UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





x
                QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the quarterly period ended March 31, 2010ORo
                TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF
      1934For
      the transition period from ________________ to
      _________________





Commission
File Number 333-120926





SOLAR
ENERTECH CORP.


(Exact
name of registrant as specified in its charter)





Delaware
              
              98-0434357State
      or other jurisdiction of
              
              (I.R.S.
      Employerincorporation
      or organization
              
              Identification
      No.)





444
Castro Street, Suite #707


Mountain
View, CA 94041


(Address
of principal executive offices) (Zip Code)





Registrant’s
telephone number, including area code(650) 688-5800





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes    x
    No   o





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).  Yes    o    
No    o





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “large
accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule
12b-2 of the Exchange Act. (Check one):





Large
      accelerated filer
                  o
                  
                  Accelerated
      Filer     oNon-accelerated
      filer
                  o
                  
                  Smaller
      reporting company      x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes   o 
No    x





Number of
shares outstanding of registrant’s class of common stock as of May 10, 2010:
177,224,747







SOLAR
ENERTECH CORP





FORM
10-Q





INDEX




PAGEPart I. Financial
      InformationItem
      1.
                Financial
      StatementsConsolidated
      Balance Sheets – March 31, 2010 (Unaudited) and September 30,
      2009 (Audited)
                
                3Unaudited
      Consolidated Statements of Operations – Three and Six Months Ended
      March 31, 2010 and 2009
                
                4Unaudited Consolidated
      Statements of Cash Flows – Six Months Ended March 31, 2010 and
      2009
                
                5Notes
      to Unaudited Consolidated Financial Statements
                
                6Item
      2.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                26Item
      3.
                Quantitative
      and Qualitative Disclosures about Market Risks
                
                34Item
      4T.
                Controls
      and Procedures
                
                34Part
      II. Other InformationItem
      1.
                Legal
      Proceedings
                
                35Item 1A.
                Risk
      Factors
                
                35Item
      2.
                Unregistered
      Sale of Equity Securities and Use of Proceeds
                
                35Item
      3.
                Defaults
      upon Senior Securities
                
                35Item
      4.
                Removed
      and Reserved
                
                35Item
      5.
                Other
      Information
                
                35Item
      6.
                Exhibits
                
                35Signatures
                
                36




2




PART
I




ITEM
1. FINANCIAL STATEMENTS


Solar
EnerTech Corp.


Consolidated
Balance Sheets





March
      31, 2010
                          
                          
                          September
      30, 2009(Unaudited)
                          
                          
                          (Audited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                          
                          $
                          897,000
                          
                          
                          $
                          1,719,000Accounts
      receivable, net of allowance for doubtful account of $96,000 and $96,000 at
      March 31, 2010 and September 30, 2009, respectively
                          
                          
                          13,351,000
                          
                          
                          
                          7,395,000Advance
      payments and other
                          
                          
                          199,000
                          
                          
                          
                          799,000Inventories,
      net
                          
                          
                          5,532,000
                          
                          
                          
                          3,995,000Deferred
      financing costs, net of accumulated amortization
                          
                          
                          -
                          
                          
                          
                          1,250,000VAT
      receivable
                          
                          
                          1,085,000
                          
                          
                          
                          334,000Other
      receivable
                          
                          
                          115,000
                          
                          
                          
                          408,000Total
      current assets
                          
                          
                          21,179,000
                          
                          
                          
                          15,900,000Property
      and equipment, net
                          
                          
                          9,965,000
                          
                          
                          
                          10,509,000Other
      assets
                          
                          
                          732,000
                          
                          
                          
                          -Investment
                          
                          
                          1,000,000
                          
                          
                          
                          1,000,000Deposits
                          
                          
                          102,000
                          
                          
                          
                          87,000Total
      assets
                          
                          $
                          32,978,000
                          
                          
                          $
                          27,496,000LIABILITIES
      AND STOCKHOLDERS' EQUITYAccounts
      payable
                          
                          $
                          12,326,000
                          
                          
                          $
                          5,794,000Customer
      advance payment
                          
                          
                          20,000
                          
                          
                          
                          27,000Accrued
      expenses
                          
                          
                          2,252,000
                          
                          
                          
                          1,088,000Accounts
      payable and accrued liabilities, related parties
                          
                          
                          5,730,000
                          
                          
                          
                          5,646,000Convertible
      notes, net of discount
                          
                          
                          -
                          
                          
                          
                          3,061,000Derivative
      liabilities
                          
                          
                          -
                          
                          
                          
                          178,000Total
      current liabilities
                          
                          
                          20,328,000
                          
                          
                          
                          15,794,000Convertible
      notes, net of discount
                          
                          
                          1,535,000
                          
                          
                          
                          -Derivative
      liabilities
                          
                          
                          1,279,000
                          
                          
                          
                          -Warrant
      liabilities
                          
                          
                          2,437,000
                          
                          
                          
                          2,068,000Total
      liabilities
                          
                          
                          25,579,000
                          
                          
                          
                          17,862,000STOCKHOLDERS'
      EQUITY:Common
      stock - 400,000,000 shares authorized at $0.001 par value
      177,224,747 and 111,406,696 shares issued and outstanding at March
      31, 2010 and September 30, 2009, respectively
                          
                          
                          177,000
                          
                          
                          
                          111,000Additional
      paid in capital
                          
                          
                          96,159,000
                          
                          
                          
                          75,389,000Other
      comprehensive income
                          
                          
                          2,467,000
                          
                          
                          
                          2,456,000Accumulated
      deficit
                          
                          
                          (91,404,000
                          )
                          
                          
                          (68,322,000
                          )Total
      stockholders' equity
                          
                          
                          7,399,000
                          
                          
                          
                          9,634,000Total
      liabilities and stockholders' equity
                          
                          $
                          32,978,000
                          
                          
                          $
                          27,496,000




The
accompanying notes are an integral part of these consolidated financial
statements.


3




Solar
EnerTech Corp.


Consolidated
Statements of Operations


(Unaudited)





Three
      Months Ended March 31,
                      
                      
                      Six
      Months Ended March 31,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Sales
                      
                      $
                      17,751,000
                      
                      
                      $
                      4,412,000
                      
                      
                      $
                      35,444,000
                      
                      
                      $
                      9,496,000Cost
      of sales
                      
                      
                      (16,824,000
                      )
                      
                      
                      (5,714,000
                      )
                      
                      
                      (32,586,000
                      )
                      
                      
                      (13,134,000
                      )Gross
      profit (loss)
                      
                      
                      927,000
                      
                      
                      
                      (1,302,000
                      )
                      
                      
                      2,858,000
                      
                      
                      
                      (3,638,000
                      )Operating
      expenses:Selling,
      general and administrative
                      
                      
                      2,550,000
                      
                      
                      
                      3,086,000
                      
                      
                      
                      4,768,000
                      
                      
                      
                      5,647,000Research
      and development
                      
                      
                      125,000
                      
                      
                      
                      436,000
                      
                      
                      
                      233,000
                      
                      
                      
                      771,000Loss
      on debt extinguishment
                      
                      
                      18,549,000
                      
                      
                      
                      181,000
                      
                      
                      
                      18,549,000
                      
                      
                      
                      491,000Total
      operating expenses
                      
                      
                      21,224,000
                      
                      
                      
                      3,703,000
                      
                      
                      
                      23,550,000
                      
                      
                      
                      6,909,000Operating
      loss
                      
                      
                      (20,297,000
                      )
                      
                      
                      (5,005,000
                      )
                      
                      
                      (20,692,000
                      )
                      
                      
                      (10,547,000
                      )Other
      income (expense):Interest
      income
                      
                      
                      1,000
                      
                      
                      
                      3,000
                      
                      
                      
                      4,000
                      
                      
                      
                      10,000Interest
      expense
                      
                      
                      (899,000
                      )
                      
                      
                      (558,000
                      )
                      
                      
                      (5,324,000
                      )
                      
                      
                      (923,000
                      )Gain
      on change in fair market value of compound embedded
    derivative
                      
                      
                      294,000
                      
                      
                      
                      113,000
                      
                      
                      
                      398,000
                      
                      
                      
                      588,000Gain
      on change in fair market value of warrant liability
                      
                      
                      2,055,000
                      
                      
                      
                      99,000
                      
                      
                      
                      2,976,000
                      
                      
                      
                      1,743,000Other
      expense
                      
                      
                      (312,000
                      )
                      
                      
                      (194,000
                      )
                      
                      
                      (444,000
                      )
                      
                      
                      (214,000
                      )Net
      loss
                      
                      $
                      (19,158,000
                      )
                      
                      $
                      (5,542,000
                      )
                      
                      $
                      (23,082,000
                      )
                      
                      $
                      (9,343,000
                      )Net
      loss per share - basic
                      
                      $
                      (0.14
                      )
                      
                      $
                      (0.06
                      )
                      
                      $
                      (0.20
                      )
                      
                      $
                      (0.11
                      )Net
      loss per share - diluted
                      
                      $
                      (0.14
                      )
                      
                      $
                      (0.06
                      )
                      
                      $
                      (0.20
                      )
                      
                      $
                      (0.11
                      )Weighted
      average shares outstanding - basic
                      
                      
                      140,801,393
                      
                      
                      
                      87,716,403
                      
                      
                      
                      114,240,342
                      
                      
                      
                      87,376,406Weighted
      average shares outstanding - diluted
                      
                      
                      140,801,393
                      
                      
                      
                      87,716,403
                      
                      
                      
                      114,240,342
                      
                      
                      
                      87,376,406





The
accompanying notes are an integral part of these consolidated financial
statements.


4




Solar
EnerTech Corp.


Consolidated
Statements of Cash Flows


(Unaudited)





Six
      Months Ended March 31,2010
                      
                      
                      2009Cash
      flows from operating activities:Net
      loss
                      
                      $
                      (23,082,000
                      )
                      
                      $
                      (9,343,000
                      )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      of property and equipment
                      
                      
                      1,190,000
                      
                      
                      
                      1,123,000Loss
      on disposal of property and equipment
                      
                      
                      51,000
                      
                      
                      
                      -Stock-based
      compensation
                      
                      
                      1,531,000
                      
                      
                      
                      3,217,000Loss
      on debt extinguishment
                      
                      
                      18,549,000
                      
                      
                      
                      491,000Payment
      of interest by issuance of shares
                      
                      
                      210,000
                      
                      
                      
                      -Amortization
      of note discount and deferred financing cost
                      
                      
                      5,114,000
                      
                      
                      
                      565,000Gain
      on change in fair market value of compound embedded
    derivative
                      
                      
                      (398,000
                      )
                      
                      
                      (588,000
                      )Gain
      on change in fair market value of warrant liability
                      
                      
                      (2,976,000
                      )
                      
                      
                      (1,743,000
                      )Changes
      in operating assets and liabilities:Accounts
      receivable, net
                      
                      
                      (5,952,000
                      )
                      
                      
                      591,000Advance
      payments and other
                      
                      
                      588,000
                      
                      
                      
                      975,000Inventories,
      net
                      
                      
                      (1,535,000
                      )
                      
                      
                      2,511,000VAT
      receivable
                      
                      
                      (750,000
                      )
                      
                      
                      1,015,000Other
      receivable
                      
                      
                      294,000
                      
                      
                      
                      629,000Accounts
      payable, accrued liabilities and customer advance payment
                      
                      
                      6,524,000
                      
                      
                      
                      567,000Accounts
      payable and accrued liabilities, related parties
                      
                      
                      84,000
                      
                      
                      
                      113,000Net
      cash (used in) provided by operating activities
                      
                      
                      (558,000
                      )
                      
                      
                      123,000Cash
      flows from investing activities:Acquisition
      of property and equipment
                      
                      
                      (272,000
                      )
                      
                      
                      (309,000
                      )Proceeds
      from sales of property and equipment
                      
                      
                      9,000
                      
                      
                      
                      -Net
      cash used in investing activities
                      
                      
                      (263,000
                      )
                      
                      
                      (309,000
                      )Effect
      of exchange rate on cash and cash equivalents
                      
                      
                      (1,000
                      )
                      
                      
                      8,000Net
      decrease in cash and cash equivalents
                      
                      
                      (822,000
                      )
                      
                      
                      (178,000
                      )Cash
      and cash equivalents, beginning of period
                      
                      
                      1,719,000
                      
                      
                      
                      3,238,000Cash
      and cash equivalents, end of period
                      
                      $
                      897,000
                      
                      
                      $
                      3,060,000Supplemental
      disclosure of non-cash activities:Extinguishment
      of convertible notes by issuance of common stocks
                      
                      $
                      (5,704,000
                      )
                      
                      $
                      -Extinguishment
      of convertible notes by issuance of Series B-1 Note
                      
                      $
                      (1,815,000
                      )
                      
                      $
                      -Issuance
      of Series B-1 Note
                      
                      $
                      1,535,000
                      
                      
                      $
                      -Acquisition
      of other assets
                      
                      $
                      732,000
                      
                      
                      $
                      -





The
accompanying notes are an integral part of these consolidated financial
statements.


5




SOLAR
ENERTECH CORP.





Notes
to Consolidated Financial Statements


March
31, 2010 (Unaudited)





NOTE 1—ORGANIZATION AND NATURE OF
OPERATIONS





Solar
EnerTech Corp. was originally incorporated under the laws of the State of Nevada
on July 7, 2004 as Safer Residence Corporation and was reincorporated to
the State of Delaware on August 13, 2008 (“Solar EnerTech” or the
“Company”).  The Company engaged in a variety of businesses until
March 2006, when the Company began its current operations as a photovoltaic
(“PV”) solar energy cell (“PV Cell”) manufacturer. The Company’s management
decided that, to facilitate a change in business that was focused on the PV Cell
industry, it was appropriate to change the Company’s name. A plan of merger
between Safer Residence Corporation and Solar EnerTech Corp., a
wholly-owned inactive subsidiary of Safer Residence Corporation, was approved on
March 27, 2006, under which the Company was to be renamed “Solar EnerTech Corp.”
On April 7, 2006, the Company changed its name to Solar EnerTech
Corp.





The
Company’s management in February 2008 decided that it was in the Company’s and
its shareholders best interests to change the Company’s state of domicile from
Nevada to Delaware (the “Reincorporation”).  On August 13, 2008, the
Company, a Nevada entity at the time, entered into an Agreement and Plan of
Merger with Solar EnerTech Corp., a Delaware corporation and wholly-owned
subsidiary of the Nevada entity (the “Delaware Subsidiary”), whereby the Nevada
entity merged with and into the Delaware Subsidiary in order to effect the
Reincorporation. After the Reincorporation, the Nevada entity ceased to exist
and the Company survived as a Delaware entity.





The
Reincorporation was duly approved by both the Company’s Board of Directors and a
majority of the Company’s stockholders at its annual meeting of stockholders
held on May 5, 2008. On August 13, 2008, the Reincorporation was completed. The
Reincorporation into Delaware did not result in any change to the Company’s
business, management, employees, directors, capitalization, assets or
liabilities.





On April
27, 2009, the Company entered into a Joint Venture Agreement (the “JV
Agreement”) with Jiangsu Shunda Semiconductor Development Co., Ltd. (“Jiangsu
Shunda”) to form a joint venture in the United States by forming a new
company, to be known as Shunda-SolarE Technologies, Inc. (the “Joint Venture
Company”), in order to jointly pursue opportunities in the United
States solar market. After its formation, the Joint Venture Company’s name
was later changed to SET-Solar Corp.





Pursuant
to the terms of the JV Agreement, Jiangsu Shunda would own 55% of the Joint
Venture Company, the Company would own 35% of the Joint Venture Company and
the remaining 10% of the Joint Venture Company would be owned by the Joint
Venture Company’s management.  The Joint Venture Company’s Board of
Directors consist of five directors: three of the directors were nominated by
Jiangsu Shunda and two of whom were nominated by the
Company.  Furthermore, Mr. Yunda Ni, the President of Jiangsu Shunda,
serves as the Joint Venture Company’s Chairman of the Board and Mr. Leo Shi
Young, the Company’s Chief Executive Officer serves as the Joint Venture
Company’s Vice Chairman of the Board.  Jiangsu Shunda is responsible
for managing the Joint Venture Company in China and the Company is
responsible for managing the Joint Venture Company in the United
States.  The JV Agreement is valid for 18 months. As of March 31,
2010, due to the foreign currency controls imposed by the PRC government,
Jiangsu Shunda and the Company have not contributed any capital to the Joint
Venture Company and no equity interest has been issued to either Jiangsu Shunda
or the Company.





On
January 15, 2010, the Company incorporated a wholly-owned subsidiary in Yizheng,
Jiangsu province of China to supplement its existing production facilities to
meet increased sales demands.  The subsidiary was formed with a
registered capital requirement of $33 million, of which $23.4 million is to be
funded by October 16, 2011.  In order to fund the registered capital
requirement, the Company will have to raise funds or otherwise obtain the
approval of local authorities to reduce the amount of registered capital for the
subsidiary.





On
February 8, 2010, the Company acquired land use rights of a parcel of land at
the price of approximately $0.7 million. This piece of land is 68,025 square
meters and is located in Yizheng, Jiangsu province of China, which will be used
to house the Company’s second manufacturing facility. As part of the
acquisition of the land use right, the Company is required to complete
construction of the facility by February 8, 2012.





NOTE 2—LIQUIDITY AND GOING CONCERN
ISSUES





The
Company has incurred significant net losses and has had negative cash flows from
operations during each period from inception through March 31, 2010 and has an
accumulated deficit of approximately $91.4 million at March 31, 2010. For the
six months ended March 31, 2010, the Company had negative operating cash flows
of approximately $0.6 million and incurred a net loss of approximately $23.1
million.


6





As of
December 31, 2009, the Company had outstanding convertible notes with a
principal balance of $11.6 million consisting of $2.5 million in principal
amount of Series A Convertible Notes (the “Series A Notes”) and $9.1 million in
principal amount of Series B Convertible Notes (the “Series B Notes”), which
were recorded at carrying amount at $6.8 million, collectively known as the
“Notes”. These Notes bore interest at 6% per annum and were due on March 7,
2010.





On
January 7, 2010 (the “Conversion Date”), the Company entered into a Series A and
Series B Notes Conversion Agreement (the “Conversion Agreement”) with the
holders of Notes representing at least seventy-five percent of the aggregate
principal amounts outstanding under the Notes to restructure the terms of the
Notes. Pursuant to the terms of the Conversion Agreement, the Notes would
automatically be converted into shares of the Company’s common stock at a
conversion price which was reduced from $0.69 and $0.57, respectively to $0.15
per share and were amended to eliminate the maximum ownership percentage
restriction prior to such conversion.  Under the Conversion Agreement,
the Notes were amended and election has been taken such that all outstanding
principal, all accrued but unpaid interest, and all accrued and unpaid Late
Charges (as defined in the Notes) with respect to all of the outstanding Notes
would automatically be converted into shares of the Company’s common stock at a
conversion price per share of common stock of $0.15 effective as of January 7,
2010. As of the Conversion Date, each Note no longer represents a right to
receive any cash payments (including, but not limited to, interest payments) and
only represents a right to receive the shares of common stock into which such
Note has been converted into.  On January 7, 2010, a total of
approximately $9.8 million of the Series A and B Convertible Notes were
effectively converted into shares of the Company’s common stock. As of March 31,
2010, the Company has an outstanding convertible note with a principal balance
of $1.8 million consisting of the Series B-1 Note, which was recorded at
carrying amount at $1.5 million. The Series B-1 Note bears interest at 6% per
annum and is due on March 19, 2012.





On March
25, 2010, the Company entered into a one year contract with China Export &
Credit Insurance Corporation (“CECIC”) to insure the collectability of
outstanding accounts receivable for two of the Company’s key customers. The
Company pays a fee based on a fixed percentage of the accounts receivable
outstanding and expenses this fee when it is incurred. In addition, on March 30,
2010, the Company entered into a one year revolving credit facility arrangement
with Industrial Bank Co., Ltd. (“IBC”) that is secured by the accounts
receivable balances of the Company’s two key customers insured by CECIC above.
The Company can draw up to the lower of $2.0 million or the cumulative amount of
accounts receivable outstanding from the respective two key customers. If any of
the insured customers fail to repay the amounts outstanding due to the Company,
the insurance proceeds will be remitted directly to IBC instead of the Company.
As of March 31, 2010, the Company has not drawn on this credit facility with IBC
and there have been no insurance claims submitted to CECIC.





The
Company has approximately $0.9 million in cash and cash equivalents on hand as
of March 31, 2010. The conditions described raise substantial doubt about the
Company’s ability to continue as a going concern. The Company’s
consolidated financial statements have been prepared on the assumption that it
will continue as a going concern, which contemplates the realization of assets
and liquidation of liabilities in the normal course of business. The financial
statements do not include any adjustments to reflect the possible future effects
on the recoverability and classification of assets or the amounts and
classification of liabilities that may result from the outcome of this
uncertainty.





Since
April 2009, significant steps were taken to improve operations including
securing key new customer contracts, which have increased sales volumes. In
addition, the Company has engaged in various cost cutting programs and
renegotiated most of its contracts to reduce operating expenses. Due to these
actions and the decrease in raw material prices, specifically silicon wafer
prices, the Company has been generating positive gross margins since the third
quarter of fiscal year 2009.





Management
believes that if the Company is able to execute on its business plan, its
existing cash resources and the cash expected to be generated from operations
during fiscal year 2010 along with the availability of the credit facility will
be sufficient to meet the Company’s projected operating requirements at least
through September 30, 2010 and enable it to continue as a going
concern.





NOTE 3—SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES





Principles
of Consolidation and Basis of Accounting





Prior to
August 19, 2008, the Company operated its business in the People’s Republic of
China through Infotech Hong Kong New Energy Technologies, Limited (“Infotech
HK”) and Solar EnerTech (Shanghai) Co., Ltd (“Infotech Shanghai” and together
with Infotech HK, “Infotech”). While the Company did not own Infotech, the
Company’s financial statements have included the results of the financials of
each of Infotech HK and Infotech Shanghai since these entities were
wholly-controlled variable interest entities of the Company through an Agency
Agreement dated April 10, 2006 by and between the Company and Infotech (the
“Agency Agreement”). Under the Agency Agreement the Company engaged Infotech to
undertake all activities necessary to build a solar technology business in
China, including the acquisition of manufacturing facilities and equipment,
employees and inventory. The Agency Agreement continued through April 10,
2008 and then on a month to month basis thereafter until terminated by either
party.


7


To
permanently consolidate Infotech with the Company through legal ownership, the
Company acquired Infotech at a nominal amount on August 19, 2008 through a
series of agreements. In connection with executing these agreements, the Company
terminated the original agency relationship with Infotech.





The
Company had previously consolidated the financial statements of Infotech with
its financial statements pursuant to FASB ASC 810-10 “Consolidations”, formerly
referenced as FASB Interpretation No. 46(R),  due to the agency
relationship between the Company and Infotech and, notwithstanding the
termination of the Agency Agreement, the Company continues to consolidate the
financial statements of Infotech with its financial statements since Infotech
became a wholly-owned subsidiary of the Company as a result of the
acquisition.




The
Company’s consolidated financial statements include the accounts of Solar
EnerTech Corp. and its subsidiaries. All intercompany balances and transactions
have been eliminated in consolidation. These consolidated financial statements
have been prepared in U.S. dollars and in accordance with U.S. generally
accepted accounting principles (“U.S. GAAP”).





Use
of Estimates





The
preparation of consolidated financial statements in conformity with U.S. GAAP
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 consolidated financial statements and the
reported amounts of revenue and expenses during the reporting period. Actual
results could differ from those estimates.





Cash
and Cash Equivalents





Cash and
cash equivalents are defined as cash on hand, demand deposits and short-term,
highly liquid investments that are readily convertible to known amounts of cash
within ninety days of deposit.





Currency
and Foreign Exchange





The
Company’s functional currency is the Renminbi as substantially all of the
Company’s operations are in China. The Company’s reporting currency is the U.S.
dollar.





Transactions
and balances originally denominated in U.S. dollars are presented at their
original amounts. Transactions and balances in other currencies are converted
into U.S. dollars in accordance with FASB ASC 830, “Foreign Currency Matters,”
formerly referenced as SFAS No. 52,“Foreign Currency
Translation”, and are included in determining net income or loss.





For
foreign operations with the local currency as the functional currency, assets
and liabilities are translated from the local currencies into U.S. dollars at
the exchange rate prevailing at the balance sheet date. Revenues and expenses
are translated at weighted average exchange rates for the period to approximate
translation at the exchange rates prevailing at the dates those elements are
recognized in the consolidated financial statements. Translation adjustments
resulting from the process of translating the local currency consolidated
financial statements into U.S. dollars are included in determining comprehensive
loss.





Property
and Equipment





The
Company’s property and equipment are stated at cost net of accumulated
depreciation. Depreciation is provided using the straight-line method over the
related estimated useful lives, as follows:





Useful Life (Years)Office
      equipment
              
              3
      to 5Machinery
              
              10Production equipment
              
              5Automobiles
              
              5Furniture
              
              5Leasehold
      improvement
              
              the shorter of the lease term or 5 years





Expenditures
for maintenance and repairs that do not improve or extend the lives of the
related assets are expensed to operations. Major repairs that improve or extend
the lives of the related assets are capitalized.





Inventories





Inventories
are stated at the lower of cost or market. Cost is determined by the
weighted-average method. Market is defined principally as net realizable value.
Raw material cost is based on purchase costs while work-in-progress and finished
goods are comprised of direct materials, direct labor and an allocation of
manufacturing overhead costs. Inventory in-transit is included in finished goods
and consists of products shipped but not recognized as revenue because it does
not meet the revenue recognition criteria. Provisions are made for excess, slow
moving and obsolete inventory as well as inventory whose carrying value is in
excess of net realizable value.


8





Warranty
Cost





The
Company provides product warranties and accrues for estimated future warranty
costs in the period in which the revenue is recognized. The Company’s standard
solar modules are typically sold with a two-year warranty for defects in
materials and workmanship and a 10-year and 25-year warranty against
declines of more than 10.0% and 20.0%, respectively, of the initial minimum
power generation capacity at the time of delivery. The Company therefore
maintains warranty reserves to cover potential liabilities that could arise from
its warranty obligations and accrues the estimated costs of warranties based
primarily on management’s best estimate. The Company has not experienced any
material warranty claims to date in connection with declines of the power
generation capacity of its solar modules and will prospectively revise its
actual rate to the extent that actual warranty costs differ from the
estimates. As of March 31, 2010 and September 30, 2009, the Company’s
warranty liabilities were $773,000 and $515,000, respectively. The Company’s
warranty costs for the six months ended March 31, 2010 and 2009 were $258,000
and $89,000, respectively. There were no warranty claim payments during the six
months ended March 31, 2010 and 2009.





Other
Assets





The
Company acquired land use rights to a parcel of land from the government in the
PRC. All lands in the PRC are owned by the PRC government and cannot be sold to
any individual or entity. The government in the PRC, according to relevant
PRC law, may sell the right to use the land for a specified period of time.
Thus, the Company’s land purchase in the PRC is considered to be leasehold land
and recorded as other assets at cost less accumulated amortization. Amortization
is provided over the term of the land use right agreements on a straight-line
basis, which is for 46.5 years from February 8, 2010 through August 31,
2056.





Impairment
of Long-Lived Assets





The
Company reviews its long-lived assets for impairment whenever events or changes
in circumstances indicate that the carrying value of an asset may not be
recoverable. When such factors and circumstances exist, management compares the
projected undiscounted future cash flows associated with the future use and
disposal of the related asset or group of assets to their respective carrying
values. Impairment, if any, is measured as the excess of the carrying value over
the fair value, based on market value when available, or discounted expected
cash flows, of those assets and is recorded in the period in which the
determination is made. No loss on property and equipment impairment was recorded
during the six months ended March 31, 2010 and 2009, respectively.





Investments





Investments
in an entity where the Company owns less than twenty percent of the voting stock
of the entity and does not exercise significant influence over operating and
financial policies of the entity are accounted for using the cost method.
Investments in the entity where the Company owns twenty percent or more but not
in excess of fifty percent of the voting stock of the entity or less than twenty
percent and exercises significant influence over operating and financial
policies of the entity are accounted for using the equity method. The Company
has a policy in place to review its investments at least annually, to evaluate
the carrying value of the investments in these companies. The cost method
investment is subject to impairment assessment if there are identified events or
changes in circumstance that may have a significant adverse affect on the fair
value of the investment. If the Company believes that the carrying value of
an investment is in excess of estimated fair value, it is the Company’s policy
to record an impairment charge to adjust the carrying value to the estimated
fair value, if the impairment is considered other-than-temporary.





On August 21, 2008, the Company entered
into an equity purchase agreement in which it acquired two million shares of
common stock of 21-Century Silicon for $1.0 million in cash. On August 21, 2008,
the two million shares acquired by theCompany constituted approximately 7.8%
of 21-Century Silicon’s outstanding equity. On March 5, 2009,
the Emerging Technology Fund, created by the State of Texas, invested $3.5
million in 21-Century Silicon to expedite innovation andcommercialization of research. As of March 31, 2010, the two
million shares acquired by the Company have been diluted and constituted
approximately 5.5% of 21-Century Silicon’s outstanding
equity.





As of
March 31, 2010, the Company accounted for the investment in 21-Century Silicon
at cost amounting to $1.0 million. There were no impairment indicators
associated with the investment.





Income
Taxes





The
Company files federal and state income tax returns in the United States for its
United States operations, and files separate foreign tax returns for its foreign
subsidiary in the jurisdictions in which this entity operates. The Company
accounts for income taxes under the provisions of FASB ASC 740, “Income Taxes”,
formerly referenced as SFAS No. 109, “Accounting for Income
Taxes”.


9


Under the
provisions of FASB ASC 740, deferred tax assets and liabilities are recognized
for the future tax consequences attributable to differences between their
financial statement carrying values and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.





Valuation
Allowance





Significant
judgment is required in determining any valuation allowance recorded against
deferred tax assets. In assessing the need for a valuation allowance, the
Company considers all available evidence including past operating results,
estimates of future taxable income, and the feasibility of tax planning
strategies. In the event that the Company changes its determination as to the
amount of deferred tax assets that can be realized, the Company will adjust its
valuation allowance with a corresponding impact to the provision for income
taxes in the period in which such determination is made.




Unrecognized
Tax Benefits




Effective
on October 1, 2007, the Company adopted the provisions related to uncertain tax
position under FASB ASC 740, “Income Taxes”, formerly referenced as FIN 48,
“Accounting for Uncertainty in Income Taxes - An Interpretation of FASB
Statement No. 109”.  Under FASB ASC 740, the impact of an uncertain income
tax position on the income tax return must be recognized at the largest amount
that is more-likely-than-not to be sustained upon audit by the relevant taxing
authority based solely on the technical merits of the associated tax
position.  An uncertain income tax position will not be recognized if it
has less than a 50% likelihood of being sustained. The Company also elected the
accounting policy that requires interest and penalties to be recognized as a
component of tax expense. The Company classifies the unrecognized tax benefits
that are expected to result in payment or receipt of cash within one year as
current liabilities, otherwise, the unrecognized tax benefits will be classified
as non-current liabilities. Additionally, this guidance provides guidance on
de-recognition, accounting in interim periods, disclosure and
transition.





Derivative
Financial Instruments and Warrants





FASB ASC
815,“Derivatives
and Hedging”, formerly referenced as SFAS No. 133, “Accounting for
Derivative Instruments and Hedging Activities,” as amended, requires all
derivatives to be recorded on the balance sheet at fair value. These
derivatives, including embedded derivatives in the Company’s structured
borrowings, are separately valued and accounted for on the balance sheet. Fair
values for exchange-traded securities and derivatives are based on quoted market
prices. Where market prices are not readily available, fair values are
determined using market based pricing models incorporating readily observable
market data and requiring judgment and estimates.




FASB ASC
815 requires freestanding contracts that are settled in a company’s own stock,
including common stock warrants, to be designated as an equity instrument, an
asset or a liability. Under FASB ASC 815 guidance, a contract designated as an
asset or a liability must be carried at fair value on a company’s balance sheet,
with any changes in fair value recorded in the company’s results of
operations.





The
Company’s management used market-based pricing models to determine the fair
values of the Company’s derivatives. The model uses market-sourced inputs such
as interest rates, exchange rates and volatilities. Selection of these inputs
involves management’s judgment and may impact net income.




The
Company’s management used the binomial valuation model to value the derivative
financial instruments and warrant liabilities at each valuation date. The model
uses inputs such as implied term, suboptimal exercise factor, volatility,
dividend yield and risk free interest rate. Selection of these inputs involves
management’s judgment and may impact estimated value. Management selected the
binomial model to value these derivative financial instruments and warrants as
opposed to the Black-Scholes-Merton model primarily because management believes
the binomial model produces a more reliable value for these instruments because
it uses an additional valuation input factor, the suboptimal exercise factor,
which accounts for expected holder exercise behavior which management believes
is a reasonable assumption with respect to the holders of these derivative
financial instruments and warrants.





Stock-Based
Compensation





On
January 1, 2006, Solar EnerTech began recording compensation expense
associated with stock options and other forms of employee equity compensation in
accordance with FASB ASC 718, “Compensation – Stock Compensation”, formerly
referenced as SFAS 123R, “Share-Based Payment”.





The
Company estimates the fair value of stock options granted using the
Black-Scholes-Merton option-pricing formula and a single option approach. This
fair value is then amortized on a straight-line basis over the requisite service
periods of the awards, which is generally the vesting period. The following
assumptions are used in the Black-Scholes-Merton option pricing
model:





Expected
Term — The Company’s expected term represents the period that the Company’s
stock-based awards are expected to be outstanding.


10





Expected
Volatility — The Company’s expected volatilities are based on historical
volatility of the Company’s stock, adjusted where determined by management for
unusual and non-representative stock price activity not expected to recur. Due
to the limited trading history, the Company also considered volatility data of
guidance companies.





Expected
Dividend — The Black-Scholes-Merton valuation model calls for a single expected
dividend yield as an input. The Company currently pays no dividends and does not
expect to pay dividends in the foreseeable future.





Risk-Free
Interest Rate — The Company bases the risk-free interest rate on the implied
yield currently available on U.S. Treasury zero-coupon issues with an equivalent
remaining term.





Estimated
Forfeitures — When estimating forfeitures, the Company takes into consideration
the historical option forfeitures over the expected term.





Revenue
Recognition





The
Company recognizes revenues from product sales in accordance with guidance in
FASB ASC 605, “Revenue Recognition,” which states that revenue is realized or
realizable and earned when all of the following criteria are met: persuasive
evidence of an arrangement exists; delivery has occurred or services have been
rendered; the price to the buyer is fixed or determinable; and collectability is
reasonably assured. Where a revenue transaction does not meet any of these
criteria it is deferred and recognized once all such criteria have been met. In
instances where final acceptance of the product, system, or solution is
specified by the customer, revenue is deferred until all acceptance criteria
have been met.




On a
transaction by transaction basis, the Company determines if the revenue should
be recorded on a gross or net basis based on criteria discussed in the Revenue
Recognition topic of the FASB Subtopic 605-405, “Reporting Revenue Gross as a
Principal versus Net as an Agent”. The Company considers the following factors
to determine the gross versus net presentation: if the Company (i) acts as
principal in the transaction; (ii) takes title to the products; (iii) has risks
and rewards of ownership, such as the risk of loss for collection, delivery
or return; and (iv) acts as an agent or broker (including performing services,
in substance, as an agent or broker) with compensation on a commission or fee
basis.





Accounts
Receivable and Allowance for Doubtful Accounts





Accounts
receivable are carried at net realizable value. The Company records its
allowance for doubtful accounts based upon its assessment of various factors.
The Company considers historical experience, the age of the accounts receivable
balances, credit quality of the Company’s customers, current economic
conditions, and other factors that may affect customers’ ability to
pay.





Shipping
and Handling Costs





The
Company incurred shipping and handling costs of $933,000 and $89,000 for the six
months ended March 31, 2010 and 2009, respectively, which are included in
selling expenses. Shipping and handling costs include costs incurred with
third-party carriers to transport products to customers.





Research
and Development Cost





Expenditures
for research activities relating to product development are charged to expense
as incurred. Research and development cost for the six months ended March 31,
2010 and 2009 were $233,000 and $771,000, respectively.





Comprehensive
Loss





Comprehensive
loss is defined as the change in equity of the Company during a period from
transactions and other events and circumstances excluding transactions resulting
from investments by owners and distributions to owners.  Comprehensive
loss is reported in the consolidated statements of shareholder’s
equity.  Other comprehensive income of the Company consists of
cumulative foreign currency translation adjustments.





Segment
Information





The
Company identifies its operating segments based on its business activities. The
Company operates within a single operating segment - the manufacture of solar
energy cells and modules in China. The Company’s manufacturing operations and
fixed assets are all based in China. The solar energy cells and modules are
distributed to customers, located in Europe, Australia, North America and
China.





During
the six months ended March 31, 2010 and 2009, the Company had four and three
customers, respectively, that accounted for more than 10% of net
sales.


11





Recent
Accounting Pronouncements





In
January 2010, the FASB issued ASU 2010-06, which amended “Fair Value
Measurements and Disclosures” (ASC Topic 820) — “Improving Disclosures
about Fair Value Measurements”. This guidance amends existing authoritative
guidance to require additional disclosures regarding fair value measurements,
including the amounts and reasons for significant transfers between Level 1 and
Level 2 of the fair value hierarchy, the reasons for any transfers into or out
of Level 3 of the fair value hierarchy, and presentation on a gross basis of
information regarding purchases, sales, issuances, and settlements within the
Level 3 rollforward.  This guidance also clarifies certain existing
disclosure requirements.  The guidance is effective for interim and annual
reporting periods beginning after December 15, 2009, except for the disclosures
about purchases, sales, issuances, and settlements within the Level 3
rollforward, which are effective for interim and annual reporting periods
beginning after December 15, 2010.  The Company adopted this guidance on
January 1, 2010. The adoption of this guidance did not have a significant impact
on the Company’s financial statements.





In
February 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-09,
which amended “Subsequent Events” (ASC Topic 855) — “Amendments to Certain
Recognition and Disclosure Requirements”. The amendments were made to address
concerns about conflicts with SEC guidance and other practice issues. Among the
provisions of the amendment, the FASB defined a new type of entity, termed an
“SEC filer,” which is an entity required to file or furnish its financial
statements with the SEC. Entities other than registrants whose financial
statements are included in SEC filings (e.g., businesses or real estate
operations acquired or to be acquired, equity method investees, and entities
whose securities collateralize registered securities) are not SEC filers. While
an SEC filer is still required by U.S. GAAP to evaluate subsequent events
through the date its financial statements are issued, it is no longer
required to disclose in the financial statements that it has done so or the date
through which subsequent events have been evaluated. The Company adopted this
guidance on February 24, 2010. The adoption of this guidance did not have a
significant impact on the Company’s financial statements.





NOTE
4 — FINANCIAL INSTRUMENTS





Concentration
of Credit risk





The
Company’s assets that are potentially subject to significant concentration of
credit risk are primarily cash and cash equivalents, advance payments to
suppliers and accounts receivable.





The
Company maintains cash deposits with financial institutions, which from time to
time may exceed federally insured limits. The Company has not experienced any
losses in connection with these deposits and believes it is not exposed to any
significant credit risk from cash. At March 31, 2010 and September 30, 2009, the
Company had approximately $82,000 and $144,000, respectively in excess of
insured limits.





Advance
payments to suppliers are typically unsecured and arise from deposits paid in
advance for future purchases of raw materials. During the financial crisis in
2008, the Company was generally required to make prepayments for some of its raw
materials. The Company does not require collateral or other security against the
prepayments to suppliers for raw materials.  In the event of a failure
by the Company’s suppliers to fulfill their contractual obligations and to the
extent that the Company is not able to recover its prepayments, the Company
would suffer losses. The Company’s prepayments to suppliers have been steadily
decreasing due to the change in the industry practice from requiring full cash
advance to secure key raw material (silicon wafers) as a result of the financial
crisis in 2008 to requiring less or no cash advance since fiscal year 2009 as
the economy is recovering from the crisis. The economic crisis may affect the
Company’s customers’ ability to pay the Company for its products that the
Company has delivered.  If the customers fail to pay the Company
for its products and services, the Company’s financial condition, results of
operations and liquidity may be adversely affected.




Other
financial instruments that potentially subject the Company to concentration of
credit risk consist principally of accounts
receivables.  Concentrations of credit risk with respect to accounts
receivables are limited because a number of geographically diverse customers
make up the Company’s customer base, thus spreading the trade credit
risk.  The Company controls credit risk through credit approvals,
credit limits and monitoring procedures.  The Company performs credit
evaluations for all new customers but does not require collateral to support
customer receivables. All of the Company’s customers have gone through a
very strict credit approval process. The Company diligently monitors
the customers’ financial position. The Company has purchased insurance from the
China Export & Credit Insurance Company to insure the collectability of the
outstanding accounts receivable balances for two key customers. Therefore, the
credit risk in accounts receivable is controllable even though the Company has a
relatively high accounts receivable balance. During the six months ended
March 31, 2010 and 2009, the Company had four customers and three customers,
respectively that accounted for more than 10% of net sales.





Foreign
exchange risk and translation





The
Company may be subject to significant currency risk due to the fluctuations of
exchange rates between the Chinese Renminbi, Euro and the United States
dollar.


12


The local
currency is the functional currency for the China subsidiary.  Assets
and liabilities are translated at end of period exchange rates while revenues
and expenses are translated at the average exchange rates in effect during the
period.  Equity is translated at historical rates and the resulting
cumulative translation adjustments, to the extent not included in net income,
are included as a component of accumulated other comprehensive income (loss)
until the translation adjustments are realized. Included in other accumulated
comprehensive income were cumulative foreign currency translation
adjustments amounting to $2.5 million and $2.5 million at March 31, 2010
and September 30, 2009, respectively.   Foreign currency
transaction gains and losses are included in earnings. For the six months ended
March 31, 2010 and 2009, the Company recorded foreign exchange losses of $0.4
million and $0.2 million, respectively.





NOTE
5 — INVENTORIES





At March
31, 2010 and September 30, 2009, inventories consist of:





March
      31, 2010
                    
                    
                    September
      30, 2009Raw
      materials
                    
                    $
                    3,968,000
                    
                    
                    $
                    1,708,000Work
      in process
                    
                    
                    131,000
                    
                    
                    
                    945,000Finished
      goods
                    
                    
                    1,433,000
                    
                    
                    
                    1,342,000Total
      inventories
                    
                    $
                    5,532,000
                    
                    
                    $
                    3,995,000




NOTE 6
— ADVANCE PAYMENTS AND OTHER





At March
31, 2010 and September 30, 2009, advance payments and other consist
of:





March
      31, 2010
                    
                    
                    September
      30, 2009Prepayment
      for raw materials
                    
                    $
                    32,000
                    
                    
                    $
                    698,000Others
                    
                    
                    167,000
                    
                    
                    
                    101,000Total
      advance payments and other
                    
                    $
                    199,000
                    
                    
                    $
                    799,000





NOTE
7 — PROPERTY AND EQUIPMENT





At March
31, 2010 and September 30, 2009, property and equipment consists
of:





March
      31, 2010
                      
                      
                      September
      30, 2009Production
      equipment
                      
                      $
                      8,014,000
                      
                      
                      $
                      7,383,000Leasehold
      improvements
                      
                      
                      3,621,000
                      
                      
                      
                      3,620,000Machinery
                      
                      
                      2,808,000
                      
                      
                      
                      2,749,000Automobiles
                      
                      
                      360,000
                      
                      
                      
                      496,000Office
      equipment
                      
                      
                      340,000
                      
                      
                      
                      342,000Furniture
                      
                      
                      39,000
                      
                      
                      
                      39,000Construction
      in progress
                      
                      
                      43,000
                      
                      
                      
                      22,000Total
      property and equipment
                      
                      
                      15,225,000
                      
                      
                      
                      14,651,000Less:  accumulated
      depreciation
                      
                      
                      (5,260,000
                      )
                      
                      
                      (4,142,000
                      )Total
      property and equipment, net
                      
                      $
                      9,965,000
                      
                      
                      $
                      10,509,000




NOTE
8 — INCOME TAX





The
Company has no taxable income and no provision for federal and state income
taxes is required for the six months ended March 31, 2010 and 2009,
respectively, except certain minimum taxes.





The
Company conducts its business in the United States and in various foreign
locations and generally is subject to the respective local countries’ statutory
tax rates.





The
Company accounts for income taxes using the liability method in accordance with
FASB ASC 740, “Income Taxes”, formerly referenced as SFAS No. 109,
“Accounting for Income Taxes”. FASB ASC 740 requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been recognized in the Company’s financial statements, but have not been
reflected in the Company’s taxable income. A valuation allowance is established
to reduce deferred tax assets to their estimated realizable value. Therefore,
the Company provides a valuation allowance to the extent that the Company does
not believe it is more likely than not that the Company will generate sufficient
taxable income in future periods to realize the benefit of the Company’s
deferred tax assets. As of March 31, 2010 and 2009, the deferred tax asset was
subject to a 100% valuation allowance and therefore is not recorded on the
Company’s balance sheet as an asset.


13





Utilization
of the U.S. federal and state net operating loss carry forwards may be subject
to substantial annual limitation due to certain limitations resulting from
ownership changes provided by U.S. federal and state tax laws. The annual
limitation may result in the expiration of net operating losses carryforwards
and credits before utilization. The Company has net operating losses in its
foreign jurisdiction and that loss can be carried over 5 years from the
year the loss was incurred.





Under the
New Income Tax Law, a "resident enterprise," which includes an enterprise
established outside of the PRC with management located in the PRC, will be
subject to PRC income tax. If the PRC tax authorities determine that the Company
and its subsidiaries registered outside PRC should be deemed a resident
enterprise, the Company's PRC tax resident entities will be subject to the PRC
income tax at a rate of 25%.




The
Company’s operations are subject to income and transaction taxes in the United
States and in certain foreign jurisdictions. Significant estimates and judgments
are required in determining the Company’s worldwide provision for income taxes.
Some of these estimates are based on interpretations of existing tax laws or
regulations. The ultimate amount of tax liability may be uncertain as a
result.




There are
no ongoing examinations by taxing authorities at this time. The Company’s tax
years starting from 2006 to 2009 remain open in various tax jurisdictions. The
Company has not undertaken tax positions for which a reserve has been recorded.
The Company does not anticipate any significant change within the next 12 months
of its uncertain tax positions.





NOTE 9—CONVERTIBLE NOTES





On
March 7, 2007, Solar EnerTech entered into a securities purchase agreement
to issue $17.3 million of secured convertible notes (the “Notes”) and detachable
stock purchase warrants the “Series A and Series B Warrants”). Accordingly,
during the quarter ended March 31, 2007, Solar EnerTech sold units
consisting of:




·
            $5.0
      million in principal amount of Series A Convertible Notes and
      warrants to purchase 7,246,377 shares (exercise price of $1.21 per share)
      of its common stock;




·
            $3.3
      million in principal amount of Series B Convertible Notes and
      warrants to purchase 5,789,474 shares (exercise price of $0.90 per share)
      of its common stock ; and




·
            $9.0
      million in principal amount of Series B Convertible Notes and
      warrants to purchase 15,789,474 shares (exercise price of $0.90 per share)
      of its common stock.





These
Notes bore an interest rate of 6% per annum and were due on March 7, 2010. Under
their original terms, the principal amount of the Series A Convertible
Notes may be converted at the initial rate of $0.69 per share for a total of
7,246,377 shares of common stock (which amount does not include shares of common
stock that may be issued for the payment of interest). Under their original
terms, the principal amount of the Series B Convertible Notes may be
converted at the initial rate of $0.57 per share for a total of 21,578,948
shares of common stock (which amount does not include shares of common stock
that may be issued for the payment of interest).





The
Company evaluated the Notes for derivative accounting considerations under FASB
ASC 815 and determined that the notes contained two embedded derivative
features, the conversion option and a redemption privilege accruing to the
holder if certain conditions exist (the “compound embedded derivative” or
“CED”). The compound embedded derivative is measured at fair value both
initially and in subsequent periods. Changes in fair value of the compound
embedded derivative are recorded in the account “gain (loss) on fair market
value of compound embedded derivative” in the accompanying consolidated
statements of operations.





In
connection with the issuance of the Notes and Series A and Series B Warrants,
the Company engaged an exclusive advisor and placement agent (the “Advisor”) and
issued warrants to the Advisor to purchase an aggregate of 1,510,528 shares at
an exercise price of $0.57 per share and 507,247 shares at an exercise price of
$0.69 per share, of the Company’s common stock (the “Advisor Warrants”). In
addition to the issuance of the warrants, the Company paid $1,038,000 in
commissions, an advisory fee of $173,000, and other fees and expenses of
$84,025.


14


The
Series A and Series B Warrants (including the Advisor Warrants) were classified
as a liability, as required by FASB ASC 480, “Distinguishing Liabilities from
Equity”, formerly referenced as SFAS No. 150, “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity”, due to the
terms of the warrant agreement which contains a cash redemption provision in the
event of a fundamental transaction. The warrants are measured at fair value
both initially and in subsequent periods. Changes in fair value of the warrants
are recorded in the account “gain (loss) on fair market value of warrant
liability” in the accompanying consolidated statements of
operations.





In
conjunction with March 2007 financing, the Company recorded total deferred
financing cost of $2.5 million, of which $1.3 million represented cash payment
and $1.2 million represented the fair market value of the Advisor Warrants. The
deferred financing cost is amortized over the three year life of the notes
using a method that approximates the effective interest rate method. The Advisor
Warrants were recorded as a liability and adjusted to fair value in each
subsequent period.





On
January 7, 2010 (the “Conversion Date”), the Company entered into a Series A and
Series B Notes Conversion Agreement (the “Conversion Agreement”) with the
holders of Notes representing at least seventy-five percent of the aggregate
principal amounts outstanding under the Notes to restructure the terms of the
Notes. Pursuant to the terms of the Conversion Agreement, the Notes are to be
automatically converted into shares of the Company’s common stock at a
conversion price which was reduced from $0.69 and $0.57, respectively, to $0.15
per share and were amended to eliminate the maximum ownership percentage
restriction prior to such conversion.  Under the Conversion Agreement,
the Notes were amended and election has been taken such that all outstanding
principal, all accrued but unpaid interest, and all accrued and unpaid Late
Charges (as defined in the Notes) with respect to all of the outstanding Notes
would automatically be converted into shares of the Company’s common stock at a
conversion price of $0.15 per share effective as of the Conversion Date. As
of the Conversion Date, each Note no longer represents a right to receive any
cash payments (including, but not limited to, interest payments) and only
represents a right to receive the shares of common stock into which such Note
has been converted into. On January 7, 2010, approximately $9.8
million of the Series A and B Convertible Notes were effectively converted into
64,959,227 shares of the Company’s common stock, and the remaining $1.8 million
of the Series B Notes were exchanged into another convertible note as further
discussed below. In connection with the Conversion Agreement, on January 7,
2010, the Company entered into an Amendment (the “Warrant Amendment”) to the
Series A, Series B and Series C Warrants with the holders of at least a majority
of the common stock underlying each of its outstanding Series A Warrants, Series
B Warrants and Series C Warrants (collectively the “PIPE Warrants”). The Warrant
Amendment reduced the exercise price for all of the PIPE Warrants from $1.21,
$0.90 and $1.00, respectively, to $0.15, removed certain maximum ownership
provisions and removed anti-dilution provisions for lower-priced security
issuances.





The
Conversion Agreement resulted in modifications or exchanges of the Notes and
PIPE Warrants, which should be accounted for pursuant to FASB ASC 405-20,
“Liabilities” and FASB ASC 470-50, "Debt/Modifications and Extinguishment"
formerly referenced as EITF Consensus for Issue No. 96-19, "Debtor's Accounting
for a Modification (or Exchange) of Convertible Debt Instruments". The
combination of the adjustment to conversion price and the automatic conversion
of the Notes effectively resulted in the settlement of the Notes through the
issuance of shares of the Company’s common stock and amendment of the PIPE
Warrants’ terms. Since the Company is relieved of its obligation for the Notes,
the transaction is accounted for as an extinguishment of the Notes upon issuance
of ordinary shares and modification of the PIPE Warrants’ terms. The loss on
extinguishment associated with the Conversion Agreement amounted to
approximately $17.2 million.





On
January 19, 2010, a holder of approximately $1.8 million of the Company’s
formerly outstanding Series B Notes and Series B Warrants (hereinafter referred
to as the “Holder”) of the Company’s common stock disputed the effectiveness of
the Conversion Agreement and the Warrant Amendment.  Accordingly, the
Holder did not tender its Series B Notes for conversion. After negotiations with
the Holder, on March 19, 2010, the Company entered into an Exchange Agreement
with the Holder (the “Exchange Agreement”), whereby the Company issued the
Series B-1 Note with a principal amount of $1.8 million (the “Series B-1
Note”) to the Holder along with 283,498 shares of the Company’s common stock as
settlement of the accrued interest on the Holder’s Series B Notes and
666,666 shares of the Company’s common stock as settlement of the outstanding
dispute regarding the effectiveness of the Company’s Conversion Agreement and
the Warrant Amendment.  The Company did not capitalize any financing
costs associated with the issuance of the Series B-1 Note.





The
Exchange Agreement resulted in modifications or exchanges of the Holder’s Series
B Notes, which should be accounted for pursuant to FASB ASC 470-50,
"Debt/Modifications and Extinguishment" formerly referenced as EITF Consensus
for Issue No. 96-19, "Debtor's Accounting for a Modification (or Exchange) of
Convertible Debt Instruments", and FASB ASC 470-50, "Debt/Modifications and
Extinguishment" formerly referenced as EITF Consensus for Issue No.06-06,
"Debtor's Accounting for a Modification (or Exchange) of Convertible Debt
Instruments". The loss on debt extinguishment associated with the Exchange
Agreement amounted to approximately $1.3 million.





The
Company evaluated the Series B-1 Note for derivative accounting considerations
under FASB ASC 815 and determined that the Series B-1 Note contained two
embedded derivative features, the conversion option and a redemption privilege
accruing to the holder if certain conditions exist (the “compound embedded
derivative”). The compound embedded derivative is measured at fair value both
initially and in subsequent periods. Changes in fair value of the compound
embedded derivative are recorded in the account “gain (loss) on fair market
value of compound embedded derivative” in the accompanying consolidated
statements of operations.


15




The loss
on debt extinguishment is computed as follows:





Three
      Months Ended March 31,
                  
                  
                  Six
      Months Ended March 31,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Fair
      value of the common shares
                  
                  $
                  18,838,000
                  
                  
                  $
                  135,000
                  
                  
                  $
                  18,838,000
                  
                  
                  $
                  281,000Fair
      value of Series B-1 Note
                  
                  
                  3,108,000
                  
                  
                  
                  -
                  
                  
                  
                  3,108,000
                  
                  
                  
                  -Unamortized
      deferred financing costs associated with the converted
    notes
                  
                  
                  594,000
                  
                  
                  
                  59,000
                  
                  
                  
                  594,000
                  
                  
                  
                  127,000Fair
      value of the CED liability associated with the converted
    notes
                  
                  
                  (74,000
                  )
                  
                  
                  (13,000
                  )
                  
                  
                  (74,000
                  )
                  
                  
                  (27,000
                  )Accreted
      amount of the notes discount
                  
                  
                  (7,519,000
                  )
                  
                  
                  -
                  
                  
                  
                  (7,519,000
                  )
                  
                  
                  110,000Common
      shares issued in conjunction with Series B-1 Note
                  
                  
                  100,000
                  
                  
                  
                  -
                  
                  
                  
                  100,000
                  
                  
                  
                  -Loss
      on extinguishment of warrants
                  
                  
                  3,502,000
                  
                  
                  
                  -
                  
                  
                  
                  3,502,000
                  
                  
                  
                  -Loss
      on debt extinguishment
                  
                  $
                  18,549,000
                  
                  
                  $
                  181,000
                  
                  
                  $
                  18,549,000
                  
                  
                  $
                  491,000





During
the three months and six months ended March 31, 2010, the Company recorded a
cumulative loss on debt extinguishment of approximately $18.5 million as a
result of the Conversion Agreement and the Exchange Agreement.





During
the three and six months ended March 31, 2009, $0.4 million and $0.8 million of
Series A and B Convertible Notes were converted into the Company’s common
shares, respectively. The Company recorded a loss on debt extinguishment of $0.2
million and $0.5 million, respectively as a result of the conversion based on
the quoted market closing price of our common shares on the conversion
dates.


16





The
following table summarizes the valuation of the Notes and the related Compound
Embedded Derivative, the Series A and Series B Warrants (including the Advisor
Warrants), and the Series B-1 Note and the related Compound Embedded
Derivative:





AmountCarrying
      amount of notes at September 30, 2008
                            
                            $
                            85,000Amortization
      of note discount and conversion effect
                            
                            
                            2,976,000Carrying
      amount of notes at September 30, 2009
                            
                            
                            3,061,000Amortization
      of note discount and conversion effect
                            
                            
                            (3,061,000
                            )Carrying
      amount of notes at March 31, 2010
                            
                            $
                            -Carrying
      amount of Series B-1 Note at March 19, 2010
                            
                            $
                            1,815,000Fair
      value of compound embedded derivative liabilities
                            
                            
                            (1,573,000
                            )Loss
      on debt extinguishment
                            
                            
                            1,293,000Carrying
      amount of Series B-1 Note at March 31, 2010
                            
                            $
                            1,535,000Fair
      value of warrant liability at September 30, 2008
                            
                            $
                            3,412,000Gain
      on fair market value of warrant liability
                            
                            
                            (1,344,000
                            )Fair
      value of warrant liability at September 30, 2009
                            
                            
                            2,068,000Loss
      on PIPE warrant extinguishment
                            
                            
                            3,502,000Cashless
      exercise of warrants
                            
                            
                            (157,000
                            )Gain
      on fair market value of warrant liability
                            
                            
                            (2,976,000
                            )Fair
      value of warrant liability at March 31, 2010
                            
                            $
                            2,437,000Fair
      value of Series A and B compound embedded derivative at September 30,
      2008
                            
                            $
                            980,000Gain
      on fair market value of embedded derivative liability
                            
                            
                            (770,000
                            )Conversion
      of Series A and B Notes
                            
                            
                            (32,000
                            )Fair
      value of compound embedded derivative at September 30,
2009
                            
                            
                            178,000Gain
      on fair market value of embedded derivative liability
                            
                            
                            (104,000
                            )Loss
      on debt extinguishment
                            
                            
                            (74,000
                            )Fair
      value of Series A and B compound embedded derivative at March 31,
      2010
                            
                            $
                            -Fair
      value of the Series B-1 compound embedded derivative liabilities at March
      19, 2010
                            
                            $
                            1,573,000Gain
      on fair market value of embedded derivative liability
                            
                            
                            (294,000
                            )Fair
      value of the Series B-1compound embedded derivative liabilities at March
      31, 2010
                            
                            $
                            1,279,000




Series
B-1 Note





The
material terms of the Series B-1 Note are as follows:





Interest
Payments





The
Series B-1 Note bears interest at 6% per annum and is due on March 19, 2012.
Accrued interest is payable quarterly in arrears on each of January 1,
April 1, July 1 and October 1, beginning on the first such
date after issuance, in cash or registered shares of common stock at the option
of the Company. If the Company elects to pay any interest due in registered
shares of the Company’s common stock: (i) the issuance price
will be 90% of the 5-day weighted average price of the common stock ending on
the day prior to the interest payment due date, and (ii) a trigger event shall
not have occurred.





Voting
Rights





The
holder of the Series B-1 Note does not have voting rights under these
agreements.





Dividends





Until all
amounts owed under the Series B-1 Note have been converted, redeemed or
otherwise satisfied in accordance with their terms, the Company shall not,
directly or indirectly, redeem, repurchase or declare or pay any cash dividend
or distribution on its capital stock without the prior express written consent
of the required holders.


17





Conversion
Right





At any
time or times on or after the issuance date of the Series B-1 Note, the holder
is entitled to convert, at the holder’s sole discretion, any portion of the
outstanding and unpaid conversion amount (principal, accrued and unpaid interest
and accrued and unpaid late charges) may be converted into fully paid and
non-assessable shares of common stock, at the conversion rate discussed
next.





Conversion
Rate





The
number of shares of common stock issuable upon conversion of the Series B-1 Note
is determined by dividing (x) the conversion amount (principal, interest
and late charges accrued and unpaid), by (y) the then applicable conversion
price (initially $0.15 for Series B-1 Note, subject to adjustment as
provided in the agreement). No adjustment in the conversion price of the Series
B-1 Note will be made in respect of the issuance of additional shares of common
stock unless the consideration per share of an additional share of common stock
issued or deemed to be issued by the Company is less than the conversion price
of the Series B-1 Note in effect on the date of, and immediately prior to, such
issuance. Should the outstanding shares of common stock increase (by stock
split, stock dividend, or otherwise) or decrease (by reclassification or
otherwise), the conversion price of the Series B-1 Note in effect immediately
prior to the change shall be proportionately adjusted.





Redemptions





Each of
the following events shall constitute a trigger event, permitting the holder the
right of redemption:





1)
            The
      suspension from trading or failure of the common stock to be listed on the
      principal market or an eligible market for a period of five
      (5) consecutive trading days or for more than an aggregate of ten
      (10) trading days in any 365-day
period;




2)
            The
      Company’s (A) failure to cure a conversion failure by delivery of the
      required number of shares of common stock within ten (10) trading
      days after the applicable conversion date or (B) notice, written or
      oral, to any holder of the Series B-1 Note, including by way of public
      announcement or through any of its agents, at any time, of its intention
      not to comply with a request for conversion of any Series B-1 Note into
      shares of common stock that is tendered in accordance with the provisions
      of the Series B-1 Note;





3)
            The
      Company's failure to pay to the Holder any amount of Principal (including,
      without limitation, any redemption payments), Interest, Late Charges or
      other amounts when and as due under this Series B-1 Note except, in the
      case of a failure to pay any Interest and Late Charges when and as due, in
      which case only if such failure continues for a period of at least five
      (5) Business Days;




4)
            (A)
      The occurrence of any payment default or other default under any
      indebtedness of the Company or any of its subsidiaries that results in a
      redemption of or acceleration prior to maturity of $100,000 or more of
      such indebtedness in the aggregate, or (B) the occurrence of any
      material default under any indebtedness of the Company or any of its
      subsidiaries having an aggregate outstanding balance in excess of $100,000
      and such default continues uncured for more than ten (10) business days,
      other than, in each case (A) or (B) above, or a default with
      respect to any other Series B-1
Note;





5)
            The
      Company or any of its subsidiaries, pursuant to or within the meaning of
      Title 11, U.S. Code, or any similar Federal, foreign or state law for the
      relief of debtors (A) commences a voluntary case, (B) consents
      to the entry of an order for relief against it in an involuntary case,
      (C) consents to the appointment of a receiver, trustee, assignee,
      liquidator or similar official, (D) makes a
      general assignment for the benefit of its creditors or (E) admits in
      writing that it is generally unable to pay its debts as they become
      due;





6)
            A
      court of competent jurisdiction enters an order or decree under any
      bankruptcy law that (A) is for relief against the Company or any of
      its subsidiaries in an involuntary case, (B) appoints a custodian of
      the Company or any of its subsidiaries or (C) orders the liquidation
      of the Company or any of its
subsidiaries;


18


7)
            A
      final judgment or judgments for the payment of money aggregating in excess
      of $250,000 are rendered against the Company or any of its subsidiaries
      and which judgments are not, within sixty (60) days after the entry
      thereof, bonded, discharged or stayed pending appeal, or are not
      discharged within sixty (60) days after the expiration of such stay;
      provided, however, that any judgment which is covered by insurance or an
      indemnity from a credit worthy party shall not be included in calculating
      the $250,000 amount set forth above so long as the Company provides the
      holder with a written statement from such insurer or indemnity provider
      (which written statement shall be reasonably satisfactory to the holder)
      to the effect that such judgment is covered by insurance or an
      indemnity and the Company will receive the proceeds of such insurance or
      indemnity within thirty (30) days of the issuance of such judgment;
      and





8)
            The
      Company breaches any representation, warranty, covenant or other term or
      condition of any transaction document, except, in the case of a breach of
      a covenant which is curable, only if such breach continues for a period of
      at least ten (10) consecutive business
  days.




At any
time after becoming aware of a trigger event, the holder may require the Company
to redeem all or any portion of the Series B-1 Note at an amount equal to any
accrued and unpaid liquidated damages, plus the greater of (A) the
conversion amount to be redeemed multiplied by the redemption premium (125% for
trigger events described above in subparagraphs 1 to 5 and 8 above or 100% for
other events), or (B) the conversion amount to be redeemed multiplied by
the quotient of (i) the closing sale price at the time of the trigger event
(or at the time of payment of the redemption price, if greater) divided by
(ii) the conversion price, provided, however,
(B) shall be applicable only in the event that a trigger event of the type
specified above in subparagraphs 1, 2 or 3 has occurred and remains uncured or
the conversion shares otherwise could not be received or sold by the holder
without any resale restrictions.





Rights
upon Fundamental Transaction, Change of Control and Qualified
Financing





1)
            Assumption. The Company
      may not enter into or be party to a fundamental transaction, as such terms
      is defined in the Series B-1 Note,
unless:





•
            The
      successor entity assumes in writing all of the obligations of the Company
      under the Series B-1 Note and related documents;
  and


•
            The
      successor entity (including its parent entity) is a publicly traded
      corporation whose common stock is quoted on or listed for trading on an
      eligible market.





2)
            Redemption Righton Change of
      Control. At
      any time during the period beginning on the date of the holder’s receipt
      of a change of control notice and ending twenty (20) trading days
      after the consummation of such change of control, the holder may require
      the Company to redeem all or any portion of the Series B-1 Note in cash
      for an amount equal to any accrued and unpaid liquidated damages, plus the
      greater of (i) the product of (x) the conversion amount being
      redeemed and (y) the quotient determined by dividing (A) the
      greater of the closing sale price of the common stock immediately prior to
      the consummation of the change of control, the closing sale price
      immediately following the public announcement of such proposed change of
      control and the closing sale price of the common stock immediately prior
      to the public announcement of such proposed change of control by
      (B) the conversion price and (ii) 125% of the conversion amount
      being redeemed.





3)
            Redemption Right on Subsequent
      Financing. In the event that
      the Company or any of its subsidiaries shall issue any of its or its
      subsidiaries' equity or equity equivalent securities, or commit to issue
      or sell in one or more series of related transactions or financings,
      including without limitation any debt, preferred stock or other instrument
      or security that is, at any time during its life and under any
      circumstances, convertible into or exchangeable or exercisable for shares
      of common stock, options or convertible securities (any such offer, sale,
      grant, disposition or announcement of such current or future committed
      financing is referred to as a "Subsequent Financing"), the Company is
      obligated to provide the Holder written notice of the Subsequent Financing
      and the Holder, at its option, may require the Company to redeem the
      Series B-1 Note up to the Redemption
  Amount.  .




(A) In
the event that the Gross Proceeds of the Subsequent Financing equals or exceeds
$15,000,000 (a “Qualified Financing”), the “Redemption Amount” shall equal 100%
of the Principal Amount then outstanding.  For purposes hereof, “Gross
Proceeds” shall mean the aggregate proceeds received or receivable by the
Company in respect of one or more series of related future transactions or
financings for which the Company is committed in connection with such Qualified
Financing.


19




(B)In the
event that the Gross Proceeds of the Subsequent Financing is less than
$15,000,000, the Redemption Amount shall equal a pro-rated portion of the
Principal Amount equaling a ratio, the numerator of which is the amount of
proceeds raised by the Company in the Subsequent Financing and the denominator
which is $15,000,000.





NOTE 10—EQUITY
TRANSACTIONS





Warrants





During
March 2007, in conjunction with the issuance of $17.3 million in convertible
debt, the board of directors approved the issuance of warrants (as described in
Note 9 above) to purchase shares of the Company’s common stock. The 7,246,377
Series A warrants and the 21,578,948 Series B warrants are exercisable at $1.21
and $0.90, respectively and expire in March 2012. In addition, in March 2007, as
additional compensation for services as placement agent for the convertible debt
offering, the Company issued the advisor warrants, which entitle the placement
agent to purchase 507,247 and 1,510,528 shares of the Company’s common stock at
exercise prices of $0.69 and $0.57 per share, respectively. The advisor warrants
expire in March 2012.




The
Series A and Series B Warrants (including the Advisor Warrants) are classified
as a liability in accordance with FASB ASC 480, “Distinguishing Liabilities from
Equity”, due to the terms of the warrant agreements which contain cash
redemption provisions in the event of a fundamental transaction, which provide
that the Company would repurchase any unexercised portion of the warrants at the
date of the occurrence of the fundamental transaction for the value as
determined by the Black-Scholes Merton valuation model. As a result, the
warrants are measured at fair value both initially and in subsequent periods.
Changes in fair value of the warrants are recorded in the account “gain (loss)
on fair market value of warrant liability” in the accompanying Consolidated
Statements of Operations.





Additionally,
in connection with the offering all of the Company’s Series A and
Series B warrant holders waived their full ratchet anti-dilution and price
protection rights previously granted to them in connection with the Company’s
March 2007 convertible note and warrant financing.





On
January 12, 2008, the Company sold 24,318,181 shares of its common stock and
24,318,181 Series C warrants (the “Series C Warrants”) to purchase shares of
common stock for an aggregate purchase price of $21.4 million in a private
placement offering to accredited investors. Under its original terms, the
exercise price of the Series C Warrants is $1.00 per share. The warrants are
exercisable for a period of 5 years from the date of issuance of the Series C
Warrants.





For the
services in connection with this closing, the placement agent and the selected
dealer, Knight Capital Markets, LLC and Ardour Capital Investments, received an
aggregate of a 6.0% cash commission, a 1.0% advisory fee and warrants to
purchase 1,215,909 shares of common stock at $0.88 per share, exercisable for a
period of 5 years from the date of issuance of the warrants. The net proceeds
from issuing common stock and Series C warrants in January 2008 after all the
financing costs were $19.9 million and were recorded in additional paid in
capital and common stock. Neither the shares of common stock nor the shares of
common stock underlying the warrants sold in this offering were granted
registration rights.





In
connection with the Conversion Agreement, on January 7, 2010, the Company
entered into an Amendment (the “Warrant Amendment”) to the Series A, Series B
and Series C Warrants with the holders of at least a majority of the common
stock underlying each of its outstanding Series A Warrants, Series B Warrants
and Series C Warrants (collectively the “PIPE Warrants”). The Warrant Amendment
reduced the exercise price for all of the PIPE Warrants from $1.21, $0.90 and
$1.00, respectively, to $0.15, removed certain maximum ownership provisions and
removed anti-dilution provisions for lower-priced security issuances. Given the
above, the liability associated with the PIPE Warrants at the pre Conversion
Agreement exercise price was considered extinguished and was replaced with the
liability associated with the PIPE Warrants at the post Conversion Agreement
exercise price, which were recorded at fair value.


20





A summary
of outstanding warrants as of March 31, 2010 is as follows:





Number
      of
                        Shares
                      
                      
                      Exercise
                        Price
      ($)
                      
                      Recognized
      asGranted
      in connection with convertible notes — Series A
                      
                      
                      7,246,377
                      
                      
                      
                      1.21
                      
                      Discount
      to notes payableGranted
      in connection with convertible notes — Series B
                      
                      
                      21,578,948
                      
                      
                      
                      0.90
                      
                      Discount
      to notes payableGranted
      in connection with common stock purchase — Series C
                      
                      
                      24,318,181
                      
                      
                      
                      1.00
                      
                      Additional
      paid in capitalGranted
      in connection with placement service
                      
                      
                      507,247
                      
                      
                      
                      0.69
                      
                      Deferred
      financing costGranted
      in connection with placement service
                      
                      
                      1,510,528
                      
                      
                      
                      0.57
                      
                      Deferred
      financing costGranted
      in connection with placement service
                      
                      
                      1,215,909
                      
                      
                      
                      0.88
                      
                      Additional
      paid in capitalExtinguishment
      in accordance with the Conversion Agreement
                      
                      
                      (53,143,506
                      )
                      
                      
                      N/A
                      
                      Loss
      on debt extinguishmentIssuance
      in accordance with the Conversion Agreement
                      
                      
                      53,143,506
                      
                      
                      
                      0.15
                      
                      Warrant
      liabilitiesCashless
      exercise of warrants
                      
                      
                      (1,147,394
                      )
                      
                      
                      0.15
                      
                      Additional
      paid in capitalOutstanding
      at March 31, 2010
                      
                      
                      55,229,796





At March
31, 2010, the range of warrant prices for shares under warrants and the
weighted-average remaining contractual life is as follows:





Warrants
      Outstanding and ExercisableWeighted-Weighted-
                  
                  
                  AverageRange
      of
                  
                  
                  
                  
                  Average
                  
                  
                  RemainingWarrant
                  
                  Number
      of
                  
                  
                  Exercise
                  
                  
                  ContractualExercise Price
                  
                  Warrants
                  
                  
                  Price
                  
                  
                  Life$0.15
                  
                  
                  51,996,112
                  
                  
                  $
                  0.15
                  
                  
                  
                  2.34$0.57-$0.88
                  
                  
                  3,233,684
                  
                  
                  $
                  0.71
                  
                  
                  
                  2.27





Restricted
Stock





On August
19, 2008, Mr. Leo Young, our Chief Executive Officer, entered into a Stock
Option Cancellation and Share Contribution Agreement with Jean Blanchard, a
former officer, to provide for (i) the cancellation of a stock option agreement
by and between Mr. Young and Ms. Blanchard dated on or about March 1, 2006 and
(ii) the contribution to the Company by Ms. Blanchard of the remaining
25,250,000 shares of common stock underlying the cancelled option
agreement.





On the
same day, an Independent Committee of the Company’s Board of Directors adopted
the 2008 Restricted Stock Plan (the “2008 Plan”) providing for the issuance of
25,250,000 shares of restricted common stock to be granted to the Company’s
employees pursuant to forms of restricted stock agreements.





The 2008
Plan provides for the issuance of a maximum of 25,250,000 shares of restricted
stock in connection with awards under the 2008 Plan. The 2008 Plan is
administered by the Company’s Compensation Committee, a subcommittee of our
Board of Directors, and has a term of 10 years. Restricted stock vest over
a three year period and unvested restricted stock are forfeited and cancelled as
of the date that employment terminates. Participation is limited to employees,
directors and consultants of the Company and its subsidiaries and other
affiliates. During any period in which shares acquired pursuant to the 2008 Plan
remain subject to vesting conditions, the participant shall have all of the
rights of a stockholder of the Company holding shares of stock, including the
right to vote such shares and to receive all dividends and other distributions
paid with respect to such shares.  If a participant terminates his or
her service for any reason (other than death or disability), or the
participant’s service is terminated by the Company for cause, then the
participant shall forfeit to the Company any shares acquired by the participant
which remain subject to vesting Conditions as of the date of the participant’s
termination of service. If a participant’s service is terminated by the Company
without cause, or due to the death or disability of the participant, then the
vesting of any restricted stock award shall be accelerated in full as of the
effective date of the participant’s termination of service.





Issuance
of fully vested restricted stock to our former Board of Directors





On
January 12, 2010, the Company issued 400,000 shares of fully vested restricted
stock to the Company’s former board of directors on their resignation date. As
the former directors no longer provide services to the Company, these awards
were properly accounted for as awards to non-employees in accordance with FASB
ASC 718.


21





The
following table summarizes the activity of the Company’s unvested restricted
stock units as of March 31, 2010 and changes during the six months ended March
31, 2010:





Number
      of
                      shares
                    
                    
                    Weighted
                      average
      fair
                      valueUnvested
      as of September 30, 2008
                    
                    
                    25,250,000
                    
                    
                    $
                    0.62Restricted
      stock cancelled
                    
                    
                    (2,100,000
                    )
                    
                    $
                    0.62Unvested
      as of September 30, 2009
                    
                    
                    23,150,000
                    
                    
                    $
                    0.62Restricted
      stock cancelled
                    
                    
                    (2,400,000
                    )
                    
                    $
                    0.62Restricted
      stock granted
                    
                    
                    400,000
                    
                    
                    $
                    0.31Restricted
      stock vested
                    
                    
                    (400,000
                    )
                    
                    $
                    0.31Unvested
      as of March 31, 2010
                    
                    
                    20,750,000
                    
                    
                    $
                    0.62





The total
unvested restricted stock as of March 31, 2010 and September 30, 2009 were
20,750,000 and 23,150,000 shares, respectively.




Stock-based
compensation expense for restricted stock for the three and six months ended
March 31, 2010 were $0.8 million and $1.4 million, respectively. As of March 31,
2010, the total unrecognized compensation cost net of forfeitures relate to
unvested awards not yet recognized is $3.8 million and is expected to be
amortized over a weighted average period of 1.4 years.





Issuance
of common shares to non-employees





On
February 1, 2010, the Company issued 400,000 shares of common stock to the
Company’s third party financial advisors. These awards were properly accounted
for as awards to non-employees in accordance with FASB ASC 718.





Options





Amended
and Restated 2007 Equity Incentive Plan





In
September 2007, the Company adopted the 2007 Equity Incentive Plan (the
“2007 Plan”) that allows the Company to grant non-statutory stock options to
employees, consultants and directors. A total of 10 million shares of the
Company’s common stock are authorized for issuance under the 2007 Plan. The
maximum number of shares that may be issued under the 2007 Plan will be
increased for any options granted that expire, are terminated or repurchased by
the Company for an amount not greater than the holder’s purchase price and may
also be adjusted subject to action by the stockholders for changes in capital
structure. Stock options may have exercise prices of not less than 100% of the
fair value of a share of stock at the effective date of the grant of the
option.





On
February 5, 2008, the Board of Directors of the Company adopted the Amended and
Restated 2007 Equity Incentive Plan (the “Amended 2007 Plan”), which increases
the number of shares authorized for issuance from 10 million to 15 million
shares of common stock and was to be effective upon approval of the Company’s
stockholders and upon the Company’s reincorporation into the State of
Delaware.





On May 5,
2008, at the Company’s Annual Meeting of Stockholders, the Company’s
stockholders approved the Amended 2007 Plan.  On August 13, 2008, the
Company reincorporated into the State of Delaware. As of March 31, 2010 and
September 30, 2009, 12,660,000 and 12,060,000 shares of common stock,
respectively remain available for future grants under the Amended 2007
Plan.


22





These
options vest over various periods up to four years and expire no more than ten
years from the date of grant. A summary of activity under the Amended 2007 Plan
is as follows:





Option
      Available For
                          Grant
                        
                        
                        Number
      of Option
                          Outstanding
                        
                        
                        Weighted
      Average
                          Fair
      Value Per
                          Share
                        
                        
                        Weighted
      Average
                          Exercise
      Price Per
                          ShareBalance
      at September 30, 2008
                        
                        
                        7,339,375
                        
                        
                        
                        7,660,625
                        
                        
                        $
                        0.39
                        
                        
                        $
                        0.62Options
      granted
                        
                        
                        (500,000
                        )
                        
                        
                        500,000
                        
                        
                        $
                        0.13
                        
                        
                        $
                        0.20Options
      cancelled
                        
                        
                        5,220,625
                        
                        
                        
                        (5,220,625
                        )
                        
                        $
                        0.39
                        
                        
                        $
                        0.62Balance
      at September 30, 2009
                        
                        
                        12,060,000
                        
                        
                        
                        2,940,000
                        
                        
                        $
                        0.32
                        
                        
                        $
                        0.55Options
      granted
                        
                        
                        (250,000
                        )
                        
                        
                        250,000
                        
                        
                        $
                        0.20
                        
                        
                        $
                        0.32Options
      cancelled
                        
                        
                        850,000
                        
                        
                        
                        (850,000
                        )
                        
                        $
                        0.42
                        
                        
                        $
                        0.62Balance
      at March 31, 2010
                        
                        
                        12,660,000
                        
                        
                        
                        2,340,000
                        
                        
                        $
                        0.27
                        
                        
                        $
                        0.50





The total
fair value of shares vested during the six months ended March 31, 2010 and 2009
were $17,000 and $242,000, respectively.





At March
31, 2010 and September 30, 2009, 2,340,000 and 2,940,000 options were
outstanding, respectively and had a weighted-average remaining contractual life
of 7.47 years and 6.98 years, respectively. Of these options, 1,568,750 and
2,333,127 shares were vested and exercisable on March 31, 2010 and
September 30, 2009, respectively.  The weighted-average exercise price and
weighted-average remaining contractual term of options currently exercisable
were $0.62 and 6.56 years, respectively.





The fair
values of employee stock options granted during the three and six months ended
March 31, 2010 were estimated using the Black-Scholes option-pricing model with
the following weighted average assumptions:




Three
      Months Ended
                    
                    
                    Six
      Months EndedMarch
      31, 2010
                    
                    
                    March
      31, 2010Volatility
                    
                    
                    93.00
                    %
                    
                    
                    93.00
                    %Expected
      dividend
                    
                    
                    0.0
                    %
                    
                    
                    0.0
                    %Risk-free
      interest rate
                    
                    
                    1.70
                    %
                    
                    
                    1.70
                    %Expected
      term in years
                    
                    
                    3.32
                    
                    
                    
                    3.32Weighted-average
      fair value
                    
                    $
                    0.20
                    
                    
                    $
                    0.20




There
were no employee stock options granted during the three and six months ended
March 31, 2009.





In
accordance with the provisions of FASB ASC 718, the Company has recorded
stock-based compensation expense of $0.8 million and $1.5 million for the three
and six months ended March 31, 2010, respectively, which include the
compensation effect for the options repriced and restricted stock. The Company
recorded $0.4 million and $0.6 million for the three and six months ended March
31, 2009, respectively, which include the compensation effect for the options
repriced and restricted stock. The stock-based compensation expense is based on
the fair value of the options at the grant date.  The Company
recognized compensation expense for share-based awards based upon their value on
the date of grant amortized over the applicable service period, less an
allowance estimated future forfeited awards.





NOTE
11 — FAIR VALUE OF FINANCIAL INSTRUMENTS





In
September 2006, the FASB issued SFAS 157, “Fair Value Measurements”, codified in
FASB ASC 820, “Fair Value Measurements and Disclosures”, which defines fair
value to measure assets and liabilities, establishes a framework for measuring
fair value, and requires additional disclosures about the use of fair value.
FASB ASC 820 is applicable whenever another accounting pronouncement requires or
permits assets and liabilities to be measured at fair value. FASB ASC 820 does
not expand or require any new fair value measures. FASB ASC 820 is effective for
fiscal years beginning after November 15, 2007. In December 2007, the FASB
agreed to a one year deferral of FASB ASC 820’s fair value measurement
requirements for nonfinancial assets and liabilities that are not required or
permitted to be measured at fair value on a recurring basis. The Company adopted
FASB ASC 820 on October 1, 2008, which had no effect on the
Company’s financial position, operating results or cash flows.





FASB ASC
820 defines fair value and establishes a hierarchal framework which prioritizes
and ranks the market price observability used in fair value measurements. Market
price observability is affected by a number of factors, including the type of
asset or liability and the characteristics specific to the asset or liability
being measured. Assets and liabilities with readily available, active, quoted
market prices or for which fair value can be measured from actively quoted
prices generally are deemed to have a higher degree of market price
observability and a lesser degree of judgment used in measuring fair value.
Under FASB ASC 820, the inputs used to measure fair value must be classified
into one of three levels as follows:


23




Level
      1 -
            Quoted
      prices in an active market for identical assets or
      liabilities;





Level
      2 -
            Observable
      inputs other than Level 1, quoted prices for similar assets or liabilities
      in active markets, quoted prices for identical or similar assets and
      liabilities in markets that are not active, and model-derived prices whose
      inputs are observable or whose significant value drivers are observable;
      and





Level
      3 -
            Assets
      and liabilities whose significant value drivers are
      unobservable.





Observable
inputs are based on market data obtained from independent sources, while
unobservable inputs are based on the Company’s market assumptions. Unobservable
inputs require significant management judgment or estimation. In some cases, the
inputs used to measure an asset or liability may fall into different levels of
the fair value hierarchy. In those instances, the fair value measurement is
required to be classified using the lowest level of input that is significant to
the fair value measurement. Such determination requires significant management
judgment.





The
Company’s liabilities measured at fair value on a recurring basis consisted of
the following types of instruments as of March 31, 2010:





Fair
      Value at
                        March
      31, 2010
                      
                      
                      Quoted
      prices in
                        active
      markets
                        for
      identical
                        assets
                      
                      
                      Significant
      other
                        observable
      inputs
                      
                      
                      Significant
                        unobservable
                        inputs(Level
      1)
                      
                      
                      (Level
      2)
                      
                      
                      (Level
      3)Derivative
      liabilites
                      
                      $
                      1,279,000
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      1,279,000Warrant
      liabilities
                      
                      
                      2,437,000
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2,437,000Total
      liabilities
                      
                      $
                      3,716,000
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      3,716,000





The
method used to estimate the value of the Series B-1 Note compound embedded
derivatives (“CED”) was a binomial model with the following
assumptions:





March
      31, 2010Implied
      term(years)
                    
                    
                    1.97Suboptimal
      exercise factor
                    
                    
                    2.50Volatility
                    
                    
                    84.70
                    %Dividend
      yield
                    
                    
                    0.00
                    %Risk-free
      interest rate
                    
                    
                    1.01
                    %





The fair
value of the Series A and Series B Warrants (including the Advisor Warrants)
were estimated using a binomial valuation model with the following
assumptions:





March
      31, 2010
                    
                    
                    September
      30, 2009Implied
      term (years)
                    
                    
                    1.93
                    
                    
                    
                    2.43Suboptimal
      exercise factor
                    
                    
                    2.5
                    
                    
                    
                    2.5Volatility
                    
                    
                    84
                    %
                    
                    
                    106
                    %Dividend
      yield
                    
                    
                    0
                    %
                    
                    
                    0
                    %Risk
      free interest rate
                    
                    
                    0.99
                    %
                    
                    
                    1.15
                    %




24


The
carrying values of cash and cash equivalents, accounts receivable, accrued
expenses, accounts payable, accrued liabilities and amounts due to related party
approximate fair value because of the short-term maturity of these instruments.
The Company does not invest its cash in auction rate
securities.





At March
31, 2010, the principal outstanding and the carrying value of the Company’s
Series B-1 Note were $1.8 million and $1.5 million, respectively. The
Series B-1 Note contains two embedded derivative features, the conversion option
and a redemption privilege accruing to the holder if certain conditions exist
(the “compound embedded derivative”), which are measured at fair value both
initially and in subsequent periods. The fair value of the convertible notes can
be determined based on the fair value of the entire financial instrument.
However, it was not practicable to estimate the fair value of the convertible
notes because the Company has to incur excessive costs to estimate the fair
value.




NOTE
12 — COMPREHENSIVE LOSS





The
components of comprehensive loss were as follows:





Three
      Months Ended March 31,
                  
                  
                  Six
      Months Ended March 31,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Net
      loss
                  
                  $
                  (19,158,000
                  )
                  
                  $
                  (5,542,000
                  )
                  
                  $
                  (23,082,000
                  )
                  
                  $
                  (9,343,000
                  )Other
      comprehensive income:Change
      in foreign currency translation
                  
                  
                  5,000
                  
                  
                  
                  (9,000
                  )
                  
                  
                  11,000
                  
                  
                  
                  (48,000
                  )Comprehensive
      loss
                  
                  $
                  (19,153,000
                  )
                  
                  $
                  (5,551,000
                  )
                  
                  $
                  (23,071,000
                  )
                  
                  $
                  (9,391,000
                  )





The
accumulated other comprehensive income at March 31, 2010 and September 30, 2009
comprised of accumulated translation adjustments of $2.5 million and $2.5
million, respectively.




NOTE 13—COMMITMENTS AND
CONTINGENCIES





Research
and development commitment





Pursuant
to a joint research and development laboratory agreement with
Shanghai University, dated December 15, 2006 and expiring on
December 15, 2016, Solar EnerTech is committed to fund the establishment of
laboratories and completion of research and development activities.
The Company committed to invest no less than RMB5 million each year for the
first three years and no less than RMB30 million cumulatively for the first
five years. The following table summarizes the commitments in U.S. dollars based
upon a translation of the RMB amounts into U.S. dollars at an exchange rate of
6.8263 as of March 31, 2010.





Year
                    
                    Amount2010
                    
                    
                    2,606,0002011
                    
                    
                    1,113,000Total
                    
                    $
                    3,719,000





The
Company intends to increase research and development spending as it
grows its business. The payment to Shanghai University will be used to
fund program expenses and equipment purchase. Due to the delay in the progress
of research and development activities, the amount of $1.7 million originally
committed to be paid during fiscal years 2009 and 2008 has not been paid as of
March 31, 2010, as Shanghai University has not incurred the additional costs to
meet its research and development milestones and therefore has not made the
request for payments. If the Company fails to make payments, when requested, it
is deemed to be a breach of the agreement. If the Company is unable to correct
the breach within the requested time frame, Shanghai University could seek
compensation up to an additional 15% of the total committed amount for
approximately $0.7 million. As of March 31, 2010, the Company is not in breach
as it has not received any additional compensation requests from
Shanghai University.





The
agreement is for shared investment in research and development on fundamental
and applied technology in the fields of semi-conductive photovoltaic theory,
materials, cells and modules. The agreement calls for Shanghai University
to provide equipment, personnel and facilities for joint laboratories. The
Company will provide funding, personnel and facilities for conducting research
and testing. Research and development achievements from this joint research and
development agreement will be available to both parties. The Company is entitled
to intellectual property rights including copyrights and patents obtained as a
result of this research.





Expenditures
under this agreement will be accounted for as research and development
expenditures under FASB ASC 730, "Research and Development” and expensed as
incurred.


25





Capital
commitments





On August
21, 2008, we entered into an equity purchase agreement in which it acquired two
million shares of common stock of 21-Century Silicon, a polysilicon manufacturer
based in Dallas, Texas, for $1.0 million in cash. We are obligated to acquire an
additional two million shares at the same per share price upon the first
polysilicon shipment meeting the quality specifications determined solely by
the. In connection with the equity purchase agreement, we have also signed a
memorandum of understanding with 21-Century Silicon for a four-year
supply framework agreement for polysilicon shipments. On August 21, 2008,
the two million shares acquired by us constituted approximately 7.8% of
21-Century Silicon’s outstanding equity. On March 5, 2009, the Emerging
Technology Fund created by the State of Texas, invested $3.5 million in
21-Century Silicon. As of March 31, 2010, we have not yet acquired the
additional two million shares as the product shipments have not occurred.
Accordingly, as of March 31, 2010, the two million shares acquired by us have
been diluted and constituted approximately 5.5% of 21-Century Silicon’s
outstanding equity.





On
January 15, 2010, the Company incorporated a wholly-owned subsidiary in Yizheng,
Jiangsu province of China to supplement its existing production facilities to
meet increased sales demands.  The subsidiary was formed with a
registered capital requirement of $33 million, of which $23.4 million is to be
funded by October 16, 2011.  In order to fund the registered capital
requirement, the Company will have to raise funds or otherwise obtain the
approval of local authorities to reduce the amount of registered capital for the
subsidiary. The registered capital requirement outstanding as of March 31,
2010 is $23.4 million.





On
February 8, 2010, the Company acquired land use rights of a parcel of land at
the price of approximately $0.7 million. This piece of land is 68,025 square
meters and is located in Yizheng, Jiangsu province of China, which will be used
to house the Company’s second manufacturing facility. As part of the
acquisition of the land use right, the Company is required to complete
construction of the facility by February 8, 2012.





NOTE 14—RELATED PARTY
TRANSACTIONS





At March
31, 2010 and September 30, 2009, the accounts payable and accrued liabilities,
related party balance was $5.7 million and $5.6 million, respectively. The $5.7
million accrued liability represents $4.7 million of compensation expense
related to the Company’s obligation to withhold tax upon exercise of stock
options by Mr. Young in the fiscal year 2006 and the related interest and
penalties, and $1.0 million of indemnification provided by the Company to Mr.
Young  for any liabilities he may incur as a result of previous stock
options granted to him by Ms. Blanchard, a former officer, in conjunction with
the purchase of Infotech on August 19, 2008.





On April
27, 2009, the Company entered into a Joint Venture Agreement with Jiangsu
Shunda Semiconductor Development Co., Ltd. to form a joint venture in the United
States by forming a new company, to be known as Shunda-SolarE Technologies,
Inc., in order to jointly pursue opportunities in the United States solar
market. After its formation, the Joint Venture Company’s name was later changed
to SET-Solar Corp.





NOTE
15 — FOREIGN OPERATIONS





The
Company identifies its operating segments based on its business activities. The
Company operates within a single operating segment, the manufacture of solar
energy cells and modules in China.





The
Company’s manufacturing operations and fixed assets are all based in China. The
Company’s sales occurred in Europe, Australia, North America and
China.




ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





All
references to “Solar EnerTech”, the “Company,” “we,” “our,” and “us” refer to
Solar EnerTech Corp. and its subsidiaries.





The
following discussion contains forward-looking statements within the meaning of
the Private Securities Litigation Reform Act of 1995 that relate to our current
expectations and views of future events. In some cases, readers can identify
forward-looking statements by terminology such as “may,” “will,” “should,”
“could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,”
“potential,” or “continue.” These statements relate to events that involve known
and unknown risks, uncertainties and other factors, including those listed under
the heading “Risks Related to Our Business,” “Risks Related to an Investment in
Our Securities” and under the heading “Risks Related To an Investment in Our
Securities” in our Form 10-K filed with the Securities and Exchange Commission
(the “SEC”) on January 12, 2010 as well as other relevant risks detailed in our
filings with the SEC which may cause our actual results, performance or
achievements to be materially different from any future results, performance or
achievements expressed or implied by the forward-looking statements. The
information set forth in this report on Form 10-Q should be read in light of
such risks and in conjunction with the consolidated financial statements
and the notes thereto included elsewhere in this Form 10-Q.


26


Overview





We
originally incorporated under the laws of the State of Nevada on July 7,
2004 and reincorporated to the State of Delaware on August 13, 2008. We engaged
in a variety of businesses, including home security assistance, until
March 2006, when we began our current operations. We manufacture and sell
photovoltaic (commonly known as “PV”) cells and modules. PV modules consist of
solar cells that produce electricity from the sun’s rays. Our manufacturing
operations consisted of one 25MW solar cell production line and 50MW of solar
module production facility. Our 67,107 square foot manufacturing facility is
located in Shanghai, China.





Our solar
cells and modules are sold under the brand name “SolarE”.  Our total
revenue for the six months ended March 31, 2010 was $35.4 million and our end
users are mainly in Europe.  In anticipation of entering the US
market, we have established a marketing, purchasing and distribution office in
Mountain View, California. Our goal is to become a worldwide supplier of PV
cells and modules.





We
purchase our key raw materials, silicon wafer, from the spot
market.  We do not have a long term contract with any silicon
supplier.  However, on August 21, 2008, we entered into an equity
purchase agreement with 21-Century Silicon, Inc., a polysilicon manufacturer
based in Dallas, Texas (“21-Century Silicon”) to acquire two million shares of
common stock, for $1 million cash. As of March 31, 2010 the two million
shares acquired by us constituted approximately 5.5% of 21-Century Silicon’s
outstanding equity.  Related to the equity purchase agreement, we also
signed a memorandum of understanding with 21-Century Silicon for a four-year
supply framework agreement for polysilicon shipments. Through its proprietary
technology, processes and methods, 21-Century Silicon is planning to manufacture
solar-grade polysilicon at a lower manufacturing and plant setup cost, as well
as a shorter plant setup time than those of its major competitors. If 21-Century
Silicon's manufacturing goals are met, 21-Century Silicon’s customers, including
us, will benefit from the cost advantages and will expect to receive a
high-purity product at a price significantly lower than that offered elsewhere
within the industry.





On April
27, 2009, we entered into a Joint Venture Agreement (the “JV Agreement”)
with Jiangsu Shunda Semiconductor Development Co., Ltd. (“Jiangsu Shunda”) to
form a joint venture in the United States by forming a new company, to be
known as Shunda-SolarE Technologies, Inc. (the “Joint Venture Company” or
“SET-Solar Corp”), in order to jointly pursue opportunities in the United
States solar market. After its formation, the Joint Venture Company’s name
was later changed to SET-Solar Corp.




Pursuant
to the terms of the JV Agreement, Jiangsu Shunda would own 55% of the Joint
Venture Company, we would own 35% of the Joint Venture Company and the remaining
10% of the Joint Venture Company would be owned by the Joint Venture Company’s
management.  The Joint Venture Company’s Board of Directors consist of
five directors: three of the directors are nominated by Jiangsu Shunda and two
of whom were nominated by us.  Furthermore, Mr. Yunda Ni, the
President of Jiangsu Shunda, serves as the Joint Venture Company’s Chairman of
the Board and Mr. Leo Shi Young, our Chief Executive Officer serves as the Joint
Venture Company’s Vice Chairman of the Board.  Jiangsu Shunda is
responsible for managing the Joint Venture Company in China and we are
responsible for managing the Joint Venture Company in the United
States.  The JV Agreement is valid for 18 months. As of March 31,
2010, due to the foreign currency controls imposed by PRC government, Jiangsu
Shunda and the Company have not contributed any capital to the Joint Venture
Company and no equity interest has been issued to either Jiangsu Shunda or the
Company.





In
December 2006, we entered into a joint venture with
Shanghai University to operate a research facility to study various aspects
of advanced PV technology. Our joint venture with Shanghai University is
for shared investment in research and development on fundamental and applied
technologies in the fields of semi-conductive photovoltaic theory, materials,
cells and modules. The agreement calls for Shanghai University to provide
equipment, personnel and facilities for joint laboratories. It is our
responsibility to provide funding, personnel and facilities for conducting
research and testing. Research and development achievements from this joint
research and development agreement will be available for use by both parties. We
are entitled to the intellectual property rights, including copyrights and
patents, obtained as a result of this research. The research and development we
will undertake pursuant to this agreement includes the
following:





•
            we
      plan to research and test theories of PV, thermo-physics, physics of
      materials and chemistry;





•
            we
      plan to develop efficient and ultra-efficient PV cells with
      light/electricity conversion rates ranging from 20% to
  35%;





•
            we
      plan to develop environmentally friendly high conversion rate
      manufacturing technology of chemical compound film PV cell
      materials;





•
            we
      plan to develop highly reliable, low-cost manufacturing technology and
      equipment for thin film PV cells;





•
            we
      plan to research and develop key material for low-cost flexible film PV
      cells and non-vacuum technology;
and


27





•
            we
      plan to research and develop key technology and fundamental theory for
      third-generation PV cells.





On
January 7, 2010 (the “Conversion Date”), we entered into a Series A and Series B
Notes Conversion Agreement (the “Conversion Agreement”) with the holders of
Notes representing at least seventy-five percent of the aggregate principal
amounts outstanding under the Notes to restructure the terms of the Notes. On
January 7, 2010, as part of the Conversion Agreement, approximately $9.8 million
of convertible notes outstanding were successfully converted into shares of our
common stock. On January 19, 2010, a holder of approximately $1.8 million of our
formerly outstanding Series B Notes and Series B Warrants disputed the
effectiveness of the Conversion Agreement and the Warrant
Amendment.  Accordingly, the holder did not tender its Series B Notes
for conversion. After negotiations with the Holder, on March 19, 2010, the
Company entered into an Exchange Agreement with the Holder (“Exchange
Agreement”), whereby the Company issued the Series B-1 Note with a
principal amount of $1.8 million (the “Series B-1 Note”) due on March 19,
2012, which extended the original maturity date by 24 month, in exchange for the
Series B Notes.





Our
future operations are dependent upon the achievement of profitable operations.
Other than as discussed in this report, we know of no trends, events or
uncertainties that are reasonably likely to impact our future
liquidity.





Environmental,
Health and Safety Regulations





We will
use, generate and discharge toxic, volatile or otherwise hazardous chemicals and
wastes in our manufacturing activities. We are subject to a variety of federal,
state and local governmental laws and regulations related to the purchase,
storage, use and disposal of hazardous materials. We are also subject to
occupational health and safety regulations designed to protect worker health and
safety from injuries and adverse health effects from exposure to hazardous
chemicals and working conditions. If we fail to comply with present or future
environmental laws and regulations, we could be subject to fines, suspension of
production or a cessation of operations. In addition, under some federal, state
and local statutes and regulations, a governmental agency may seek recovery and
response costs from operators of property where releases of hazardous substances
have occurred or are ongoing, even if the operator was not responsible for the
release or otherwise was not at fault.





Any
failure by us to control the use of, or to restrict adequately the discharge of,
hazardous substances could subject us to substantial financial liabilities,
operational interruptions and adverse publicity, any of which could materially
and adversely affect our business, results of operations and financial
condition.




Solar
Energy Industry





We
believe that economic and national security issues, technological advances,
environmental regulations seeking to limit emissions by fossil fuel, air
pollution regulations restricting the release of greenhouse gasses, aging
electricity transmission infrastructure and depletion and limited supply of
fossil fuels, has made reliance on traditional sources of fuel for generating
electricity less attractive. Government policies, in the form of both regulation
and incentives, have accelerated the adoption of solar technologies by
businesses and consumers. For example, in the U.S., EPACT enacted a 30%
investment tax credit for solar, and in January 2006 California approved the
largest solar program in the country's history that provides for long term
subsidies in the form of rebates to encourage use of solar energy where
possible.





Government
Subsidies and Incentives





Various
subsidies and tax incentive programs exist at the federal and state level to
encourage the adoption of solar power including capital cost rebates,
performance-based incentives, feed-in tariffs, tax credits and net metering.
Capital cost rebates provide funds to customers based on the cost of size of a
customer's solar power system. Performance-based incentives provide funding to a
customer based on the energy produced by their solar system. Under a feed-in
tariff subsidy, the government sets prices that regulated utilities are required
to pay for renewable electricity generated by end-users. The prices are set
above market rates and may be differentiated based on system size or
application. Feed-in tariffs pay customers for solar power system generation
based on kilowatt-hours produced, at a rate generally guaranteed for a period of
time. Tax credits reduce a customer's taxes at the time the taxes are due. Under
net metering programs, a customer can generate more energy than used, during
which periods the electricity meter will spin backwards. During these periods,
the customer "lends" electricity to the grid, retrieving an equal amount of
power at a later Net time metering programs enable end-users to sell excess
solar electricity to their local utility in exchange for a credit against their
utility bills. Net metering programs are usually combined with rebates, and do
not provide cash payments if delivered solar electricity exceeds their utility
bills. In addition, several states have adopted renewable portfolio standards,
which mandate that a certain portion of electricity delivered to customers come
from a set of eligible renewable energy resources. Under a renewable portfolio
standard, the government requires regulated utilities to supply a portion of
their total electricity in the form of renewable electricity. Some programs
further specify that a portion of the renewable energy quota must be from solar
electricity.


28


Despite
the benefits of solar power, there are also certain risks and challenges faced
by solar power. Solar power is heavily dependent on government subsidies to
promote acceptance by mass markets. We believe that the near-term growth in the
solar energy industry depends significantly on the availability and size of
these government subsidies and on the ability of the industry to reduce the cost
of generating solar electricity. The market for solar energy products is, and
will continue to be, heavily dependent on public policies that support growth of
solar energy. There can be no assurances that such policies will continue.
Decrease in the level of rebates, incentives or other governmental support for
solar energy would have an adverse affect on our ability to sell our
products





Critical
Accounting Policies





We
consider our accounting policies related to principles of consolidation, revenue
recognition, inventory reserve, and stock based compensation, fair value of
equity instruments and derivative financial instruments to be critical
accounting policies. A number of significant estimates, assumptions, and
judgments are inherent in determining our consolidation policy, when to
recognize revenue, how to evaluate our equity instruments and derivative
financial instruments, and the calculation of our inventory reserve and
stock-based compensation expense. We base our estimates and judgments on
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances. Actual results could differ materially from
these estimates. Management believes that there have been no significant changes
during the three months ended March 31, 2010 to the items that we disclosed as
our critical accounting policies and estimates in Management’s Discussion and
Analysis or Plan of Operations in our Annual Report on Form 10-K filed for the
year ended September 30, 2009 with the Securities and Exchange Commission. For a
description of those critical accounting policies, please refer to our 2009
Annual Report on Form 10-K.





Recent
Accounting Pronouncements





For
recent accounting pronouncements, including the expected dates of adoption and
estimated effects, if any, on our consolidated condensed financial statements,
see “Note 3 – Summary of Significant Accounting Policies” in the Notes to
Consolidated Financial Statements of this Form 10-Q.




Results
of Operations for the three and six months ended March 31, 2010 and
2009





The
following discussion of the financial condition, results of operations, cash
flows and changes in financial position of our Company should be read in
conjunction with our audited consolidated financial statements and notes filed
with the SEC on Form 10-K and its subsequent amendments.





Revenues,
Cost of Sales and Gross Profit (Loss)





Three
      Months Ended March 31, 2010
                  
                  
                  Three
      Months Ended March 31, 2009
                  
                  
                  Year-Over-Year
      ChangeAmount
                  
                  
                  %
      of net sales
                  
                  
                  Amount
                  
                  
                  %
      of net sales
                  
                  
                  Amount
                  
                  
                  %
      of changeSales
                  
                  $
                  17,751,000
                  
                  
                  
                  100.0
                  %
                  
                  $
                  4,412,000
                  
                  
                  
                  100.0
                  %
                  
                  $
                  13,339,000
                  
                  
                  
                  302.3
                  %Cost
      of sales
                  
                  
                  (16,824,000
                  )
                  
                  
                  (94.8
                  )%
                  
                  
                  (5,714,000
                  )
                  
                  
                  (129.5
                  )%
                  
                  
                  (11,110,000
                  )
                  
                  
                  194.4
                  %Gross
      profit (loss)
                  
                  $
                  927,000
                  
                  
                  
                  5.2
                  %
                  
                  $
                  (1,302,000
                  )
                  
                  
                  (29.5
                  )%
                  
                  $
                  2,229,000
                  
                  
                  
                  (171.2
                  )%





Six
      Months Ended March 31, 2010
                  
                  
                  Six
      Months Ended March 31, 2009
                  
                  
                  Year-Over-Year
      ChangeAmount
                  
                  
                  %
      of net sales
                  
                  
                  Amount
                  
                  
                  %
      of net sales
                  
                  
                  Amount
                  
                  
                  %
      of changeSales
                  
                  $
                  35,444,000
                  
                  
                  
                  100.0
                  %
                  
                  $
                  9,496,000
                  
                  
                  
                  100.0
                  %
                  
                  $
                  25,948,000
                  
                  
                  
                  273.3
                  %Cost
      of sales
                  
                  
                  (32,586,000
                  )
                  
                  
                  (91.9
                  )%
                  
                  
                  (13,134,000
                  )
                  
                  
                  (138.3
                  )%
                  
                  
                  (19,452,000
                  )
                  
                  
                  148.1
                  %Gross
      profit (loss)
                  
                  $
                  2,858,000
                  
                  
                  
                  8.1
                  %
                  
                  $
                  (3,638,000
                  )
                  
                  
                  (38.3
                  )%
                  
                  $
                  6,496,000
                  
                  
                  
                  (178.6
                  )%





For the
three months ended March 31, 2010, we reported total revenue of $17.8 million,
representing an increase of $13.3 million or 302.3% compared to $4.4 million of
revenue in the same period of the prior year.  The increase in revenue
was due to the strong organic growth from our existing customers in a growing
market and increased sales orders from new customers as a result of heightened
efforts by our sales and marketing team. Specifically, during the last quarter
of fiscal year 2009, we acquired a new key customer, specifically a 10MW
contract with a German system integrator, and in the first quarter of
fiscal year 2010, we signed a 15 MW and a 10MW contracts with existing
customers. Both of these events contributed to the increased in sales
volume during the three months ended March 31, 2010.





For the
six months ended March 31, 2010, we recorded $35.4 million in revenue which
comprised of $28.6 million in solar module sales, $4.7 million in cell
sales and $2.1 million in resale of raw materials compared to $9.5 million of
revenue in the same period of the prior year which comprised of $9.0 million in
solar module sales and $0.5 million in resale of raw materials. The increase in
revenue resulted from increases in solar module shipments from 2.97MW for the
six months ended March 31, 2009 to 11.53MW for the six months ended March 31,
2010.


29


For the
three months ended March 31, 2010, we incurred a gross profit of $0.9 million,
representing an increase of $2.2 million or 171.2% compared to negative gross
profit of $1.3 million in the same period of the prior year.  The
increase in gross profit was primarily due to the decrease in raw material
prices, specifically silicon wafer prices which offset the decrease in
module sales prices. Silicon wafer prices decreased approximately 39% from
RMB26.7/piece during the three months ended March 31, 2009 to RMB16.2/piece
during the three months ended March 31, 2010. The increase in gross profit was
also due to economies of scale generated from higher production volume, which
lowered per unit production cost. In addition, the Company has
continued with its various cost cutting programs and renegotiated most of its
vendor contracts to reduce operating expenses.





For the
six months ended March 31, 2010, we incurred a gross profit of $2.9 million,
representing an increase of $6.5 million or 178.6% compared to negative gross
profit of $3.6 million in the same period of the prior year.  The
increase in gross profit was primarily due to the decrease in raw material
prices, specifically the silicon wafer prices which offset the decrease in
module sales prices. Silicon wafer prices decreased approximately 52% from
RMB33.6/piece during the six months ended March 31, 2009 to RMB16.2/piece during
the six months ended March 31, 2010. The increase in gross profit was
also due to economies of scale generated from higher production volume, which
lowered per unit production cost. In addition, the Company has
continued with its various cost cutting programs and renegotiated most of its
vendor contracts to reduce operating expenses.





Selling,
general & administrative





Three
      Months Ended March 31, 2010
                    
                    
                    Three
      Months Ended March 31, 2009
                    
                    
                    Year-Over-Year
      ChangeAmount
                    
                    
                    %
      of net sales
                    
                    
                    Amount
                    
                    
                    %
      of net sales
                    
                    
                    Amount
                    
                    
                    %
      of changeSelling,
      general and administrative
                    
                    $
                    2,550,000
                    
                    
                    
                    14.4
                    %
                    
                    $
                    3,086,000
                    
                    
                    
                    69.9
                    %
                    
                    $
                    (536,000
                    )
                    
                    
                    (17.4
                    )%





Six
      Months Ended March 31, 2010
                
                
                Six
      Months Ended March 31, 2009
                
                
                Year-Over-Year
      ChangeAmount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of changeSelling,
      general and administrative
                
                $
                4,768,000
                
                
                
                13.5
                %
                
                $
                5,647,000
                
                
                
                59.5
                %
                
                $
                (879,000
                )
                
                
                (15.6
                )%





For the
three months ended March 31, 2010, our selling, general and administrative
expenses were $2.6 million, representing a decrease of $0.5 million or 17.4%
from $3.1 million in the three months ended March 31, 2009. Selling, general and
administrative expenses as a percentage of net sales for the three months ended
March 31, 2010 decreased to 14.4% from 69.9% for the three months ended March
31, 2009. The decrease in the selling, general and administrative expenses were
primarily due to a decrease of $0.4 million in stock-based compensation expenses
related to employee options and restricted stock from $1.2 million for the three
months ended March 31, 2009 to $0.8 million for the three months ended March 31,
2010. Excluding stock-based compensation expenses, our selling, general &
administrative expenses decreased by approximately $0.1 million primarily due to
the write-off of the advance payments in the three months ended March 31,
2009.





For the
six months ended March 31, 2010, our selling, general and administrative
expenses were $4.8 million, representing a decrease of $0.9 million or 15.6%
from $5.6 million in the six months ended March 31, 2009. Selling, general and
administrative expenses as a percentage of net sales for the six months ended
March 31, 2010 decreased to 13.5% from 59.5% for the six months ended March 31,
2009. The decrease in the selling, general and administrative expenses were
primarily due to a decrease of $0.8 million in stock-based compensation expenses
related to employee options and restricted stock from $2.3 million for the six
months ended March 31, 2009 to $1.5 million for the six months ended March 31,
2010. Excluding stock-based compensation expenses, our selling, general &
administrative expenses decreased by approximately $0.1 million primarily due to
the write-off of the advance payments in the six months ended March 31,
2009.





Research
& development





Three
      Months Ended March 31, 2010
                
                
                Three
      Months Ended March 31, 2009
                
                
                Year-Over-Year
      ChangeAmount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of changeResearch
      and development
                
                $
                125,000
                
                
                
                0.7
                %
                
                $
                436,000
                
                
                
                9.9
                %
                
                $
                (311,000
                )
                
                
                (71.3
                )%





Six
      Months Ended March 31, 2010
                
                
                Six
      Months Ended March 31, 2009
                
                
                Year-Over-Year
      ChangeAmount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of changeResearch
      and development
                
                $
                233,000
                
                
                
                0.7
                %
                
                $
                771,000
                
                
                
                8.1
                %
                
                $
                (538,000
                )
                
                
                (69.8
                )%





Research
and development expenses in the three months ended March 31, 2010 were $0.1
million, representing a decrease of $0.3 million or 71.3% over $0.4 million for
the three months ended March 31, 2009. Research and development expenses as a
percentage of net sales for the three months ended March 31, 2010 decreased to
0.7% from 9.9% for the three months ended March 31, 2009. The decrease in
research and development expenses were mainly due to a decrease of $0.3 million
in stock-based compensation expenses related to employee options and restricted
stock from $0.3 million for the three months ended March 31, 2009 to $19,000 for
the three months ended March 31, 2010.


30





Research
and development expense in the six months ended March 31, 2010 of $0.2 million,
representing a decrease of $0.5 million or 69.8 % over $0.8 million for the six
months ended March 31, 2009. Research and development expense as a percentage of
net sales for the six months ended March 31, 2010 decreased to 0.7% from 8.1%
for the six months ended March 31, 2009. The decrease in research and
development expenses were mainly due to a decrease of $0.5 million in
stock-based compensation expenses related to employee options and restricted
stock from $0.6 million for the six months ended March 31, 2009 to $42,000 for
the six months ended March 31, 2010.





Excluding
stock-based compensation expenses, the research and development expense slightly
increased for the three and six months ended March 31, 2010 compared to the
three and six months ended March 31, 2009 mainly as a result of our funding of
the development contract with Shanghai University amounting to
$44,000. In accordance with our joint research and development laboratory
agreement with Shanghai University, dated December 15, 2006 and expiring on
December 15, 2016, we are committed to funding an additional $3.7 million in the
next 2 years. The delay in the payment of remaining fiscal years 2008 and 2009
total commitments of $1.7 million could lead to Shanghai University
requesting the Company pay the committed amount within a short time frame. If
the Company does not pay and is unable to correct the breach within the
requested time frame, Shanghai University could seek compensation up to an
additional 15% of the total committed amount for approximately $0.7 million. As
of the date of this report, we have not received any additional compensation
requests from Shanghai University. We expect to increase our funding to
research and development activities as we grow our business.





Loss
on debt extinguishment





Three
      Months Ended March 31, 2010
                
                
                Three
      Months Ended March 31, 2009
                
                
                Year-Over-Year
      ChangeAmount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of changeLoss
      on debt extinguishment
                
                $
                18,549,000
                
                
                
                104.5
                %
                
                $
                181,000
                
                
                
                4.1
                %
                
                $
                18,368,000
                
                
                
                10,148.1
                %





Six
      Months Ended March 31, 2010
                
                
                Six
      Months Ended March 31, 2009
                
                
                Year-Over-Year
      ChangeAmount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of net sales
                
                
                Amount
                
                
                %
      of changeLoss
      on debt extinguishment
                
                $
                18,549,000
                
                
                
                52.3
                %
                
                $
                491,000
                
                
                
                5.2
                %
                
                $
                18,058,000
                
                
                
                3,677.8
                %





During
the three months and six months ended March 31, 2010, the Company recorded a
cumulative loss on debt extinguishment of approximately $18.5 million as a
result of the Conversion Agreement and the Exchange Agreement.





During
the three and six months ended March 31, 2009, $0.4 million and $0.8
million of Series A and B Convertible Notes were converted into
the Company’s common shares, respectively. The Company recorded a loss on
debt extinguishment of $0.2 million and $0.5 million, respectively as a result
of the conversion based on the quoted market closing price of our common shares
on the conversion dates.





Other
income (expense)





Three
      Months Ended March 31, 2010
                    
                    
                    Three
      Months Ended March 31, 2009
                    
                    
                    Year-Over-Year
      ChangeAmount
                    
                    
                    %
      of net sales
                    
                    
                    Amount
                    
                    
                    %
      of net sales
                    
                    
                    Amount
                    
                    
                    %
      of changeInterest
      income
                    
                    $
                    1,000
                    
                    
                    
                    0.0
                    %
                    
                    $
                    3,000
                    
                    
                    
                    0.1
                    %
                    
                    $
                    (2,000
                    )
                    
                    
                    (66.7
                    )%Interest
      expense
                    
                    
                    (899,000
                    )
                    
                    
                    (5.1
                    )%
                    
                    
                    (558,000
                    )
                    
                    
                    (12.6
                    )%
                    
                    
                    (341,000
                    )
                    
                    
                    61.1
                    %Gain
      on change in fair market value of compound embedded
    derivative
                    
                    
                    294,000
                    
                    
                    
                    1.7
                    %
                    
                    
                    113,000
                    
                    
                    
                    2.6
                    %
                    
                    
                    181,000
                    
                    
                    
                    160.2
                    %Gain
      on change in fair market value of warrant liability
                    
                    
                    2,055,000
                    
                    
                    
                    11.6
                    %
                    
                    
                    99,000
                    
                    
                    
                    2.2
                    %
                    
                    
                    1,956,000
                    
                    
                    
                    1,975.8
                    %Other
      expense
                    
                    
                    (312,000
                    )
                    
                    
                    (1.8
                    )%
                    
                    
                    (194,000
                    )
                    
                    
                    (4.4
                    )%
                    
                    
                    (118,000
                    )
                    
                    
                    60.8
                    %Total
      other income (expense)
                    
                    $
                    1,139,000
                    
                    
                    
                    6.4
                    %
                    
                    $
                    (537,000
                    )
                    
                    
                    (12.2
                    )%
                    
                    $
                    1,676,000
                    
                    
                    
                    (312.1
                    )%


31





Six
      Months Ended March 31, 2010
                    
                    
                    Six
      Months Ended March 31, 2009
                    
                    
                    Year-Over-Year
      ChangeAmount
                    
                    
                    %
      of net sales
                    
                    
                    Amount
                    
                    
                    %
      of net sales
                    
                    
                    Amount
                    
                    
                    %
      of changeInterest
      income
                    
                    $
                    4,000
                    
                    
                    
                    0.0
                    %
                    
                    $
                    10,000
                    
                    
                    
                    0.1
                    %
                    
                    $
                    (6,000
                    )
                    
                    
                    (60.0
                    )%Interest
      expense
                    
                    
                    (5,324,000
                    )
                    
                    
                    (15.0
                    )%
                    
                    
                    (923,000
                    )
                    
                    
                    (9.7
                    )%
                    
                    
                    (4,401,000
                    )
                    
                    
                    476.8
                    %Gain
      on change in fair market value of compound embedded
    derivative
                    
                    
                    398,000
                    
                    
                    
                    1.1
                    %
                    
                    
                    588,000
                    
                    
                    
                    6.2
                    %
                    
                    
                    (190,000
                    )
                    
                    
                    (32.3
                    )%Gain
      on change in fair market value of warrant liability
                    
                    
                    2,976,000
                    
                    
                    
                    8.4
                    %
                    
                    
                    1,743,000
                    
                    
                    
                    18.4
                    %
                    
                    
                    1,233,000
                    
                    
                    
                    70.7
                    %Other
      expense
                    
                    
                    (444,000
                    )
                    
                    
                    (1.3
                    )%
                    
                    
                    (214,000
                    )
                    
                    
                    (2.3
                    )%
                    
                    
                    (230,000
                    )
                    
                    
                    107.5
                    %Total
      other income (expense)
                    
                    $
                    (2,390,000
                    )
                    
                    
                    (6.7
                    )%
                    
                    $
                    1,204,000
                    
                    
                    
                    12.7
                    %
                    
                    $
                    (3,594,000
                    )
                    
                    
                    (298.5
                    )%





For the
three months ended March 31, 2010, total other income were $1.1 million,
representing an increase of $1.7 million or 312.1% compared to total other
expense of $0.5 million for the same period of the prior year. Other income as a
percentage of net sales for the three months ended March 31, 2010 was a 6.4%
compared to a negative 12.2% for the same period in the prior year. We incurred
interest expenses of $0.9 million and $0.6 million in the three months ended
March 31, 2010 and 2009, respectively, primarily related to the amortization of
the discount on the convertible notes and deferred financing cost, and 6%
interest charges on Series A and B Convertible Notes. In the three months
ended March 31, 2010, we recorded a gain on change in fair market value of
warranty liability of $2.1 million and a gain on change in fair market value of
compound embedded derivative of $0.3 million compared to a gain on change in
fair market value of warrant liability of $0.1 million and a gain on change in
fair market value of compound embedded derivative of $0.1 million during the
three months ended March 31, 2009. The lower conversion price of the
compound embedded derivative and warrant in the three months ended March 31,
2010 compared to that in the three months ended March 31, 2009 resulted in less
decrease in the fair value of the compound embedded derivative and warrant
liability and less gains on change in fair market value of the compound embedded
derivative and warrant liability. Other expenses of $0.3 million and $0.2
million for the three months ended March 31, 2010 and 2009, respectively, were
primarily related to foreign exchange loss.





For the
six months ended March 31, 2010, total other expenses were $2.4 million,
representing a decrease of $3.6 million or 298.5% compared to total other income
of $1.2 million for the same period of the prior year. Other expenses as a
percentage of net sales for the six months ended March 31, 2010 decreased to a
negative 6.7% from a positive 12.7% for the six months ended March 31, 2009. In
the six months ended March 31, 2010, we recorded a gain on change in fair market
value of compound embedded derivative of $0.4 million and a gain on change in
fair market value of warrant liability of $3.0 million compared to a gain on
change in fair market value of compound embedded derivative of $0.6 million and
a gain on change in fair market value of warrant liability of $1.7 million
during the six months ended March 31, 2009. The lower conversion price of the
compound embedded derivative and warrant in the three months ended March 31,
2010 compared to that in the three months ended March 31, 2009, resulted in
less decrease in the fair value of the compound embedded derivative and
warrant liability and less gains on change in fair market value of the compound
embedded derivative and warrant liability. We incurred interest expenses of $5.3
million and $0.9 million in the six months ended March 31, 2010 and 2009,
respectively, primarily related to the amortization of the discount on the
convertible notes and deferred financing cost, and 6% interest charges on Series
A and B Convertible Notes. Other expenses of $0.4 million and $0.2 million for
the six months ended March 31, 2010 and 2009, respectively, were primarily
related to foreign exchange loss.




Liquidity
and Capital Resources





March
      31, 2010
                
                
                September
      30, 2009
                
                
                ChangeCash
      and cash equivalents
                
                $
                897,000
                
                
                $
                1,719,000
                
                
                $
                (822,000
                )





As of
March 31, 2010, we had cash and cash equivalents of $0.9 million, as compared to
$1.7 million at September 30, 2009. We will require a significant amount of cash
to fund our operations. Changes in our operating plans, an increase in our
inventory, increased expenses, additional acquisitions, or other events, may
cause us to seek additional equity or debt financing in the future. In order to
continue as a going concern, we will need to continue to generate new sales
while controlling our costs.  If we are unable to successfully
generate enough revenues to cover our costs, we only have limited cash resources
to bear operating losses.  To the extent our operations are not
profitable, we may not continue as a going concern.


32





Six
      Months Ended March 31,2010
                  
                  
                  2009
                  
                  
                  ChangeNet
      cash provided by (used in):Operating
      activities
                  
                  $
                  (558,000
                  )
                  
                  $
                  123,000
                  
                  
                  $
                  (681,000
                  )Investing
      activities
                  
                  
                  (263,000
                  )
                  
                  
                  (309,000
                  )
                  
                  
                  46,000Effect
      of exchange rate changes on cash and cash equivalents
                  
                  
                  (1,000
                  )
                  
                  
                  8,000
                  
                  
                  
                  (9,000
                  )Net
      decrease in cash and cash equivalents
                  
                  $
                  (822,000
                  )
                  
                  $
                  (178,000
                  )
                  
                  $
                  (644,000
                  )





Net cash
(used in) provided by operating activities were negative $0.6 million and $0.1
million for the six months ended March 31, 2010 and 2009, respectively. Cash
flow from operating activities reflected a net loss of $23.1 million adjusted
for non-cash items, including depreciation of property and equipment,
stock-based compensation, the change in the fair market value of the compound
derivative liabilities and warrants liabilities, amortization of note discount
and deferred financing cost and loss on debt extinguishment. The decrease of
$0.7 million in cash flow from operating activities from March 31, 2009 to March
31, 2010 was mainly attributable to higher balances of accounts receivable,
inventories and VAT receivables, partially offset by a higher accounts payable
balance outstanding in the current quarter.





Net cash
used in investment activities were $0.3 million and $0.3 million in the six
months ended March 31, 2010 and 2009, respectively.





There was
no cash provided by financing activities for the six months ended March 31, 2010
and 2009.





Our
consolidated balance sheet, statements of operations and cash flows have been
prepared on the assumption that the Company will continue as a going concern,
which contemplates the realization of assets and liquidation of liabilities in
the normal course of business.





As part
of the Conversion Agreement and Exchange Agreement, the only outstanding
convertible note is the Series B-1 Note. At March 31, 2010, the principal
outstanding and the carrying value of the Company’s Series B-1 Note were $1.8
million and 1.5 million, respectively. The Series B-1 Note bears interest at 6%
per annum and is due on March 19, 2012. The holders of the Series B-1 Note can
demand repayment from the Company upon the occurrence of any of the triggering
events detailed in the Series B-1 Note. It is uncertain whether the Company will
be able to satisfy this claim if it comes due. In addition, the Company has
certain commitments as disclosed in the “Off Balance Sheet Arrangements” section
below. Notwithstanding the claim that may be made by the Holder, the Company’s
liquidity and financial position raises substantial doubt about the Company’s
ability to continue as a going concern. The independent auditor’s report on the
Company’s most recent annual report on Form 10-K for the year ended
September 30, 2009 contains an explanatory paragraph stating that the Company’s
recurring net losses and negative cash flows from operations raises substantial
doubt about the Company’s ability to continue as a going concern.





As of
March 31, 2010, we had $0.9 million of cash and cash
equivalents.  Since April 2009 significant steps were taken to improve
operations. Gross margin has turned into positive territory and expenses have
been significantly reduced. Starting in the third quarter of fiscal year 2009,
we achieved positive gross margins. Our management expects the current upward
trend to continue and we expect to generate positive cash flow to support our
future operations in fiscal year 2010.





On March
25, 2010, the Company entered into a one year contract with China Export &
Credit Insurance Corporation (“CECIC”) to insure the collectability of the
outstanding accounts receivable for two of the Company’s key customers. The
Company pays a fee based on a fixed percentage of the accounts receivable
outstanding and expenses this fee when it is incurred. In addition, on March 30,
2010, the Company entered into a one year revolving credit facility arrangement
with Industrial Bank Co., Ltd. (“IBC”) that is secured by the accounts
receivable balances of the Company’s two key customers insured by CECIC above.
The Company can draw up to the lower of $2.0 million or the cumulative amount of
outstanding accounts receivable from the respective two key customers. If any of
the insured customers fail to repay the amounts outstanding due to the Company,
the insurance proceeds will be remitted directly to IBC instead of the Company.
As of March 31, 2010, the Company has not drawn on this credit facility with IBC
and there have been no insurance claims submitted to CECIC.





We
believe that the debt restructuring, availability of the new credit facility,
along with our existing cash resources and the cash expected to be generated
from sales during fiscal year 2010 will be sufficient to meet our projected
operating requirements through September 30, 2010 and enable us to continue as a
going concern. If we experience a material shortfall versus our plan for fiscal
year 2010, we have a range of actions we can take to remediate the cash
shortage, including but not limited to, raising additional funds through debt
financing, securing a credit facility, entering into secured or unsecured bank
loans, or undertaking equity offerings such a rights offering to existing
shareholders. However, due to the tight capital and credit markets, we
cannot be sure that external financing will be available when needed or that, if
available, financing will be obtained on terms favorable to us or our
stockholders.


33





Off-Balance
Sheet Arrangements




On August
21, 2008, we entered into an equity purchase agreement in which it acquired two
million shares of common stock of 21-Century Silicon, a polysilicon manufacturer
based in Dallas, Texas, for $1.0 million in cash. We are obligated to acquire an
additional two million shares at the same per share price upon the first
polysilicon shipment meeting the quality specifications determined solely by
the. In connection with the equity purchase agreement, we have also signed a
memorandum of understanding with 21-Century Silicon for a four-year supply
framework agreement for polysilicon shipments. On August 21, 2008, the two
million shares acquired by us constituted approximately 7.8% of 21-Century
Silicon’s outstanding equity. On March 5, 2009, the Emerging Technology Fund
created by the State of Texas, invested $3.5 million in 21-Century Silicon. As
of March 31, 2010, we have not yet acquired the additional two million shares as
the product shipments have not occurred. Accordingly, as of March 31, 2010, the
two million shares acquired by us have been diluted and constituted
approximately 5.5% of 21-Century Silicon’s outstanding equity.





On
January 15, 2010, we incorporated a wholly-owned subsidiary in Yizheng, Jiangsu
province of China to supplement our existing production facilities to meet
increased sales demands.  The subsidiary was formed with a registered
capital requirement of $33 million, of which $23.4 million is to be funded by
October 16, 2011.  In order to fund the registered capital
requirement, we will have to raise funds or otherwise obtain the approval of
local authorities to reduce the amount of registered capital for the
subsidiary. The registered capital requirement outstanding as of March 31,
2010, is $23.4 million.





On
February 8, 2010, the Company acquired land use rights of a parcel of land at
the price of approximately $0.7 million. This piece of land is 68,025 square
meters and is located in Yizheng, Jiangsu province of China, which will be used
to house the Company’s second manufacturing facility. As part of the
acquisition of the land use right, the Company is required to complete
construction of the facility by February 8, 2012.





ITEM 3. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK




As a
Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in
item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations and therefore are not required to provide the information requested
by this Item 3.





ITEM
4T. CONTROLS AND PROCEDURES




Disclosure
Controls and Procedures




Management
carried out an evaluation, under the supervision and with the participation of
our Chief Executive Officer and Chief Financial Officer, of the effectiveness of
the design and operation of our disclosure controls and procedures as of the end
of the period covered by this report. The evaluation was undertaken in
consultation with our accounting personnel. Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures are not effective to ensure that information required to
be disclosed by us in the reports that we file or submit under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in the SEC’s rules and forms because of the lack of
finance and accounting personnel with an appropriate level of knowledge,
experience and training in the application of U.S. GAAP. Accordingly, management
has determined that this control deficiency constitutes a material
weakness.




Internal
Control Over Financial Reporting





Our
management, with the participation of our Chief Executive Officer and our Chief
Financial Officer, has concluded there were no changes in our internal controls
over financial reporting that occurred during the three months ended March 31,
2010 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.


34





PART
II - OTHER INFORMATION




ITEM
1. LEGAL PROCEEDINGS




None





ITEM
1A. RISK FACTORS




The
Company’s risk factors are included in the Company’s Annual Report on Form 10-K
for the fiscal year ended September 30, 2009 and have not materially
changed.





ITEM
2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS




Previously
reported in our Form 8-K filed on March 22, 2010.




ITEM
3. DEFAULTS UPON SENIOR SECURITIES




None




ITEM
4. REMOVED AND RESERVED




None





ITEM
5. OTHER INFORMATION




None





ITEM
6. EXHIBITS




(a)
Pursuant to Rule 601 of Regulation S-K, the following exhibits are included
herein or incorporated by reference.




2.1
              Agreement
      and Plan of Merger with Solar EnerTech Corp., a Nevada corporation and our
      predecessor in interest, dated August 13, 2008, incorporated by reference
      from Exhibit 2.1 to our Form 8-K filed on August 14,
  2008.3.1
              Certificate
      of Incorporation, incorporated by reference from Exhibit 3.1 to our Form
      8-K filed on August 14, 2008.3.2
              By-laws,
      incorporated by reference from Exhibit 3.2 to our Form 8-K filed on August
      14, 2008.10.1
              Exchange
      Agreement effective March 19, 2010, incorporated by reference from Exhibit
      10.1 to our Form 8-K filed on March 22, 2010.10.2
              Series
      B-1 Convertible Note issued effective March 19, 2010, incorporated by
      reference from Exhibit 10.2 to our Form 8-K filed on March 22,
      2010.31.1
              Section
      302 Certification - Chief Executive Officer*31.2
              Section
      302 Certification - Chief Financial Officer*32.1
              Certification
      Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 - Chief Executive
  Officer.*32.2
              Certification
      Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 - Chief Financial
  Officer.*





* Filed
herewith.




35




SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.




SOLAR
ENERTECH CORP.





Date:
      May 14, 2010
              By:
              /s/
      Steve YeSteve
      YeChief
      Financial Officer





36