dismissal of the new lawsuit.

 

On January 25, 2006, Mr. Muller’s complaint, filed in the California District Court and transferred to the Federal Court in the Southern District of New York, was assigned to Judge George B. Daniels. It is expected that the Court will consolidate that complaint with the already pending claims encompassed within our Motion for Summary Judgment. While we believe that we have valid claims and defenses, there can be no assurance that an adverse result or outcome on the pending motions or a trial of this case would not have a material adverse effect on our financial position or cash flow.

 

Market Information

 

Through February 1, 2006, our common stock was quoted on the Pink Sheets under the symbol “ZERO.PK” Effective February 2, 2006, our common stock is quoted on the Over the Counter Bulletin Board under the symbol “ZERO.OB”. The following table sets forth the high and low closing prices of our common stock for the quarters indicated as quoted on the Pink Sheets through February 1, 2006, and on the OTC Bulletin Board since February 2, 2006:

 

 

 

 

Holders

 

According to the records of our transfer agent, we had 1,050 stockholders of record of our common stock and we estimate that we had approximately 1,629 additional beneficial owners of our common stock held in street name, at April  10, 2006.

 

Dividends

 

We do not pay a dividend on our common stock and we currently intend to retain future cash flows to finance our operations and fund the growth of our business. Any payment of future dividends will be at the discretion of our Board of Directors and will depend upon, among other things, our earnings, financial condition, capital requirements, level of indebtedness, contractual restrictions in respect to the payment of dividends and other factors that our Board of Directors deems relevant.

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Financial Statements and supplementary data referred to elsewhere in this prospectus.

 

This discussion contains forward-looking statements that involve risks and uncertainties. Such statements, which include statements concerning future revenue sources and concentration, selling, general and administrative expenses, research and development expenses, capital resources, additional financings and additional losses, are subject to risks and uncertainties, including, but not limited to, those discussed above under “Risk Factors” and elsewhere in this prospectus, that could cause actual results to differ materially from those projected. Unless otherwise expressly indicated, the information set forth in this prospectus is as of the date of the prospectus, and we undertake no duty to update this information.

 

These forward-looking statements include predictions regarding our future:

 

 

You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “expects,” “anticipates,” “believes,” “estimates,” “continues,” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.

 

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading “Risk Factors” in this prospectus. All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements.

 

Overview

 

We are a development stage company that is transitioning to operations. We have not yet generated revenues. Historically, we devoted the bulk of our efforts to the completion of the design, the development of our production models and the promotion of our products in the marketplace worldwide. Our devices, called “ZEFS” and “CAT-MATE”, are designed to reduce harmful emissions, and improve fuel efficiency and overall performance on equipment and vehicles driven by internal combustion engines. We have taken actions to secure our intellectual property rights to the ZEFS and CAT-MATE devices.

 

During 2005 and subsequently, we began to focus on the initial marketing of our devices. We entered into the first agreements for the distribution of our products in late 2005 and early 2006. Our first two U.S. distributorship agreements with Team Phantom of Alaska and Motorcycle Products Consulting of California, provides for the sale of our ZEFS devices in the North American OEM and after-market for motorcycles through the distributors to certain named prospective purchasers.

 

In January 2006, we entered into our first international distributorship agreement, with Golden Allied Enterprises (Group) Co., Ltd. (“GAE”). The agreement provides that GAE will serve as our exclusive distributor

for our ZEFS and CAT-MATE devices in the People’s Republic of China. The agreement with GAE is conditioned upon our ZEFS device achieving EURO2 standards in tests to be conducted in Shanghai. These tests were conducted and passed in April 2006.

 

We anticipate that we will begin delivering devices under these agreements commencing in the third quarter of 2006 and we currently believe that we will begin to generate revenue in late 2006.

 

In April 2006, we entered into a product development agreement with Kwong Kee (Qing Xin) Environmental Exhaust Systems Company, Ltd. in China. Kwong Kee, a manufacturer of mufflers and catalytic converters, will collaborate with us on product development of our CAT-MATE technology. As part of our strategic alliance, Kwong Kee will make available its research and development facilities, testing equipment and product design and development support team.

 

In addition, we are continuing our marketing efforts to international governmental entities in cooperation with the United Nations Environmental Programme (UNEP) and various original equipment manufacturers (OEMs), and the aftermarket to sell or license our ZEFS and CAT-MATE devices and technology. We anticipate that these efforts will continue during the remainder of 2006.

 

Expenses have been funded primarily through the sale of stock and convertible debt. We have raised capital in 2006 and will need to raise additional capital in 2006, and possibly beyond, to fund our sales and marketing efforts, continuing research and development, and certain other expenses, until our revenue base grows sufficiently.

 

Results of Operation

 

Three-Month Period Ended March 31, 2006 Compared to Three-Month Period Ended March 31, 2005

 

To date, we have not generated any revenues and our business continues in the development stage. We have focused our efforts on verifying and developing our technologies and devices and commencing marketing efforts for their license or sale. We expect to begin generating revenue in the third quarter of 2006.

 

General and administrative expenses were $2,940,011 for the three-month period ended March 31, 2006, compared to $661,595 for the three-month period ended March 31, 2005, an increase of $2,278,416. This increase is primarily attributable to an increase in non-cash expenses in the amount of $2,007,888. These non-cash items are made up of accounting valuation and amortization of warrant values associated with convertible debt financing totaling $1,183,293, which includes approximately $49,000 of accrued interest, revaluation of options and warrants using the Black- Scholes option pricing model amounting to $803,551, and depreciation of $21,044. Increases in cash expenses were $270,528 and were made up of Salaries, Benefits and Consulting Fees of $164,994; Corporate Expenses of $30,541; Professional Fees of $50,250; and Rent and Utilities and Office Expenses of $24,743.

 

Research and development expenses were $57,294 for the three-month period ended March 31, 2006, compared to $401,485 for the three-month period ended March 31, 2005, a decrease of $344,191. This decrease is primarily attributable to a decrease in research by RAND Corporation of $380,032, offset in part by an increase in product research, testing and prototype expenses of $35,841.

 

We expect our operating costs to increase during the balance of fiscal year 2006, primarily as a result of anticipated increases in product development expenses, general and administrative expenses and marketing expenses, as we continue production and sales activities during 2006.

 

We had a net loss of $2,998,105 or $.10 per share for the three-month period ended March 31, 2006, compared to a net loss of $1,065,056 or $.03 per share for the three-month period ended March 31, 2005. We expect to incur additional net loss in the fiscal year ending December 31, 2006, primarily attributable to continued general and administrative expenses and marketing-related expenditures without the benefit of any significant revenue for the remainder of the year.

 

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

To date, we have not generated any revenues and our business continues in the development stage. We have focused our efforts on verifying and developing our technologies and devices and commencing marketing efforts for

their distribution and sale. We entered into the first agreements for the distribution of our devices in late 2005 and early 2006.

 

General and administrative expenses were $2,980,046 for the fiscal year ended December 31, 2005, compared to $3,323,030 for the fiscal year ended December 31, 2004, a decrease of $342,984. This decrease is attributable to decreases in non-cash amortization of deferred compensation, consulting fees, director fees, professional fees and settlement costs ($938,935); corporate expenses ($36,695) and travel ($34,007), partially offset by increases in non-cash interest relating to convertible debt ($296,692); salaries and consulting ($201,749); interest and finance costs ($53,591); other office expense ($39,049); insurance ($24,549); professional fees ($23,741); rent and utilities ($16,619); and non-cash depreciation ($10,660).

 

Research and development expenses were $1,150,361 for the fiscal year ended December 31, 2005, compared to $1,873,464 for the fiscal year ended December 31, 2004, a decrease of $723,103. Our research and development expenses include contractual payments to RAND, consultant’s fees, capital expenditures, cost of services and supplies. The decrease in research and development expenses is primarily attributable to a decrease in non-cash research expense of $1,210,450, as well as actual R&D expenses for Australia also decreasing by $20,375. These decreases were offset by increases in actual expenses at our United States R&D facility, which increased by $112,722, and, contractual payments to RAND Corporation, which increased by $395,000.

 

Patent settlement costs were $-0- in the fiscal year ended December 31, 2005, compared to $1,610,066 in the fiscal year ended December 31, 2004. The patent settlement costs in the fiscal year ended December 31, 2004 were attributable to the Black-Scholes valuation placed on 1,000,000 warrants issued in connection with the acquisition of certain of our intellectual property.

 

Net other income increased by $1,011,940 primarily from the cancellation of the Muller loan of $1,017,208.

 

We had a net loss of $3,115,186, or $.08 per share, for the year ended December 31, 2005, as compared to a net loss of $6,803,280, or $.19 per share in the fiscal year ended December 31, 2004. We expect a decrease in the net loss in the fiscal year ending December 31, 2006 primarily attributable to sales we currently expect in the third and fourth quarter of 2006.

 

Liquidity and Capital Resources

 

We have incurred negative cash flow from operations in the development stage since our inception in 1998. As of March 31, 2006, we had cash of $320,344 and an accumulated deficit of $23,244,179. Our negative operating cash flow since inception has been funded primarily through the sale of common stock, issuance of convertible notes, and, to a lesser degree, by proceeds we received from the exercise of options and warrants.

 

The financial statements contained herein have been prepared on a going concern basis, which contemplates the realization of assets and settlement of liabilities and commitments in the normal course of our business. As reflected in the accompanying financial statements, we had a net loss of $2,998,105 and negative cash flow from operations of $935,963 for the three-month period ended March 31, 2006 and a stockholders’ deficiency of $2,256,315 as of March 31, 2006. These factors raise substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent on our ability to raise additional funds and implement our business plan. The financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.

 

As of March 31, 2006 our expenses ran at a “burn rate” of approximately $350,000 per month, and since that time, due to expanded activities, our expenses have run and are expected to continue to run, at a “burn rate” of approximately $400,000 per month. Even assuming that we will not be required to repay our Investor Notes at maturity on July 31, 2006 (described in more detail below), because they have been converted into shares of our common stock, our current capital resources will be sufficient to fund operations only through October 2006, and we will require additional capital in order to operate beyond this date. We anticipate that at least a portion of our cash flow needs will be satisfied by the exercise of outstanding warrants to purchase our common stock, at variable prices, which are coming due at various times this year. In addition, we are actively pursuing other financing alternatives, none of which are in place at present.

In addition, during 2005 we sold an aggregate of $1,501,378 principal amount of our 9% convertible subordinated notes (the “Investor Notes”) due July 31, 2006 to certain investors. Net proceeds from this offering were $1,428,432. The noteholders may convert the Investor Notes voluntarily at any time prior to maturity. The Company may, at its option, require that the Investor Notes be converted into shares of our Common Stock if we raise at least $5,000,000 gross proceeds in one or more offerings of our securities prior to such date. We have not yet satisfied this condition, but intend to seek voluntary conversion of the Investor Notes on or prior to their maturity. As of June 21, 2006, noteholders holding $213,720 aggregate principal amount of Investor Notes voluntarily converted their Investor Notes into 305,314 shares of our common stock.

 

We sold an aggregate $1,075,000 principal amount of our 9% convertible subordinated notes to investors in late 2005 and early 2006 (the “Bridge Notes”). Net proceeds to us from the sale of the Bridge Notes were $935,250. Of this amount, $550,000 principal amount was issued in the three-month period ended March 31, 2006, resulting in net proceeds to the Company of $478,500. The Bridge Notes matured on May 31, 2006. Prior to the maturity of the Bridge Notes, all of the holders of the Bridge Notes voluntarily converted their Bridge Notes into an aggregate 1,535,715 shares of our common stock, at a conversion price of $.70 per share.

 

In 2006, we have raised capital through the sale of our common stock and are continuing to raise capital through the sale of our common stock, to provide the funds necessary to continue to execute on our business plan and repay the Investor Notes when they mature on July 31, 2006, to the extent that they are not converted into shares of common stock before such date.

 

In April 2006, we conducted an offering of shares of our common stock to two overseas investors, in which we raised $737,881 gross proceeds ($667,803 net proceeds).

 

In May 2006, we conducted an offering (the “PIPE Offering”) of shares of our common stock and warrants through our exclusive placement agent, Spencer Clarke LLC of New York, in which we raised $1,650,009 gross proceeds ($1,435,508 net proceeds).

 

During the three-month period ended March 31, 2006, we also raised $153,127 through the exercises of outstanding warrants. Subsequent to the end of the three-month period ended March 31, 2006 and through June 23, 2006, we raised an additional $927,000 through the exercise of outstanding warrants.

 

Future minimum commitments for non-cancelable operating leases, convertible notes (if not converted into common stock prior to maturity) and employment agreements as of March 31, 2006 are as follows:

 

 

 

 

Convertible notes above exclude notes totaling $1,082,000 that were converted into common stock subsequent to March 31, 2006.

 

We believe that exercises of in-the-money options and warrants, together with sales of our securities in the PIPE Offering, the other recent offerings we have undertaken and may undertake, will provide most of the proceeds needed to meet our capital requirements on a going forward basis, assuming that the Investor Notes are converted into common stock. However, there can be no assurance that the Investor Notes will be converted into common stock or that any required additional equity or debt financing will be available or available on terms favorable to us. If the Investor Notes are not converted into common stock, or if we are unable to obtain additional financing, we may be required to delay, reduce the scope of, or eliminate, our ongoing research and development programs, reduce our marketing and sales activities, or relinquish rights to technologies that we might otherwise seek to develop or commercialize.

Off-Balance Sheet Arrangements

 

We are not a party to any off-balance sheet arrangements, and we do not engage in trading activities involving non-exchange traded contracts. In addition, we have no financial guarantees, debt or lease agreements or other arrangements that could trigger a requirement for an early payment or that could change the value of our assets.

 

We do not believe that inflation has had a material impact on our business or operations.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of financial condition and results of operations is based upon our Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these Financial Statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an on-going basis, our estimates and judgments, including those related to the useful life of the assets. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

 

The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results that we report in our Financial Statements. The SEC considers an entity’s most critical accounting policies to be those policies that are both most important to the portrayal of a company’s financial condition and results of operations and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain at the time of estimation. We believe the following critical accounting policies, among others, require significant judgments and estimates used in the preparation of our Financial Statements:

 

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain significant estimates were made in connection with preparing our financial statements as described in Note 2 to Notes to Financial Statements. See Part I, Item 1, “Financial Statements”. Actual results could differ from those estimates.

 

Stock-Based Compensation

 

On January 1, 2006, we adopted Statements of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123R. We have applied the provisions of SAB 107 in our adoption of SFAS 123R.

 

We adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our 2006 fiscal year. Stock-based compensation expense recognized under SFAS 123R for employees and directors for the three months ended March 31, 2006 was $478,490. Basic and diluted loss per share would have been $(0.08), if we had not adopted SFAS 123R, compared to reported basic and diluted loss per share of $(0.10) per share. As of March 31, 2006 there is $2,007,933 of unrecognized compensation expense related to unvested options that are expected to vest through February 2007. The weighted average period over which this expense is to be recognized is approximately five months.

 

Recent Accounting Pronouncements

 

In November 2004, the Financial Accounting Standards Board “(FASB”) issued Statement of Financial Accounting Standards No. 151, “Inventory Costs”. This Statement amends the guidance in ARB No. 43 Chapter 4

Inventory Pricing, to require items such as idle facility costs, excessive spoilage, double freight and rehandling costs to be expensed in the current period, regardless if they are abnormal amounts or not. This Statement will become effective for us in the first quarter of 2006. The adoption of SFAS No. 151 is not expected to have a material impact on our financial condition, results of operations, or cash flows.

 

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS No. 154”). SFAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle. APB Opinion 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects of the cumulative effect of the change. In the event of such impracticality, SFAS No. 154 provides for other means of application. In the event the Company changes accounting principles, it will evaluate the impact of SFAS No. 154.

 

Directors and Executive Officers

 

The following table sets forth the name, age and position held by each of our executive officers and directors, as of June 26, 2006. Directors are elected for a period of one year and thereafter serve until the next annual meeting at which their successors are duly elected by the stockholders.

 

 

 

 

Biographical Information

 

Eugene E. Eichler, CPA, has served as our Chief Executive Officer since October 2005, assuming the position previously held by our late Chairman and Chief Executive Officer Edward L. Masry, and has served as our Chief Financial Officer since May 2002. He has also been a director since May 2002. Mr. Eichler served as our President from March 2004 to October 2005 and as our Chief Operating Officer from October 2001 to March 2004. Mr. Eichler was the Chief Financial Officer and Firm Administrator of the law firm Masry & Vititoe from 1982 to October 2001. From 1974 to 1982, Mr. Eichler provided financial consulting services to Foundation for HMO’s, Acne Care Medical Clinics and Earth Foods, Inc. From 1960 to 1974, Mr. Eichler headed financial consulting services for Milburn Industries and Brown, Eichler & Company. From 1953 to 1960, he held the position of Chief Budgets and Forecasts at North American Aviation. From 1951 to 1953, Mr. Eichler held various audit positions at the Atomic Energy Commission. Mr. Eichler received a B.A. from University of Montana.

Bruce H. McKinnon has served as our President since October 2005 and has been a director since May 2002. He served as our Executive Vice-President of Business Development from December 2003 to March 2004 and our Chief Operating Officer from March 2004 to October 2005. Mr. McKinnon served as Chief Executive Officer and President of KZ Golf, Inc., an international golf equipment company, from 1994 to December 2003. From 1990 to 1994, he was President and Chief Executive Officer of TTL Corporation and Novaterra, Inc., environmental remediation and technology corporations. Prior to 1990, Mr. McKinnon was an owner, Chairman and Chief Executive Officer of several international trading and manufacturing corporations.

 

John Bautista has served as our Executive Vice President of Operations since February 2006 and served as our Vice President of Operations from July 2005 through February 2006. He previously served as a consultant to our company from April 2005 to June 2005. From June 2003 to June 2005, Mr, Bautista was President and CEO of JDAK Enterprise, Inc., a company engaged in international importing, distribution and brokerage of motorcycle parts, as well as the production and assembly of custom motorcycles. From January 1999 through May 2003, Mr. Bautista was Mechanical Service and Calibration Department Manager for Mechanical Environmental Systems Analysis and Adjustment Agency. Mr. Bautista has technical knowledge and experience with ISO certified programs under Department of Defense, Department of Energy and Environmental Protection Agency regulations.

 

Joseph Helleis has served as a director since May 2002 and as our Chairman of the Board since December 2005, succeeding the late Edward L. Masry, who passed away on December 6, 2005. Mr. Helleis also serves as chairperson of the Audit Committee, and, until June 26, 2006, also served as chairperson of the Compensation Committee and the Nominating and Corporate Governance Committee. Since 2002, he has been operating his own financial services consulting firm, Joseph Helleis and Associates. From 2000 to 2002, he was President/Chief Executive Officer with Bank of Whittier, California. From 1981 to 2000, he served in senior executive capacities as Chairman/CEO, President/CEO, and Chief Credit Officer with number of financial institutions in the southern California region. After his honorable discharge from the United States Navy in 1960, Mr. Helleis served with Citibank in New York City until 1981 where his last position was Vice President/Senior Credit Officer for the New York State Business Banking Region.

 

Hon. J. Joseph (“John”) Brown, AO, has served as a director since May 2002. Reflecting the Company’s increased activities and growing corporate governance needs, Mr. Brown also became chairperson of the Compensation Committee on June 26, 2006. He has served as Chairman of the Australian Tourism Task Force since 1989 and currently is a professional consultant to Service Corporation International Australia. Mr. Brown has also served as director of Macquarie Tourism and Leisure since 1990. From 1983 to 1988, Mr. Brown was Minister for Sport and Tourism for the Australian government and from 1987 to 1988 he was the Minister for the Environment. He was a member of the Olympics bid teams for Brisbane (1992), Melbourne (1996) and the successful Sydney bid (2000). Mr. Brown was Founding Director of the Sydney Olympic Games Organizing Committee in 1992 and the Sydney Paralympic Organizing Committee in 1998.

 

John F. Price, Ph.D., has served as a director since May 2002. Reflecting the Company’s increased activities and growing corporate governance needs, Mr. Price also became chairperson of the Nominating and Corporate Governance Committee on June 26, 2006. He co-founded and has served as Chairman of the Board of Conscious Investing Pty Ltd., a software company, since May 2001. In June 1998, Mr. Price founded Price Value, Inc., a software company to market software that he developed. He has served as Chairman of the Board of Price Value, Inc. since 1998. Since October 1997, Mr. Price has held various teaching positions in mathematics and physics at University of New South Wales. From 1990 to 1998, he was professor and head of the Mathematics Department at Maharishi University of Management. Mr. Price received a B.Sc. and M.Sc. from the University of Melbourne and a Ph.D. from the Australian National University.

 

Cecil Bond Kyte has served as a director on February 21, 2006. Since December 2002, Mr. Kyte has been an investor in a number of businesses, including those in oil and gas exploration, and financial services, including SwissGuard International, GmbH, based in Zurich, Switzerland, of which he is a co-founder. SwissGuard serves the American annuity market with an emphasis on asset protection and growth. From February 2000 to November 2002, Mr. Kyte was employed by Chautauqua Airways, a United States regional carrier, in various capacities, including service as an airline pilot from February 2002 to November 2002. Mr. Kyte received a B. S. Degree in Accounting from Long Beach State University.

 

The following table sets forth certain information regarding the compensation earned during the last three fiscal years by the Named Executive Officers:

 

Summary Compensation Table

 

 

 

Stock Option Grants

 

The following table sets forth information concerning the stock option grants made to each of the Named Executive Officers during the 2005 fiscal year. No stock appreciation rights were granted to any of the Named Executive Officers during the 2005 fiscal year.

 

 

Aggregated Option Exercises in Last Fiscal Year
And Year-End Option Values

 

No options were exercised by any of the Named Executive Officers during the 2005 fiscal year. No stock appreciation rights were exercised by any of the Named Executive Officers during the 2005 fiscal year. The following table sets forth the number of shares of our common stock subject to exercisable and unexercisable stock options which the Named Executive Officers held at the end of the 2005 fiscal year.

 

 

 

 

Employment Agreements

 

Agreement with Eugene E. Eichler.  On December 1, 2003, the Company entered into an employment agreement, which was subsequently amended, and then later amended and restated on June 26, 2006, with Eugene E. Eichler, pursuant to which he originally served as our Chief Operating Officer. Since October 5, 2005, Mr. Eichler has served as our Chief Executive Officer and Chief Financial Officer. The initial term of the agreement expires on December 31, 2007 and renews automatically for additional one-year terms unless either party has given notice of non-extension prior to the end of a term. Under the agreement, as amended, Mr. Eichler was paid base compensation of $192,000 per annum through March 1, 2004, $240,000 per annum from March 2, 2004 through October 4, 2005 and $300,000 per annum effective October 5, 2005. The base compensation is reviewable by the Board in subsequent years of the term. Mr. Eichler is also eligible to participate in the Company’s incentive and benefit plans, including eligibility to receive grants of stock options under the 2004 Plan, and an automobile allowance which is presently $822 per month and has been as much as $960 per month.

 

If Mr. Eichler’s employment is terminated by us without cause or as a result of his disability or death, he or his estate, as the case may be, will be entitled to receive an amount equal to the greater of (i) his highest base compensation paid to him with respect to one of the two years immediately preceding the year in which the termination occurs or (ii) his base compensation in effect immediately prior to the date of termination, for a period

of one year beginning on the date of termination. In addition, he will be entitled to receive an amount equal to the greater of the aggregate bonus(es), if any, paid to him with respect to one of the two years immediately preceding the year in which the termination occurs. Mr. Eichler and his dependents will be entitled to continue to participate at the same levels in the Company’s benefit plans for a period of one year. If Mr. Eichler’s employment is terminated by him for good reason or as a result of a change of control, he will be entitled to receive all accrued salary, bonus and benefits for a period of three years from the date of termination. If Mr. Eichler’s employment is terminated by us for cause or by Mr. Eichler without good reason, he will only be entitled to receive accrued salary and benefits through the date of termination. The agreement also contains standard confidentiality and non-solicitation provisions.

 

Agreement with Bruce H. McKinnon.  On December 1, 2003, the Company entered into an employment agreement, which was subsequently amended and later amended and restated on June 26, 2006, with Bruce H. McKinnon, pursuant to which he originally served as our Executive Vice President of Business Development. Since October 5, 2005, Mr. McKinnon has served as our President. The initial term of the agreement expires on December 31, 2007 and renews automatically for additional one-year terms unless either party has given notice of non-extension prior to the end of a term. Under the agreement, as amended, Mr. McKinnon was paid base compensation of $153,600 per annum through March 1, 2004, $192,000 per annum from March 2, 2004 through October 4, 2005 and $240,000 per annum effective October 5, 2005. The base compensation is reviewable by the Board in subsequent years of the term. Mr. McKinnon is also eligible to participate in the Company’s incentive and benefit plans (except for the Company’s group health insurance plan), including eligibility to receive grants of stock options under the 2004 Plan and an automobile allowance of $900 per month. Mr. McKinnon participates in the group health plan maintained by KZ Golf, Inc. and the Company reimburses him for premium amounts he is required to contribute therefor.

 

If Mr. McKinnon’s employment is terminated by us without cause or as a result of his disability or death, he, or his estate as the case may be, will be entitled to receive an amount equal to the greater of (i) his highest base compensation paid to him with respect to one of the two years immediately preceding the year in which the termination occurs or (ii) his base compensation in effect immediately prior to the date of termination, for a period of one year beginning on the date of termination. In addition, he will be entitled to receive an amount equal to the greater of the aggregate bonus(es), if any, paid to him with respect to one of the two years immediately preceding the year in which the termination occurs. Mr. McKinnon and his dependents will be entitled to continue to participate at the same levels in the Company’s benefit plans for a period of one year. If Mr. McKinnon’s employment is terminated by him for good reason or as a result of a change of control, he will be entitled to receive all accrued salary, bonus and benefits for a period of three years from the date of termination. If Mr. McKinnon’s employment is terminated by us for cause or by Mr. McKinnon without good reason, he will only be entitled to receive accrued salary and benefits through the date of termination. The agreement also contains standard confidentiality and non-solicitation provisions.

 

Agreement with John Bautista.  On July 1, 2005, the Company entered into an employment agreement, which has since been amended and restated on June 26, 2006, with John Bautista, pursuant to which he served as our Vice President of Operations from July 1, 2005 through February 21, 2006 and Executive Vice President of Operations since February 21, 2006, at which time he also became an executive officer of the Company. The initial term of the agreement expired on December 31, 2005 and renews automatically for additional one-year terms unless either party has given notice of non-extension prior to the end of a term. Under the agreement, as amended, Mr. Bautista was paid base compensation of $120,000 per annum from July 1, 2005 through February 28, 2006 and $150,000 per annum effective March  1, 2006. The base compensation is reviewable by the Board of Directors in subsequent years of the term. Mr. Bautista is eligible to participate in the Company’s incentive and benefit plans (except for the Company’s group health insurance plan), including eligibility to receive grants of stock options under the 2004 Plan and an automobile allowance of $900 per month. Mr. Bautista participates in the group health insurance plan maintained by his spouse’s employer and the Company reimburses him for the premium amounts he is required to contribute therefor.

 

If Mr. Bautista’s employment is terminated by us without cause or as a result of his disability or death, he, or his estate as the case may be, will be entitled to receive an amount equal to the greater of (i) his highest base compensation paid to him with respect to one of the two years immediately preceding the year in which the termination occurs or (ii) his base compensation in effect immediately prior to the date of termination, for a period

of one year beginning on the date of termination. In addition, he will be entitled to receive an amount equal to the greater of the aggregate bonus(es), if any, paid to him with respect to one of the two years immediately preceding the year in which the termination occurs. Mr. Bautista and his dependents will be entitled to continue to participate at the same levels in the Company’s benefit plans for a period of one year. If Mr. Bautista’s employment is terminated by him for good reason or as a result of a change of control, he will be entitled to receive all accrued salary, bonus and benefits for a period of three years from the date of termination. If Mr. Bautista’s employment is terminated by us for cause or by Mr. Bautista without good reason, he will only be entitled to receive accrued salary and benefits through the date of termination. The agreement also contains standard confidentiality and non-solicitation provisions.

 

Agreement with Edward L. Masry.  On December 1, 2003, the Company entered into an employment agreement with Edward L. Masry, pursuant to which he served as our Chief Executive Officer. The initial term of the agreement was due to expire on December 31, 2007 and would have renewed automatically for additional one-year terms unless either party had given notice of non-extension prior to the end of a term. The agreement provided for a base compensation of $1 per year. Mr. Masry was eligible to participate in the Company’s incentive and benefit plans, including eligibility to receive grants of stock options under the 2004 Plan.

 

If Mr. Masry’s employment was terminated by us without cause or as a result of his disability or death, he or his estate, as the case may be, will be entitled to receive an amount equal to the greater of the aggregate bonus(es), if any, paid to him with respect to one of the two years immediately preceding the year in which the termination occurs. In addition, Mr. Masry and his dependents would be entitled to continue to participate at the same levels in the Company’s benefit plans for a period of one year. If Mr. Masry’s employment had been terminated by him for good reason or as a result of a change of control, he would have been entitled to receive all accrued salary, bonus and benefits for a period of three years from the date of termination. If Mr. Masry’s employment had been terminated by us for cause or by Mr. Masry without good reason, he would only have been entitled to receive accrued salary and benefits through the date of termination. The agreement also contained standard confidentiality and non-solicitation provisions.

 

Mr. Masry passed away on December 6, 2005.

 

Compensation of Board of Directors

 

During 2006, our directors who are not officers or employees of the Company will be compensated for their services in the amount of $1,000 per meeting of the Board. In addition, the chairperson of the Audit Committee will receive a retainer of $3,000 per month and the chairperson of the Compensation, and Nominating and Corporate Governance Committees each will receive a retainer of $2,000 per month.

 

During 2005, our directors who were not officers or employees of the Company also each received, in addition to the foregoing cash compensation, annual grants of options to purchase 100,000 shares of our common stock, at $.85 per share. In addition, Joseph Helleis received an additional grant of options to purchase 75,000 shares of our common stock, at $.85 per share, for serving as the chairperson of the Audit, Compensation, and Nominating and Corporate Governance Committees. All of the foregoing options vest fully on the first anniversary of the date of grant. No option grants have yet been made to such directors in 2006.

 

The Company is undertaking a comprehensive review of its director compensation policy, including cash and non-cash components, with the assistance of an outside executive compensation consulting firm. Such review is ongoing at this time.

 

Stock Option Plan

 

Introduction.  On March 2, 2004, the Board approved our 2004 Stock Option Plan (the “2004 Plan”), subject to approval from our stockholders, which approval was received at the 2004 Annual Meeting on May 24, 2004. At the Annual Meeting of Stockholders held on May 24, 2005 (the “2005 Annual Meeting”), the Company’s stockholders approved an amendment to the 2004 Plan to increase the maximum number of shares of common stock that could be issued under the 2004 Plan from a total of 1,500,000 shares of common stock to 5,000,000 shares of common stock, or an increase of 3,500,000 shares.

On February 21, 2006, the Board approved and recommended to the stockholders for approval an additional amendment to the 2004 Plan to increase the maximum number of shares of common stock that can be issued under the 2004 Plan from a total of 5,000,000 shares of common stock to 7,000,000 shares of common stock, or an increase of an additional 2,000,000 shares. This proposal was approved by the Company’s stockholders at the 2006 Annual Meeting of Stockholders held on May 19, 2006.

 

We currently have outstanding options issued under the 2004 Plan to purchase approximately 3,931,257 shares of our common stock and options issued outside the 2004 Plan to purchase an additional 3,250,000 shares of our common stock. The weighted-average exercise price of all outstanding options is approximately $0.59 per share.

 

Purpose of the 2004 Plan.  The 2004 Plan is intended to benefit and strengthen the Company and its stockholders by:

 

 

Administration.  A committee of three or more people selected by the Board administers the 2004 Plan. The Board has designated the Compensation Committee as the administrator of the 2004 Plan.

 

Shares Available for Grant Under the Plan.  As originally adopted by the stockholders at the 2004 Annual Meeting, the 2004 Plan contained a total of 1,500,000 shares of our common stock, subject to adjustment in the event of certain changes in our capitalization. At the 2005 Annual Meeting, the stockholders approved an amendment to the 2004 Plan, increasing the total number of shares which can be the subject of grants under the 2004 Plan from 1,500,000 to 5,000,000, an increase of 3,500,000 shares. At the 2006 Annual Meeting, the stockholders approved a further amendment to the 2004 Plan, increasing the total number of shares which can be the subject of grants under the 2004 Plan from 5,000,000 to 7,000,000, an increase of an additional 2,000,000 shares. If an option terminates or expires for any reason without having vested and been exercised, the related shares of common stock will again become available for grant.

 

Eligibility.  All employees, directors, consultants and advisers of the Company are eligible to receive option grants under the 2004 Plan. As of March 31, 2006, two Named Executive Officers (as defined below on page 13), four non-employee directors and approximately eleven other employees were eligible to be selected by the Compensation Committee to receive grants under the 2004 Plan.

 

Types and Terms of Stock Options.  The Compensation Committee may grant either incentive stock options qualified with respect to Internal Revenue Code Section 422 (“ISOs”) or options not qualified under any section of the Internal Revenue Code (“non-qualified options”). All ISOs granted under the 2004 Plan must have an exercise price that is at least equal to the fair market value of our common stock on the grant date and, in the case of a person who is a 10% or greater stockholder, the exercise price must be at least 100% of the fair marketing value of our common stock on the grant date. The exercise price of a non-qualified option shall be determined by the Board or the Compensation Committee. As of March 31, 2006, the fair market value of a share of our common stock, determined by the closing price per share on that date as quoted on the OTC Bulletin Board, was $2.95. No stock option granted under the 2004 Plan may have a term longer than ten years and, in the case of a person who is a 10% or greater stockholder, the stock option may not have a term longer than five years. The exercise price of stock options may be paid in cash, or, if the Compensation Committee permits, by tendering shares of common stock.

 

Vesting.  The Compensation Committee has the authority to determine the amounts and period of time over which a stock option shall become exercisable (vest). However, the fair market value with respect to which an ISO is exercisable by an optionee during any calendar year may not exceed $100,000.

 

Stock Options Granted to Specific Individuals.  The number of options that any individual may be granted, if any, under the 2004 Plan will be determined, from time to time, in the discretion of the Compensation Committee or, when appropriate, the Board, and therefore cannot be determined in advance.

 

Federal Income Tax Consequences.  The following summary is intended only as a general guide to the United States federal income tax consequences under current law of incentive stock options and non-qualified stock

options, which are authorized for grant under the 2004 Plan. It does not attempt to describe all possible federal or other tax consequences of participation in the 2004 Plan or tax consequences based on particular circumstances. The tax consequences may vary if options are granted outside the United States.

 

Incentive Stock Options.  An option holder recognizes no taxable income for regular income tax purposes as a result of the grant or exercise of an incentive stock option qualifying under Internal Revenue Code Section 422. Option holders who dispose of the shares acquired under an incentive stock option after two years following the date the option was granted and after one year following the exercise of the option will normally recognize a capital gain or loss upon a sale of the shares equal to the difference, if any, between the sale price and the purchase price of the shares. If an option holder satisfies such holding periods upon a sale of the shares, the Company will not be entitled to any deduction for federal income tax purposes. If an option holder disposes of shares within two years after the date of grant or within one year after the date of exercise (a “disqualifying disposition”), the difference between the fair market value of the shares on the exercise date and the option exercise price (not to exceed the gain realized on the sale if the disposition is a transaction with respect to which a loss, if sustained, would be recognized) will be taxed as ordinary income at the time of disposition. Any gain in excess of that amount will be a capital gain. If a loss is recognized, there will be no ordinary income, and such loss will be a capital loss. Any ordinary income recognized by the option holder upon the disqualifying disposition of the shares generally will result in a deduction by the Company for federal income tax purposes.

 

Non-Qualified Options.  Options not designated or qualifying as incentive stock options will be non-qualified options having no special tax status. An optionee generally recognizes no taxable income as the result of the grant of such an option. Upon exercise of a non-qualified option, the optionee normally recognizes ordinary income in the amount of the difference between the option exercise price and the fair market value of the shares on the exercise date. If the optionee is an employee, such ordinary income generally is subject to withholding of income and employment taxes. Upon the sale of stock acquired by the exercise of a non-qualified option, any gain or loss, based on the difference between the sale price and the fair market value on the exercise date, will be taxed as a capital gain or loss. No tax deduction is available to the Company with respect to the grant of a non-qualified option or the sale of the stock acquired pursuant to such grant. The Company generally should be entitled to a deduction equal to the amount of ordinary income recognized by the optionee as a result of the exercise of a non-qualified option.

 

Other Considerations.  The Internal Revenue Code allows publicly-held corporations to deduct compensation in excess of $1 million paid to the corporation’s chief executive officer and its four other most highly compensated executive officers in office at the end of the tax year if the compensation is payable solely based on the attainment of one or more performance goals and certain statutory requirements are satisfied. We intend for compensation arising from grants of awards under the 2004 Plan which are based on performance goals, including stock options and stock appreciation rights granted at fair market value, to be deductible by us as performance-based compensation not subject to the $1 million limitation on deductibility.

 

Transferability.  All ISOs are non-transferable other than by will or the laws of descent and distribution and shall be exercisable during an optionee’s lifetime only by the optionee. The Compensation Committee may provide that a non-qualified option may be transferred under certain terms and conditions.

 

Extraordinary Events.  In the event of a sale of more than half the fair market value of the assets of the Company, the acquisition by a group or entity of more than 30% of the voting securities of the Company, or the dissolution or liquidation of the Company, all stock options not exercised shall terminate as of the date such transaction or event takes place, unless the stock options are assumed. The vesting of unvested stock options shall be accelerated in certain circumstances in connection with the acquisition of the assets or stock of the Company and the optionee shall be entitled to receive cash equal to the difference between the exercise price of the stock option and value of the consideration attributable to the transaction.

 

Amendment and Termination.  The Board or the Compensation Committee may suspend, amend or terminate the 2004 Plan at any time, but no such action may be taken without stockholder approval if such approval is required by law or if such action increases the maximum number of shares that may be issued under the 2004 Plan, reduces the exercise price of an ISO, increases the maximum term of an ISO or permits stock options to be granted to anyone not eligible to be granted options at the time of the adoption of the 2004 Plan. The Board may, with the consent of an

optionee, make modifications of the terms and conditions of that person’s stock option, other than as described in the preceding sentence, in which case stockholder approval is also required.

 

 

The following table sets forth certain information regarding the beneficial ownership of our common stock as of June 23, 2006 by:

 

 

As of June 23, 2006, there were 37,141,264 shares of our common stock outstanding.

 

 

 

 

Selling Security Holders Table

 

The table below sets forth information concerning the resale of the shares of common stock by the selling security holders. We will not receive any proceeds from the resale of the common stock by the selling security holders. We will receive proceeds for the exercise, if any, of the warrants referenced below.

 

The shares to be offered by the selling security holders:

 

 

The shares being registered hereunder and upon exercise of the warrants and offered pursuant to this prospectus are “restricted” securities under applicable federal and state securities laws and are being registered under the Securities Act of 1933, as amended (the “Securities Act”), to give the selling security holders the opportunity to sell these shares publicly. This prospectus is part of a registration statement on Form SB-2 filed by us with the Securities and Exchange Commission under the Securities Act covering the resale of such shares of our common stock from time to time by the selling security holders. No estimate can be given as to the amount or percentage of our common stock that will be held by the selling security holders after any sales made pursuant to this prospectus because the selling security holders are not required to sell any of the shares being registered under

this prospectus. The following table assumes that the selling security holders will sell all of the shares listed in this prospectus.

 

The following table sets forth the beneficial ownership of the selling security holders. The term “selling security holder” or “selling security holders” includes the stockholders listed below and their respective transferees, assignees, pledges, donees or other successors. Beneficial ownership is determined in accordance with Rule 13d-3 of the Securities and Exchange Act of 1934 and generally includes voting or investment power with respect to securities. Shares of common stock subject to options, warrants and convertible securities currently exercisable or convertible, or exercisable or convertible within 60 days are deemed outstanding, including for purposes of computing the percentage ownership of the person holding the option, warrant or convertible security, but not for purposes of computing the percentage of any other holder.

 

 

 

 

The information in the above table is as of the date of this prospectus. Information concerning the selling security holders may change from time to time and any such changed information will be described in supplements to this prospectus if and when necessary.

 

Relationships with Selling Security Holders

 

From October 2005 through February 2006, we sold (i) $1,075,000 aggregate principal amount of our Bridge Notes and (ii) 2,303,568 of our two-year Bridge Warrants to purchase 2,303,568 shares of our common stock, in a private offering conducted by Spencer Clarke, LLC of New York, as our placement agent. The Bridge Notes were convertible at $0.70 per share and the Bridge Warrants are exercisable at $1.00 per share. As part of the offering, warrants exercisable for 153,572 shares of our common stock were issued to Spencer Clarke. In 2006, all of the Bridge Notes were converted into a total of 1,535,715 shares of Common Stock on or before the maturity date.

 

In May 2006, we sold an aggregate (i) 873,018 shares of common stock and (ii) three-year PIPE warrants to purchase 436,511 shares of common stock at $2.70 per share, in a private offering conducted by Spencer Clarke, LLC, of New York, as our placement agent. As part of the offering, warrants exercisable for 87,302 shares of our common stock were issued to Spencer Clarke.

 

Certain of the selling security holders are our existing stockholders who acquired their securities from us previously in one or more private placements. None of such selling security holders have had any position, office or other material relationship (other than as purchasers of securities) with us or any of our affiliates within the past three years, other than as follows. Eugene E. Eichler, the trustee of the Eichler/Wise Family Trust, is our Chief Executive Officer and Chief Financial Officer. Alfred Leifer, the trustee of the Leifer Trust and the Tesoro/Leifer Community Property Trust, is our Secretary and Controller.

 

Spencer Clarke LLC is the Company’s investment banker. They have been issued warrants for investment banking services provided to us from time to time, including in connection with offerings of our securities, which securities being registered under this prospectus. The shares issuable upon exercise of certain of these warrants, at various exercise prices, are being registered hereunder.

 

Each selling security holder of our common stock and any of their transferees, pledgees, assignees, donees, and successors-in-interest may, from time to time, sell any or all of their shares of common stock on the stock exchange, market or trading facility on which the shares are traded or in private transactions. These sales may be at fixed or negotiated prices. A selling security holder may use any one or more of the following methods when selling shares:

 

 

 

The selling security holders may also sell shares under Rule 144 under the Securities Act, if available, rather than under this prospectus.

 

Broker-dealers engaged by the selling security holders may arrange for other brokers-dealers to participate in sales. Broker-dealers may receive commissions or discounts from the selling security holders (or, if any broker-dealer acts as agent for the purchaser of shares, from the purchaser) in amounts to be negotiated. Each selling security holder does not expect these commissions and discounts relating to its sales of shares to exceed what is customary in the types of transactions involved.

 

The selling security holders and any broker-dealers or agents that are involved in selling the shares of common stock may be deemed to be “underwriters” within the meaning of the Securities Act in connection with such sales. In such event, any commissions received by such broker-dealers or agents and any profit on the resale of the shares purchased by them may be deemed to be underwriting commissions or discounts under the Securities Act. Because selling security holders may be deemed to be underwriters within the meaning of the Securities Act, they will be subject to the prospectus delivery requirements of the Securities Act. Discounts, concessions, commissions and similar selling expenses, if any, that can be attributed to the sale of common stock will be paid by the selling security holder and/or the purchasers. Each selling security holder has represented and warranted to our company that it acquired the securities subject to this registration statement in the ordinary course of such selling security holder’s business and, at the time of its purchase of such securities such selling security holder had no agreements or understandings, directly or indirectly, with any person to distribute any such securities.

 

There is no underwriter or coordinating broker acting in connection with the proposed sale of the resale shares by the selling security holders. We are required to pay certain fees and expenses incurred by us incident to the registration of the shares. We have agreed to indemnify the selling security holders against certain losses, claims, damages and liabilities, including liabilities under the Securities Act.

 

The selling security holders may from time to time pledge or grant a security interest in some or all of the shares owned by them and, if they default in the performance of their secured obligations, the pledgees or secured parties may offer and sell shares of common stock from time to time under this prospectus, or under an amendment to this prospectus under Rule 424(b)(3) or other applicable provision of the Securities Act amending the list of selling security holders to include the pledgee, transferee or other successors-in-interest as selling security holders under this prospectus. Upon our company being notified in writing by a selling security holder that any material arrangement has been entered into with a broker-dealer for the sale of common stock through a block trade, special offering, exchange distribution or secondary distribution or a purchase by a broker or dealer, a supplement to this prospectus will be filed, if required, pursuant to Rule 424(b) under the Securities Act, disclosing (i) the name of each such selling security holder and of the participating broker-dealer(s), (ii) the number of shares involved, (iii) the price at which such the shares of common stock were sold, (iv) the commissions paid or discounts or concessions allowed to such broker-dealer(s), where applicable, (v) that such broker-dealer(s) did not conduct any investigation to verify the information set out or incorporated by reference in this prospectus, and (vi) other facts material to the transaction. In addition, upon our company being notified in writing by a selling security holder that a donee or pledgee intends to sell more than 500 shares of common stock, a supplement to this prospectus will be filed if then required in accordance with applicable securities law.

Under applicable rules and regulations under the Exchange Act, any person engaged in the distribution of the resale shares may not simultaneously engage in market making activities with respect to our common stock for a period of two business days prior to the commencement of the distribution. In addition, the selling security holders will be subject to applicable provisions of the Exchange Act and the rules and regulations thereunder, including Regulation M, which may limit the timing of purchases and sales of shares of our common stock by the selling security holders or any other person. We will make copies of this prospectus available to the selling security holders and have informed them of the need to deliver a copy of this prospectus to each purchaser at or prior to the time of the sale.

 

Our principal executive offices consist of leased space in North Hollywood, California. We lease this space from KZ Golf, Inc. (“KZG”), pursuant to a lease we originally entered into on October 16, 2003 and which expired on October 16, 2005. We exercised an option to renew the lease, which renewal term was due to expire on October 15, 2007. Through October 16, 2005, the rent was $3,400 per month for approximately 1,225 square feet, and for comprehensive office support services, including reception, parking and conference facilities. During the extended lease term, the rent was $3,740 per month.

 

In connection with our need to acquire additional office space and expanded services as our business activities grow, we entered into a new lease dated as of January 1, 2006 with KZG, replacing the prior lease and the terms applicable under the extended term thereof. The new lease is for a term of 19 months, expiring July 31, 2007. The new rent is $6,208 per month for approximately 1,700 square feet of office space, and for additional common area use, expanded office support services, including a computer network, and additional parking spaces. We have the right to renew the lease for an additional term of two years at a 10% increase over the then-current rent.

 

Bruce H. McKinnon, our President and a director, is an owner of KZG. Management believes that the terms of the lease with KZG are no less favorable than what we would have had to pay for equivalent space and comparable services with an unaffiliated party.

 

In December 2005, Eugene Eichler, the Company’s Chief Executive Officer, loaned $45,000 to the Company for working capital purposes. The loan was unsecured, bore interest at 6% per annum and was due on demand. In February 2006, Mr. Eichler converted the loan into the Company’s Bridge Notes, which notes themselves were convertible into 64,286 shares of common stock at a conversion price of $.70 per share, and, in addition, received warrants to purchase 96,429 shares of common stock at an exercise price of $1.00 per share, as part of a private offering which we were conducting at that time. Mr. Eichler’s Bridge Notes were converted prior to the maturity of the Bridge Notes into 64,286 shares of common stock. The securities that were issued to Mr. Eichler upon both conversions described above were issued to him on the same terms as the securities we issued to all other investors during that private offering and upon the conversion of the Bridge Notes into shares of common stock.

 

We are presently authorized to issue 200,000,000 shares of $.001 par value common stock. As of June 23, 2006, we had 37,141,264 shares of common stock issued and outstanding.

 

Common Stock

 

The holders of our common stock are entitled to equal dividends and distributions per share with respect to the common stock when, as and if declared by the Board of Directors from funds legally available therefor. No holder of any shares of common stock has a preemptive right to subscribe for any of our securities, nor are any common shares subject to redemption or convertible into other securities. Upon liquidation, dissolution or winding- up of our company, and after payment of creditors, if any, the assets will be divided pro rata on a share-for-share basis among the holders of the shares of common stock. All shares of common stock now outstanding are fully paid, validly issued and non-assessable. Each share of our common stock is entitled to one vote with respect to the election of any director or any other matter upon which stockholders are required or permitted to vote.

Stock Purchase Warrants

 

Bridge Warrants

 

The Bridge Warrants which may be exercised for the shares of our common stock being registered in this prospectus entitle the holder to purchase the stated number of shares of our common stock at an exercise price of $1.00 per share, subject to adjustment in the event of stock splits, stock dividends, reclassifications or other similar transactions. These warrants are exercisable until 5 p.m. Eastern time on the second anniversary of the date of their issuance.

 

These Warrants may be exercised by surrendering the warrant certificates evidencing the warrants to be exercised with the accompanying form of election to purchase, together with payment of the aggregate exercise price in cash.

 

The holders of these warrants have no right to vote on matters submitted to our stockholders and have no right to receive any dividends which may be declared on our Common Stock. The holders of these warrants will not be entitled to share in our assets in the event of liquidation, dissolution or the winding up of the Company. If a bankruptcy or reorganization is commenced by or against the Company, a bankruptcy court may hold that any of these unexercised warrants are executory contracts which may be subject to rejection by us, and the holders of these warrants may, even if sufficient funds are available, receive nothing or less than they would have been entitled to if they had exercised their warrants prior to the commencement of any bankruptcy case.

 

PIPE Warrants

 

The so-called PIPE Warrants which may be exercised for the shares of our common stock being registered in this prospectus entitle the holder to purchase the stated number of shares of our common stock at an exercise price of $2.70 per share, subject to adjustment in the event of stock splits, stock dividends, reclassifications or other similar transactions. These warrants are exercisable until 5 p.m. California time on May 24, 2009.

 

These warrants may be exercised by surrendering the warrant certificates evidencing the warrants to be exercised with the accompanying form of election to purchase, together with payment of the aggregate exercise price in cash.

 

The holders of these warrants have no right to vote on matters submitted to our stockholders and have no right to receive any dividends which may be declared on our Common Stock. The holders of these warrants will not be entitled to share in our assets in the event of liquidation, dissolution or the winding up of the Company. If a bankruptcy or reorganization is commenced by or against the Company, a bankruptcy court may hold that any of these unexercised warrants are executory contracts which may be subject to rejection by us, and the holders of these warrants may, even if sufficient funds are available, receive nothing or less than they would have been entitled to if they had exercised their warrants prior to the commencement of any bankruptcy case.

 

Convertible Notes

 

Our 9% convertible subordinated notes, or Investor Notes, are due July 31, 2006. The Company may, at its option, require that these Investor Notes be converted into shares of our common stock if we raise at least $5,000,000 gross proceeds in one or more offerings of our securities prior to such date. We have not yet satisfied this condition, but intend to seek voluntary conversion of the Investor Notes on or prior to their maturity. As of June 23, 2006, noteholders holding $213,720 aggregate principal amount of Investor Notes voluntarily converted their Investor Notes into 305,314 shares of our common stock.

 

Shares Eligible For Future Sale

 

As of June 23, 2006, we had 37,141,264 shares of common stock outstanding. That number does not include (i) 7,181,257 shares that are reserved for issuance under outstanding options and that may be issued if and when the options are exercised, (ii) 22,075,058 shares that are reserved for issuance under warrants and that may be issued if and when such warrants are exercised (3,034,580 of these shares underlying warrants are included in this prospectus), (iii) 1,839,512 shares that are reserved for issuance if and when our Investor Notes are exercised;

and (iv) 3,068,743 shares that are reserved for issuance in connection with options that may be granted under the 2004 Plan.

 

Freely Tradeable Shares After Offering.  As of June 23, 2006 (and excluding the 5,443,313 shares covered by this prospectus), 24,757,012 shares of our 37,141,264 outstanding shares of common stock were free trading shares. Upon the sale of all the shares covered by this prospectus, an additional 5,443,313 shares will be freely tradable without restriction or limitation under the Securities Act. Assuming the exercise for all shares upon exercise of the related warrants, after the completion of this offering there will be 40,175,844 shares of common stock outstanding, of which 30,200,325 shares will be tradable without restriction under the Securities Act.

 

Rule 144.  In general, under Rule 144 as currently in effect, a person (or persons whose shares are aggregated) who has beneficially owned restricted securities shares for at least one year, including persons who may be deemed our “affiliates,” as that term is defined under the Securities Act, would be entitled to sell within any three month period a number of shares that does not exceed the greater of 1% of the then outstanding shares (approximately 371,413 shares if the currently outstanding warrants and options are not exercised and the Investor Notes are not converted, or approximately 682,371 shares if all options and warrants are exercised and all Investor Notes are converted) or the average weekly trading volume of shares during the four calendar weeks preceding such sale. Sales under Rule 144 are subject to certain manner of sale provisions, notice requirements and the availability of current public information about the company. A person who has not been our affiliate at any time during the three months preceding a sale, and who has beneficially owned his shares for at least two years, would be entitled under Rule 144(k) to sell such shares without regard to any volume limitations under Rule 144.

 

Form S-8 Registration of Options.  We intend to file a registration statement on Form S-8 covering the shares of common stock that have been issued or reserved for issuance under our stock option plan, which permits the resale of such shares in the public marketplace.

 

Transfer Agent

 

Our transfer agent is Nevada Agency and Trust Company, in Reno, Nevada.

 

The financial statements for the years ended December 31, 2005 and 2004 included in this prospectus have been audited by Weinberg & Co., P.A. to the extent and for the periods indicated in their report thereon. Such financial statements have been included in this prospectus and registration statement in reliance upon the report of Weinberg & Co., P.A. and upon the authority of such firm as experts in auditing and accounting.

 

Our Articles of Incorporation provide that no officer or director shall be personally liable to us or our stockholders for monetary damages except as provided pursuant to Nevada Revised Statutes. Our bylaws and Articles of Incorporation also provide that we will indemnify and hold harmless each person who serves at any time as a director, officer, employee or agent of us from and against any and all claims, judgments and liabilities to which such person shall become subject by reason of the fact that he is or was a director, officer, employee or agent of us, and shall reimburse such person for all legal and other expenses reasonably incurred by him or her in connection with any such claim or liability. We also have the power to defend such person from all suits or claims in accordance with the Nevada Revised Statutes. The rights accruing to any person under our bylaws and Articles of Incorporation do not exclude any other right to which any such person may lawfully be entitled, and we may indemnify or reimburse such person in any proper case, even though not specifically provided for by the bylaws and Articles of Incorporation.

 

In the employment agreements that we entered into with Messrs. Eichler, McKinnon and Bautista, we have agreed to indemnify each such employee for all claims arising out of performance of his duties as CEO, President

and Executive Vice President of Operations, respectively, other than those arising out of each such person’s gross negligence, recklessness or willful misconduct, to the fullest extent permitted by law.

 

Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the small business issuer pursuant to the foregoing provisions, or otherwise, we have been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the small business issuer for expenses incurred or paid by a director, officer or controlling person of the small business issuer in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, we will, unless in the opinion of our counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue.

 

SEC Law Firm, Los Angeles, California has rendered an opinion with respect to the validity of the shares of common stock covered by this prospectus.

 

We have filed with the Securities and Exchange Commission a registration statement on Form SB-2 under the Securities Act for the common stock offered under this prospectus. We are subject to the informational requirements of the Exchange Act, and file annual and current reports, proxy statements and other information with the Commission. These reports, proxy statements and other information filed by Save the World air, Inc. can be read and copied at the Commission’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the Commission at 1-800-SEC-0330. The Commission also maintains a website that contains reports, proxy statements, information statements and other information concerning Save the World Air, Inc. located at http://www.sec.gov. This prospectus does not contain all the information required to be in the registration statement (including the exhibits), which we have filed with the Commission under the Securities Act and to which reference is made in this prospectus.

 

SAVE THE WORLD AIR, INC.
(A DEVELOPMENT STAGE ENTERPRISE)

 

 

To the Board of Directors

Save the World Air, Inc.

 

We have audited the accompanying balance sheets of Save the World Air, Inc. (a development stage enterprise) as of December 31, 2005 and 2004 and the related statements of operations, changes in stockholders’ deficiency and cash flows for the years then ended and for the period from inception (February 18, 1998) to December 31, 2005. 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 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. 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 Save the World Air, Inc. (a development stage enterprise) as of December 31, 2005 and 2004 and the results of its operations and its cash flows for the years then ended and for the period from inception (February 18, 1998) to December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

 

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company had a net loss of $3,115,186 and a negative cash flow from operations of $2,567,178 for the year ended December 31, 2005, and had a working capital deficiency of $1,708,049 and a stockholders’ deficiency of $1,408,175 as of December 31, 2005. These factors raise substantial doubt about its ability to continue as a going concern. Management’s plans concerning this matter are also described in Note 2. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

/s/ WEINBERG & COMPANY, P.A.

 

WEINBERG & COMPANY, P.A.

 

March 22, 2006

Los Angeles, California

SAVE THE WORLD AIR, INC.
(A DEVELOPMENT STAGE ENTERPRISE)

 

BALANCE SHEETS

DECEMBER 31, 2004 AND 2005 AND MARCH 31, 2006 (UNAUDITED)

 

 

See notes to financial statements.

SAVE THE WORLD AIR, INC.
(A DEVELOPMENT STAGE ENTERPRISE)