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 December 31, 2009OR ̈
            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 February 9, 2010:
177,952,592







SOLAR
ENERTECH CORP





FORM
10-Q





INDEX




PAGEPart I. Financial
      InformationItem
      1.
                                              Financial
      StatementsConsolidated
      Balance Sheets – December 31, 2009 (Unaudited) and September 30,
      2009 (Audited)
                                              
                                              3Unaudited
      Consolidated Statements of Operations – Three Months Ended December
      31, 2009 and 2008
                                              
                                              4Unaudited Consolidated
      Statements of Cash Flows – Three Months Ended December 31, 2009 and
      2008
                                              
                                              5Notes
      to Unaudited Consolidated Financial Statements
                                              
                                              6Item
      2.
                                              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                              
                                              24Item
      3.
                                              Quantitative
      and Qualitative Disclosures about Market Risks
                                              
                                              29Item
      4T.
                                              Controls
      and Procedures
                                              
                                              30Part
      II. Other InformationItem
      1.
                                              Legal
      Proceedings
                                              
                                              31Item 1A.
                                              Risk
      Factors
                                              
                                              31Item
      2.
                                              Unregistered
      Sale of Equity Securities and Use of Proceeds
                                              
                                              31Item
      3.
                                              Defaults
      upon Senior Securities
                                              
                                              31Item
      4.
                                              Submission
      of Matters to a Vote of Security Holders
                                              
                                              31Item
      5.
                                              Other
      Information
                                              
                                              31Item
      6.
                                              Exhibits
                                              
                                              31Signatures
                                              
                                              32




2





PART
I




ITEM
1. FINANCIAL STATEMENTS


Solar
EnerTech Corp.


Consolidated
Balance Sheets




December 31, 2009
                              
                              
                              September 30, 2009(Unaudited)
                              
                              
                              (Audited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                              
                              $
                              1,633,000
                              
                              
                              $
                              1,719,000Accounts
      receivable, net of allowance for doubtful account of$96,000
      and $96,000 at December 31, 2009 and September 30, 2009,
      respectively
                              
                              
                              8,446,000
                              
                              
                              
                              7,395,000Advance
      payments and other
                              
                              
                              629,000
                              
                              
                              
                              799,000Inventories,
      net
                              
                              
                              5,798,000
                              
                              
                              
                              3,995,000Deferred
      financing costs, net of accumulated amortization
                              
                              
                              705,000
                              
                              
                              
                              1,250,000VAT
      receivable
                              
                              
                              878,000
                              
                              
                              
                              334,000Other
      receivable
                              
                              
                              231,000
                              
                              
                              
                              408,000Total
      current assets
                              
                              
                              18,320,000
                              
                              
                              
                              15,900,000Property
      and equipment, net
                              
                              
                              10,509,000
                              
                              
                              
                              10,509,000Investment
                              
                              
                              1,000,000
                              
                              
                              
                              1,000,000Deposits
                              
                              
                              101,000
                              
                              
                              
                              87,000Total
      assets
                              
                              $
                              29,930,000
                              
                              
                              $
                              27,496,000LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
                              
                              $
                              8,437,000
                              
                              
                              $
                              5,794,000Customer
      advance payment
                              
                              
                              26,000
                              
                              
                              
                              27,000Accrued
      expenses
                              
                              
                              1,424,000
                              
                              
                              
                              1,088,000Accounts
      payable and accrued liabilities, related parties
                              
                              
                              5,688,000
                              
                              
                              
                              5,646,000Derivative
      liabilities
                              
                              
                              74,000
                              
                              
                              
                              178,000Convertible
      notes, net of discount
                              
                              
                              6,767,000
                              
                              
                              
                              3,061,000Total
      current liabilities
                              
                              
                              22,416,000
                              
                              
                              
                              15,794,000Warrant
      liabilities
                              
                              
                              1,147,000
                              
                              
                              
                              2,068,000Total
      liabilities
                              
                              
                              23,563,000
                              
                              
                              
                              17,862,000STOCKHOLDERS'
      EQUITY:Common
      stock - 400,000,000 shares authorized at $0.001 par value
      111,106,696and
      111,406,696 shares issued and outstanding at December 31, 2009
      andSeptember
      30, 2009, respectively
                              
                              
                              111,000
                              
                              
                              
                              111,000Additional
      paid in capital
                              
                              
                              76,040,000
                              
                              
                              
                              75,389,000Other
      comprehensive income
                              
                              
                              2,462,000
                              
                              
                              
                              2,456,000Accumulated
      deficit
                              
                              
                              (72,246,000
                              )
                              
                              
                              (68,322,000
                              )Total
      stockholders' equity
                              
                              
                              6,367,000
                              
                              
                              
                              9,634,000Total
      liabilities and stockholders' equity
                              
                              $
                              29,930,000
                              
                              
                              $
                              27,496,000





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




3




Solar
EnerTech Corp.


Consolidated
Statements of Operations


(Unaudited)





QuarterEndedDecember31,2009
                      
                      
                      2008Sales
                      
                      $
                      17,693,000
                      
                      
                      $
                      5,084,000Cost
      of sales
                      
                      
                      (15,762,000
                      )
                      
                      
                      (7,420,000
                      )Gross
      profit (loss)
                      
                      
                      1,931,000
                      
                      
                      
                      (2,336,000
                      )Operating
      expenses:Selling,
      general and administrative
                      
                      
                      2,218,000
                      
                      
                      
                      2,561,000Research
      and development
                      
                      
                      108,000
                      
                      
                      
                      335,000Loss
      on debt extinguishment
                      
                      
                      -
                      
                      
                      
                      310,000Total
      operating expenses
                      
                      
                      2,326,000
                      
                      
                      
                      3,206,000Operating
      loss
                      
                      
                      (395,000
                      )
                      
                      
                      (5,542,000
                      )Other
      income (expense):Interest
      income
                      
                      
                      3,000
                      
                      
                      
                      7,000Interest
      expense
                      
                      
                      (4,425,000
                      )
                      
                      
                      (365,000
                      )Gain
      on change in fair market value of compound embedded
    derivative
                      
                      
                      104,000
                      
                      
                      
                      475,000Gain
      on change in fair market value of warrant liability
                      
                      
                      921,000
                      
                      
                      
                      1,644,000Other
      expense
                      
                      
                      (132,000
                      )
                      
                      
                      (20,000
                      )Net
      loss
                      
                      $
                      (3,924,000
                      )
                      
                      $
                      (3,801,000
                      )Net
      loss per share - basic
                      
                      $
                      (0.04
                      )
                      
                      $
                      (0.04
                      )Net
      loss per share - diluted
                      
                      $
                      (0.04
                      )
                      
                      $
                      (0.04
                      )Weighted
      average shares outstanding - basic
                      
                      
                      88,256,706
                      
                      
                      
                      87,043,800Weighted
      average shares outstanding - diluted
                      
                      
                      88,256,706
                      
                      
                      
                      87,043,800





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




4




Solar
EnerTech Corp.


Consolidated
Statements of Cash Flows


(Unaudited)





Quarter Ended December 31,2009
                
                
                2008Cash
      flows from operating activities:Net
      loss
                
                $
                (3,924,000
                )
                
                $
                (3,801,000
                )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      of property and equipment
                
                
                605,000
                
                
                
                526,000Disposal
      loss on  property and equipment
                
                
                51,000
                
                
                
                -Stock-based
      compensation
                
                
                651,000
                
                
                
                1,519,000Loss
      on debt extinguishment
                
                
                -
                
                
                
                310,000Amortization
      of note discount and deferred financing cost
                
                
                4,251,000
                
                
                
                182,000Gain
      on change in fair market value of compound embedded
    derivative
                
                
                (104,000
                )
                
                
                (475,000
                )Gain
      on change in fair market value of warrant liability
                
                
                (921,000
                )
                
                
                (1,644,000
                )Changes
      in operating assets and liabilities:Accounts
      receivable, net
                
                
                (1,049,000
                )
                
                
                1,545,000Advance
      payments and other
                
                
                170,000
                
                
                
                2,123,000Inventories,
      net
                
                
                (1,802,000
                )
                
                
                1,974,000VAT
      receivable
                
                
                (544,000
                )
                
                
                511,000Other
      receivable
                
                
                177,000
                
                
                
                595,000Accounts
      payable, accrued liabilities and customer advance payment
                
                
                2,547,000
                
                
                
                (735,000
                )Deposits
                
                
                (13,000
                )
                
                
                -Accounts
      payable and accrued liabilities, related parties
                
                
                43,000
                
                
                
                62,000Net
      cash provided by operating activities
                
                
                138,000
                
                
                
                2,692,000Cash
      flows from investing activities:Acquisition
      of property and equipment
                
                
                (235,000
                )
                
                
                (264,000
                )Proceeds
      from sales of property and equipment
                
                
                9,000
                
                
                
                -Net
      cash used in investing activities
                
                
                (226,000
                )
                
                
                (264,000
                )Effect
      of exchange rate on cash and cash equivalents
                
                
                2,000
                
                
                
                9,000Net
      (decrease) increase in cash and cash equivalents
                
                
                (86,000
                )
                
                
                2,437,000Cash
      and cash equivalents, beginning of period
                
                
                1,719,000
                
                
                
                3,238,000Cash
      and cash equivalents, end of period
                
                $
                1,633,000
                
                
                $
                5,675,000





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


5




SOLAR
ENERTECH CORP.





Notes
to Consolidated Financial Statements


December
31, 2009 (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 owns 55% of the Joint Venture
Company, the Company owns 35% of the Joint Venture Company and the
remaining 10% of the Joint Venture Company is 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 December 31, 2009, 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.





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 December 31, 2009 and has
an accumulated deficit of approximately $72.2 million at December 31, 2009. For
the three months ended December 31, 2009, the Company had operating cash flows
of approximately $0.1 million and incurred a net loss of approximately $3.9
million. 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 bear interest at 6% per annum and are due on
March 7, 2010. The Company only had approximately $1.6 million in cash and cash
equivalents on hand as of December 31, 2009. 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.


6




Since
April 2009, significant steps were taken to reach operational profitability
including securing key new contracts, which has generated increased sales
volumes. In addition, the Company engaged in various cost cutting programs and
renegotiated most of the contracts to reduce operating expenses. Due to the
above and the decrease in raw material prices, specifically silicon wafer
prices, the Company has been generating positive gross margins starting in the
third quarter of fiscal year 2009.




As
discussed in “Note 16 - Subsequent Events”, on January 7, 2010, the terms of the
Notes and the warrants issued in conjunction with the Notes were amended. The
Company believes that if the Company is able to execute on its business plan,
the successful completion of the conversion, along with our existing cash
resources and the cash expected to be generated from operations during fiscal
year 2010 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.





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.


7





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.





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
December 31, 2009 and September 30, 2009, the Company’s warranty liabilities
were $668,000 and $515,000, respectively. The Company’s warranty costs for the
three months ended December 31, 2009 and 2008 were $153,000 and $46,000,
respectively. The Company did not make any warranty payments during the three
months ended December 31, 2009 and 2008.





Impairment
of Long Lived Assets





The
Company reviews its long-lived assets and identifiable intangibles 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 three months ended December 31,
2009 and 2008.





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.


8




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 the
Company 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 and
commercialization of research. As of December 31, 2009, 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
December 31, 2009, the Company accounted for the investment in 21-Century
Silicon at cost amounting to $1.0 million. The Company performed an impairment
assessment and determined that the investment was not impaired.





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”.





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





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.


9




The
method used to estimate the value of the compound embedded derivatives (“CED”)
as of each valuation date was a Monte Carlo simulation. Under this method the
various features, restrictions, obligations and option related to each component
of the CED were analyzed and spreadsheet models of the net expected proceeds
resulting from exercise of the CED (or non-exercise) were created. Each model is
expressed in terms of the expected timing of the event and the expected stock
price as of that expected timing.





Because
the potential timing and stock price may vary over a range of possible values, a
Monte Carlo simulation was built based on the possible stock price paths (i.e.,
daily expected stock price over a forecast period). Under this approach an
individual potential stock price path is simulated based on the initial stock
price on the measurement date, and the expected volatility and risk free
interest rate over the forecast period. Each path is compared against the logic
described above for potential exercise events and the present value (or
non-exercise which result in $0 value) recorded. This is repeated over a
significant number of trials, or individual stock price paths, in order to
generate an expected or mean value for the present value of the
CED.





Fair
Value of Warrants





The
Company’s management used the binomial valuation model to value the warrants
issued in conjunction with convertible notes entered into in March 2007.
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 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
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.





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.


10





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 $177,000 and $41,000 for the
three months ended December 31, 2009 and 2008, 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 three months ended December
31, 2009 and 2008 were $108,000 and $335,000, 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 three months ended December 31, 2009 and 2008, the Company had three and
four customers, respectively that accounted for more than 10% of net
sales.





Recent
Accounting Pronouncements





In
December 2007, the FASB issued FASB ASC 805, “Business Combination”, formerly
referenced as SFAS No. 141 (revised), “Business Combinations”. FASB ASC 805
changes the accounting for business combinations, including the measurement of
acquirer shares issued in consideration for a business combination, the
recognition of contingent consideration, the accounting for pre-acquisition gain
and loss contingencies, the recognition of capitalized in-process research and
development, the accounting for acquisition-related restructuring cost accruals,
the treatment of acquisition related transaction costs, and the recognition of
changes in the acquirer’s income tax valuation allowance. FASB ASC 805 is
effective for the first annual reporting period beginning on or after
December 15, 2008. On October 1, 2009, the Company adopted FASB ASC 805
which did not have a significant impact on its consolidated financial
statements.





In
December 2007, the FASB issued FASB ASC 810, “Consolidation”, formerly
referenced as SFAS No. 160, “Non-controlling Interests in Consolidated
Financial Statements, an amendment of ARB No. 51”. FASB ASC 810 changes the
accounting for non-controlling (minority) interests in consolidated financial
statements, including the requirements to classify non-controlling interests as
a component of consolidated stockholders’ equity, and the elimination of
“minority interest” accounting in results of operations with earnings
attributable to non-controlling interests reported as part of consolidated
earnings. Additionally, FASB ASC 810 revises the accounting for both increases
and decreases in a parent’s controlling ownership interest. FASB ASC 810 is
effective for the first annual reporting period beginning on or after
December 15, 2008. The Company adopted FASB ASC 810 on October 1, 2009. The
adoption of this guidance did not have a significant impact on the Company’s
financial statements.





In
December 2007, an update was made to FASB ASC 808-10, “Collaborative
Arrangements”, formerly referenced as EITF Consensus for Issue No. 07-1,
“Accounting for Collaborative Arrangements” which defines collaborative
arrangements and establishes reporting requirements for transactions between
participants in a collaborative arrangement and between participants in the
arrangement and third parties. This guidance also establishes the appropriate
income statement presentation and classification for joint operating activities
and payments between participants, as well as the sufficiency of the disclosures
related to these arrangements. This guidance is effective for fiscal years, and
interim periods within those fiscal years, beginning after December 15, 2008.
The Company adopted FASB ASC 808-10 on October 1, 2009. The adoption of FASB ASC
808-10 did not have a significant impact on the Company's financial
statements.


11





In
February 2008, an update was made to FASB ASC 860, “Transfers and Servicing”,
formerly referenced as FASB Staff Position No. FAS 140-3, “Accounting for
Transfers of Financial Assets and Repurchase Financing Transactions” that
addresses the issue of whether or not these transactions should be viewed as two
separate transactions or as one linked” transaction. FASB ASC 860 includes a
rebuttable presumption” that presumes linkage of the two transactions unless the
presumption can be overcome by meeting certain criteria. This update will be
effective for fiscal years beginning after November 15, 2008 and will apply only
to original transfers made after that date; early adoption will not be allowed.
The Company adopted FASB ASC 860 on October 1, 2009, which did not have a
significant impact on the Company’s financial position and results of
operations.





In May
2008, an update was made to the FASB ASC 470, “Debt”, formerly referenced
as FASB Staff Position No. APB 14-1, “Accounting for Convertible Debt
Instruments That May Be Settled In Cash Upon Conversion (Including Partial Cash
Settlement)”.  FASB ASC 470 requires that the liability and equity
components of convertible debt instruments that may be settled in cash upon
conversion (including partial cash settlement) be separately accounted for in a
manner that reflects an issuer's nonconvertible debt borrowing rate. As a
result, the liability component would be recorded at a discount reflecting its
below market coupon interest rate, and the liability component would
subsequently be accreted to its par value over its expected life, with the rate
of interest that reflects the market rate at issuance being reflected in the
results of operations. This change in methodology will affect the calculations
of net income and earnings per share, but will not increase the Company's cash
interest payments. This guidance is effective for financial statements issued
for fiscal years beginning after December 15, 2008, and interim periods
within those fiscal years. Retrospective application to all periods presented is
required and early adoption is prohibited. On October 1, 2009, the Company
adopted FASB ASC 470, which did not have a significant impact on its financial
position and results of operations.





In June
2008, an update was made to the FASB ASC 718, “Compensation – Stock
Compensation”, which concluded that all unvested share-based payment awards that
contain rights to receive non-forfeitable dividends (whether paid or unpaid) are
participating securities, and should be included in the two-class method of
computing basic and diluted earnings per share. This guidance is effective for
fiscal years beginning after December 15, 2008. The Company adopted FASB ASC 718
on October 1, 2009. The adoption of this guidance did not have a significant
impact on the Company's financial statements.





In
November 2008, an update was made to the FASB ASC 323, “Investments – Equity
Method and Joint Ventures”, which addresses the impact that FASB ASC 805,
“Business Combination” and FASB ASC 810, “Consolidation” might have on the
accounting for equity method investments, including how the initial carrying
value of an equity method investment should be determined, how an impairment
assessment of an underlying indefinite lived intangible asset of an equity
method investment should be performed and how to account for a change in an
investment from the equity method to the cost method. This guidance is
effective in fiscal periods beginning on or after December 15, 2008. The
Company adopted FASB ASC 323 on October 1, 2009. The adoption of this guidance
did not have a significant impact on its consolidated financial
statements.





In August
2009, the FASB issued Accounting Standards Update (“ASU”) 2009-05, an update to
ASC 820. This update provides amendments to reduce potential ambiguity in
financial reporting when measuring the fair value of liabilities. Among other
provisions, this update provides clarification that in circumstances, in
which a quoted price in an active market for the identical liability is not
available, a reporting entity is required to measure fair value using one or
more of the valuation techniques described in ASU 2009-05. ASU 2009-05 is
effective for the first interim or annual reporting period beginning after its
issuance. The Company adopted this guidance on October 1, 2009. The adoption of
ASU 2009-05 did not have a material effect on its 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 December 31, 2009 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.


12





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. Certain key customers have also been insured
by China Export & Credit Insurance Company. Therefore, the credit risk in
accounts receivable is controllable even though the Company has a relatively
high accounts receivable balance. During the three months ended December
31, 2009 and 2008, the Company had three customers and four 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.





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 December 31, 2009
and September 30, 2009, respectively.   Foreign currency
transaction gains and losses are included in earnings. For the three months
ended December 31, 2009 and 2008, the Company recorded foreign exchange losses
of $0.1 million and $20,000, respectively.





NOTE
5 — INVENTORIES





At
December 31, 2009 and September 30, 2009, inventories consist
of:





December31,2009
                  
                  
                  September30,2009Raw
      materials
                  
                  $
                  2,653,000
                  
                  
                  $
                  1,708,000Work
      in process
                  
                  
                  927,000
                  
                  
                  
                  945,000Finished
      goods
                  
                  
                  2,218,000
                  
                  
                  
                  1,342,000Total
      inventories
                  
                  $
                  5,798,000
                  
                  
                  $
                  3,995,000





NOTE 6
— ADVANCE PAYMENTS AND OTHER





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





December31,2009
                  
                  
                  September30,2009Prepayment
      for raw materials
                  
                  $
                  449,000
                  
                  
                  $
                  698,000Others
                  
                  
                  180,000
                  
                  
                  
                  101,000Total
      advance payments and other
                  
                  $
                  629,000
                  
                  
                  $
                  799,000


13





NOTE
7 — PROPERTY AND EQUIPMENT





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





December31,2009
                  
                  
                  September30,2009Production
      equipment
                  
                  $
                  7,363,000
                  
                  
                  $
                  7,383,000Leasehold
      improvements
                  
                  
                  3,620,000
                  
                  
                  
                  3,620,000Automobiles
                  
                  
                  360,000
                  
                  
                  
                  496,000Office
      equipment
                  
                  
                  342,000
                  
                  
                  
                  342,000Machinery
                  
                  
                  2,749,000
                  
                  
                  
                  2,749,000Furniture
                  
                  
                  39,000
                  
                  
                  
                  39,000Construction
      in progress
                  
                  
                  700,000
                  
                  
                  
                  22,000Total
      property and equipment
                  
                  
                  15,173,000
                  
                  
                  
                  14,651,000Less:  accumulated
      depreciation
                  
                  
                  (4,664,000
                  )
                  
                  
                  (4,142,000
                  )Total
      property and equipment, net
                  
                  $
                  10,509,000
                  
                  
                  $
                  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 three months ended December 31, 2009 and 2008,
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 December 31, 2009 and 2008, 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.





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:


14





·
            $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 bear interest at 6% per annum and are due in 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).





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.





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 and $9.1 million in principal amount of
Series B Convertible Notes. These outstanding notes were recorded at carrying
value at $6.8 million as of December 31, 2009 and are due on March 7,
2010.





The
Company evaluated the notes for derivative accounting considerations under FASB
ASC 815 and determined that the notes contain 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.





The
Series A and Series B Warrants (including the Advisor Warrants) are 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.


15




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





AmountProceeds
      of convertible notes
                  
                  $
                  17,300,000Allocation
      of proceeds:Fair
      value of warrant liability (excluding advisor warrants)
                  
                  
                  (15,909,000
                  )Fair
      value of compound embedded derivative liability
                  
                  
                  (16,600,000
                  )Loss
      on issuance of convertible notes
                  
                  
                  15,209,000Carrying
      amount of notes at grant date
                  
                  $
                  -Carrying
      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
                  
                  
                  3,706,000Carrying
      amount of notes at December 31, 2009
                  
                  $
                  6,767,000Fair
      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
                  
                  
                  2,068,000Gain
      on fair market value of warrant liability
                  
                  
                  (921,000
                  )Fair
      value of warrant liability at December 31, 2009
                  
                  $
                  1,147,000Fair
      value of 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
                  )Fair
      value of compound embedded derivative at December 31, 2009
                  
                  $
                  74,000




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





December31,2009
                  
                  
                  September30,2009Implied
      term (years)
                  
                  
                  2.18
                  
                  
                  
                  2.43Suboptimal
      exercise factor
                  
                  
                  2.5
                  
                  
                  
                  2.5Volatility
                  
                  
                  93
                  %
                  
                  
                  106
                  %Dividend
      yield
                  
                  
                  0
                  %
                  
                  
                  0
                  %Risk
      free interest rate
                  
                  
                  1.25
                  %
                  
                  
                  1.15
                  %





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. As of December 31, 2009 and September 30, 2009, total
unamortized deferred financing cost was $0.7million and $1.3 million,
respectively.





The
method used to estimate the value of the compound embedded derivatives (“CED”)
as of each valuation date was a Monte Carlo simulation. Under this method the
various features, restrictions, obligations and option related to each component
of the CED were analyzed and spreadsheet models of the net expected proceeds
resulting from exercise (or non-exercise) of the CED were created. Each model is
expressed in terms of the expected timing of the event and the expected stock
price as of that expected timing.





Because
the potential timing and stock price may vary over a range of possible values, a
Monte Carlo simulation was built based on the possible stock price paths (i.e.,
daily expected stock price over a forecast period). Under this approach an
individual potential stock price path is simulated based on the initial stock
price on the measurement date and the expected volatility and risk free rate
over the forecast period. Each path is compared against the logic describe above
for potential exercise events and the present value (or non-exercise which
result in $0 value) recorded. This is repeated over a significant number of
trials, or individual stock price paths, in order to generate an expected or
mean value for the present value of the CED.


16





The
significant assumptions used in estimating stock price paths as of each
valuation date are:





December31,2009
                  
                  
                  September30,2009Starting
      stock price (closing price on date preceding valuation
    date)
                  
                  $
                  0.26
                  
                  
                  $
                  0.28Annual
      volatility of stock
                  
                  
                  69.5
                  %
                  
                  
                  106.0
                  %Risk free rate
                  
                  
                  0.06
                  %
                  
                  
                  0.18
                  %





Additional
assumptions were made regarding the probability of occurrence of each exercise
scenario, based on stock price ranges (based on the assumption that scenario
probability is constant over narrow ranges of stock price). The key scenarios
included public offering, bankruptcy and other defaults.





During
the three months ended December 31, 2009, none of Series A and B Convertible
Notes were converted into the Company’s common shares. As a result, no loss on
debt extinguishment was recorded during the first quarter of fiscal 2010. For
the three months ended December 31, 2008, $350,000 of Series A and B convertible
notes were converted into the Company’s common shares. The Company recorded a
loss on debt extinguishment of $310,000 as a result of the conversion based on
the quoted market closing price of its common shares on the conversion
dates.





The loss
on debt extinguishment is computed at the conversion dates as
follow:





Quarter Ended December 31,2009
                  
                  
                  2008Fair
      value of the common shares
                  
                  $
                  -
                  
                  
                  $
                  146,000Unamortized
      deferred financing costs associated with the converted
    notes
                  
                  
                  -
                  
                  
                  
                  68,000Fair
      value of the CED liability associated with the converted
    notes
                  
                  
                  -
                  
                  
                  
                  (14,000
                  )Accreted
      amount of the notes discount
                  
                  
                  -
                  
                  
                  
                  110,000Loss
      on debt extinguishment
                  
                  $
                  -
                  
                  
                  $
                  310,000





As
discussed in “Note 2 – Liquidity and Going Concern Issues” and “Note 16 –
Subsequent Events”, the terms of the Series A and Series B Convertible
Notes have been amended.





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.


17


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.





There
were no warrant activity during the three months ended December 31, 2009,
therefore the total outstanding warrant as of December 31, 2009 remains the same
as of September 30, 2009. A summary of outstanding warrant as of December 31,
2009 is as follows:





Numberof
                      Shares
                    
                    
                    Exercise
                      Price($)
                    
                    RecognizedasGranted
      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 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 common stock purchase — Series C
                    
                    
                    24,318,181
                    
                    
                    
                    1.00
                    
                    Additional paid in capitalGranted
      in connection with placement service
                    
                    
                    1,215,909
                    
                    
                    
                    0.88
                    
                    Additional paid in capitalOutstanding
      at December 31, 2009
                    
                    
                    56,377,190





At
December 31, 2009, 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$0.57-$0.69
                  
                  
                  2,017,775
                  
                  
                  $
                  0.60
                  
                  
                  
                  2.21$0.88-$1.00
                  
                  
                  47,113,038
                  
                  
                  $
                  0.95
                  
                  
                  
                  2.66$1.21
                  
                  
                  7,246,377
                  
                  
                  $
                  1.21
                  
                  
                  
                  2.18





As
discussed in “Note 2 – Liquidity and Going Concern Issues” and “Note 16 –
Subsequent Events”, the terms of the Series A, Series B and Series C Warrants
have been amended.





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.


18


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.





The
following table summarizes the activity of the Company’s unvested restricted
stock units as of December 31, 2009 and changes during the three months ended
December 31, 2009, is presented below:





RestrictedStockWeighted-Number of
                  
                  
                  average grant-shares
                  
                  
                  datefair valueUnvested
      as of September 30, 2008
                  
                  
                  25,250,000
                  
                  
                  $
                  0.62Restricted
      stock canceled
                  
                  
                  (2,100,000
                  )
                  
                  
                  0.62Unvested
      as of September 30, 2009
                  
                  
                  23,150,000
                  
                  
                  
                  0.62Restricted
      stock canceled
                  
                  
                  (300,000
                  )
                  
                  
                  0.62Unvested
      as of December 31, 2009
                  
                  
                  22,850,000
                  
                  
                  $
                  0.62





The total
unvested restricted stock as of December 31, 2009 and September 30, 2009 were
22,850,000 and 23,150,000 shares, respectively.




Stock-based
compensation expense for restricted stock for the three months ended December
31, 2009 and 2008 were $0.6 million and $1.3 million, respectively. As of
December 31, 2009, the total unrecognized compensation cost net of forfeitures
relate to unvested awards not yet recognized is $4.5 million and is expected to
be amortized over a weighted average period of 1.6 years.





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 December 31, 2009 and
September 30, 2009, 12,560,000 and 12,060,000 shares of common stock,
respectively remain available for future grants under the Amended 2007
Plan.





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:


19





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
      cancelled
                  
                  
                  500,000
                  
                  
                  
                  (500,000
                  )
                  
                  $
                  0.41
                  
                  
                  $
                  0.62Balance
      at December 31, 2009
                  
                  
                  12,560,000
                  
                  
                  
                  2,440,000
                  
                  
                  $
                  0.30
                  
                  
                  $
                  0.53




The total
fair value of shares vested during the three months ended December 31, 2009 and
2008 were $13,000 and $157,000, respectively.





At
December 31, 2009 and September 30, 2009, 2,440,000 and 2,940,000 options were
outstanding, respectively and had a weighted-average remaining contractual life
of 8.11 years and 6.98 years, respectively. Of these options, 1,869,168 and
2,333,127 shares were vested and exercisable on December 31, 2009 and September
30, 2009, respectively.  The weighted-average exercise price and
weighted-average remaining contractual term of options currently exercisable
were $0.62 and 7.79 years, respectively.





There
were no employee stock options granted during the three months ended December
31, 2009 and 2008.





On May 9,
2008, the Compensation Committee of the Board of Directors of the Company
authorized the repricing of all outstanding options issued to current employees,
directors, officers and consultants prior to February 5, 2008 under the 2007
Plan to $0.62, determined in accordance with the 2007 Plan as the closing price
for shares of common stock on the Over-the-Counter Bulletin Board on the date of
the repricing.





The
Company repriced a total of 7,720,000 shares of common stock underlying
outstanding options. The other terms of the options, including the vesting
schedules, remained unchanged as a result of the repricing. Total additional
compensation expense on non-vested options relating to the May 9, 2008 repricing
was approximately $0.4 million which will be expensed ratably over the remaining
vesting period. Additional compensation expense on vested options relating to
the May 9, 2008 repricing was approximately $0.3 million which was fully
expensed as of June 30, 2008. The repriced options had originally been issued
with $0.94 to $1.65 per share option exercise prices, which prices reflected the
then current market prices of our stock on the dates of original grant. As a
result of the recent sharp reduction in our stock price, our Board of Directors
believed that such options no longer would properly incentivize our employees,
officers, directors and consultants who held such options to work in the best
interests of our company and stockholders.





In
accordance with the provisions of FASB ASC 718, the Company has recorded
stock-based compensation expense of $0.7 million and $1.5 million for the three
months ended December 31, 2009 and 2008, 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:


20





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 December 31, 2009:





Fair Value at
                        December 31,
                        2009
                      
                      
                      Quoted prices in
                        active markets
                        for identical
                        assets
                      
                      
                      Significant other
                        observable inputs
                      
                      
                      Significant
                        unobservable
                        inputs(Level 1)
                      
                      
                      (Level 2)
                      
                      
                      (Level 3)Derivative
      liabilites
                      
                      $
                      74,000
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      74,000Warrant
      liabilities
                      
                      
                      1,147,000
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,147,000Total
      liabilities
                      
                      $
                      1,221,000
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      1,221,000





The
Company’s valuation techniques used to measure the fair values of the derivative
liabilities and warrant liabilities were derived from management’s assumptions
or estimations and are discussed in Note 9 – Convertible Notes.




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. The
carrying values of the Company’s derivative liabilities and warrant liabilities
approximate fair value (see Note 9 - Convertible Notes) for the methods and
assumptions used in the fair value estimation.




At
December 31, 2009 and September 30, 2009, the carrying value of the Company’s
convertible notes was $6.8 million and $3.1 million, respectively. These notes
bear interest at 6% per annum and are due on March 7, 2010. Warrants were issued
in connection with the issuance of the notes, and the warrants are measured at
fair value both initially and in subsequent periods. The notes contain 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 (see Note 9 – Convertible Notes). 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:





Quarter Ended December 31,2009
                  
                  
                  2008Net
      loss
                  
                  $
                  (3,924,000
                  )
                  
                  $
                  (3,801,000
                  )Other
      comprehensive income:Change
      in foreign currency translation
                  
                  
                  6,000
                  
                  
                  
                  (39,000
                  )Comprehensive
      loss
                  
                  $
                  (3,918,000
                  )
                  
                  $
                  (3,840,000
                  )





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




21


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 6.8282
as of December 31, 2009.





Year
                    
                    Amount2010
                    
                    
                    2,662,0002011
                    
                    
                    1,113,000Total
                    
                    $
                    3,775,000





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
December 31, 2009, 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. As of
December 31, 2009, the Company is not in breach as it has not received any
compensation request 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.





NOTE 14 — RELATED PARTY
TRANSACTIONS





At
December 31, 2009 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. As of December 31, 2009, the Company had advanced
SET-Solar Corp $149,000 in cash.





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.


22





NOTE 16 — SUBSEQUENT
EVENTS





On
January 7, 2010, 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 of
$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, no further payments are owing or
payable under the Notes.  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.





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.





On
January 19, 2010, a holder of approximately $1.8 million of the Company’s
formerly outstanding Series B Notes and Series B Warrants exercisable into
approximately 4.6 million shares (hereinafter referred to as the “Holder”) of
the Company’s common stock disputes the effectiveness of the Conversion
Agreement and the Warrant Amendment.  The Company concludes that the
Conversion Agreement and Warrant Amendment were duly authorized, amended and
effective and is currently under discussions with the Holder to resolve this
matter. If this matter is not resolved, the Holder has the right to demand
payment from the Company on March 7, 2010. It is uncertain whether the Company
will be able to satisfy this claim if it comes due. None-withstanding 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.





Pursuant
to the Conversion Agreement after the closing of the conversion, the Company
shall issue to its employees additional options to purchase shares of its common
stock equal to approximately 30% of each employee’s pre-closing option holdings
to provide for additional equity incentive on account for the dilution upon
conversion of the Notes and re-pricing of the PIPE Warrants. These additional
options shall be priced at $0.15 per share.





The
Conversion Agreement resulted in modifications or exchanges of Notes and PIPE
Warrants, 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". Given the significant reduction on the exercise price from $0.57
and $0.69, respectively per share to $0.15 per share, the modification is likely
to be considered substantial, and therefore the Notes are likely to be
considered extinguished. Given the significant reduction on the exercise price
from $1.21, $0.90 and $1.00, respectively, per share to $0.15 per share, the
modification is likely to be considered substantial, and therefore the liability
associated with the PIPE Warrants at the pre Conversion Agreement exercise price
is likely to be considered extinguished and will likely be replaced with the
liability associated with the PIPE Warrants at the post Conversion Agreement
exercise price, which will be recorded at fair value. As of the date of the
quarterly report, we have not performed the valuation of the Notes and their
related compound embedded derivatives and warrants immediately before the
modification, and therefore cannot estimate the accounting impact associated
with the modification of the Notes. However, assuming that the assumptions for
the valuation of the compound embedded derivatives and warrants remain the same
as of the date immediately before the modification, the Company’s preliminary
estimation of the potential loss from the extinguishment of the Notes and the
amendment of the PIPE Warrants is to be at least $3.6 million
(unaudited).





On
January 15, 2010, the Company incorporated a wholly-owned subsidiary at 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.





Pursuant
to SFAS 165, as codified in ASC 855, “Subsequent Events”, the Company has
reviewed all subsequent events and transactions that occurred through February
12, 2010, which is the date the Company's Quarterly Report (Form 10-Q) was filed
with the Securities and Exchange Commission.


23





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.





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 three months ended December 31, 2009 was $17.7 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 December 31, 2009 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 owns 55% of the Joint Venture
Company, we own 35% of the Joint Venture Company and the remaining 10% of the
Joint Venture Company is 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.





SET-Solar
Corp appointed Roland Chu, an experienced Silicon Valley entrepreneur as its
Chief Executive Officer. The Joint Venture team made significant progress during
the fiscal year 2009. It obtained a California Solar Initiative listing, which
enable SET-Solar Corp to penetrate multiple sectors of the PV market in the
United States. SET Solar’s strategy with customers has been to move beyond
simply supplying solar panels and to offer a more comprehensive service solution
that includes inverters and other accessories, as well as financing and leasing
options. SET-Solar Corp also made a very successful appearance at the Solar
Power International Conference from October 27 to October 29, 2009 at the
Anaheim Convention Center in Anaheim, California. SET-Solar Corp exhibited its
polysilicon material, silicon ingots and wafers produced by Jiangsu Shunda and
high-efficiency solar cells and high-performance solar modules produced by Solar
EnerTech.


24





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





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





To date,
we have raised money for the development of our business through the sale of our
equity securities.  On January 12, 2008, we sold 24,318,181 shares of
our common stock and 24,318,181 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. The original exercise price of the warrants is
$1.00 per share. Pursuant to the Warrant Amendment, the exercise price has been
reduced to $0.15. The warrants are exercisable for a period of 5 years from the
date of issuance of the warrants. We used the net proceeds from the offering for
working capital and general corporate purposes.   In
March 2007, we also raised $17.3 million through sales of units
consisting of our Series A and Series B Convertible Notes and
warrants. As discussed elsewhere, the Series A and Series B Convertible Notes
have been converted into shares of our common stock pursuant to the Conversion
Agreement and the Series A and Series B warrants exercise price have been
reduced to $0.15 pursuant to the Warrant Amendment. The proceeds were used to
complete our production line and working capital purpose.





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.





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 December 31, 2009 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.


25





Results
of Operations for the three months ended December 31, 2009 and 2008





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)





Quarter Ended December 31, 2009
                  
                  
                  Quarter Ended December 31, 2008
                  
                  
                  Year-Over-Year ChangeAmount
                  
                  
                  % of net sales
                  
                  
                  Amount
                  
                  
                  % of net sales
                  
                  
                  Amount
                  
                  
                  % of changeSales
                  
                  $
                  17,693,000
                  
                  
                  
                  100.0
                  %
                  
                  $
                  5,084,000
                  
                  
                  
                  100.0
                  %
                  
                  $
                  12,609,000
                  
                  
                  
                  248.0
                  %Cost
      of sales
                  
                  
                  (15,762,000
                  )
                  
                  
                  (89.1
                  )%
                  
                  
                  (7,420,000
                  )
                  
                  
                  (145.9
                  )%
                  
                  
                  (8,342,000
                  )
                  
                  
                  112.4
                  %Gross
      profit (loss)
                  
                  $
                  1,931,000
                  
                  
                  
                  10.9
                  %
                  
                  $
                  (2,336,000
                  )
                  
                  
                  (45.9
                  )%
                  
                  $
                  4,267,000
                  
                  
                  
                  (182.7
                  )%





For the
three months ended December 31, 2009, the Company reported total revenue of
$17.7 million, representing an increase of $12.6 million or 248.0% compared to
$5.1 million of revenue in the same period of the prior year.  The
increase in revenue was due to increased sales orders from new and existing
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
contributing to the increase in sales volume.





For the
three months ended December 31, 2009, we incurred a gross profit of $1.9
million, representing an increase of $4.3 million or 182.7% compared to negative
gross profit of $2.3 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 the silicon wafer prices which offset the
decrease in module sales prices. Silicon wafer prices decreased approximately
60% from RMB 40.5/piece during the three months ended December 31, 2008 to
RMB16/piece during the three months ended December 31, 2009, as compared to
module sales prices that decreased approximately 45% from EUR2.2/watt during the
three months ended December 31, 2008 to EUR1.2/watt during the three months
ended December 31, 2009. In addition, the Company has continued with its various
cost cutting programs and renegotiation of most of its vendor contracts to
reduce operating expenses.





Selling,
general & administrative





Quarter Ended December 31, 2009
                
                
                Quarter Ended December 31, 2008
                
                
                Year-Over-Year ChangeAmount
                
                
                % of net sales
                
                
                Amount
                
                
                % of net sales
                
                
                Amount
                
                
                % of changeSelling,
      general andadministrative
                
                $
                2,218,000
                
                
                
                12.5
                %
                
                $
                2,561,000
                
                
                
                50.4
                %
                
                $
                (343,000
                )
                
                
                (13.4
                )%





For the
three months ended December 31, 2009, our selling, general and administrative
expenses were $2.2 million, representing a decrease of $0.3 million or 13.4%
from $2.6 million in the three months ended December 31, 2008. Selling, general
and administrative expenses as a percentage of net sales for the three months
ended December 31, 2009 decreased to 12.5% from 50.4% for the three months ended
December 31, 2008. The decrease in the selling, general and administrative
expenses were primarily due to a decrease of $0.5 million in stock-based
compensation expenses related to employee options and restricted stock from $1.1
million for the three months ended December 31, 2008 to $0.6 million for the
three months ended December 31, 2009. Excluding stock-based compensation
expenses, our selling, general & administrative expenses increased by
approximately $0.2 million primarily due to increased shipping rates and
volume.





Research
& development





Quarter Ended December 31, 2009
                
                
                Quarter Ended December 31, 2008
                
                
                Year-Over-Year ChangeAmount
                
                
                % of net sales
                
                
                Amount
                
                
                % of net sales
                
                
                Amount
                
                
                % of changeResearch
      and development
                
                $
                108,000
                
                
                
                0.6
                %
                
                $
                335,000
                
                
                
                6.6
                %
                
                $
                (227,000
                )
                
                
                (67.8
                )%




Research
and development expenses in the three months ended December 31, 2009 were $0.1
million, representing a decrease of $0.2 million or 67.8% over $0.3 million for
the three months ended December 31, 2008. Research and development expenses as a
percentage of net sales for the three months ended December 31, 2009 decreased
to 0.6% from 6.6% for the three months ended December 31, 2008. The decrease in
research and development expenses were mainly due to a decrease of $0.2 million
in stock-based compensation expenses related to employee options and restricted
stock from $0.2 million for the three months ended December 31, 2008 to $23,000
for the three months ended December 31, 2009.


26





Loss
on debt extinguishment





Quarter Ended December 31, 2009
                
                
                Quarter Ended December 31, 2008
                
                
                Year-Over-Year ChangeAmount
                
                
                % of net sales
                
                
                Amount
                
                
                % of net sales
                
                
                Amount
                
                
                % of changeLoss
      on debt extinguishment
                
                $
                -
                
                
                
                0.0
                %
                
                $
                310,000
                
                
                
                6.1
                %
                
                $
                (310,000
                )
                
                
                (100.0
                )%





During
the three months ended December 31, 2009, there was no Series A and B
Convertible Notes were converted into common stock, as a result we did not have
any loss on debt extinguishment. For the three months ended December 31, 2008,
$0.4 million of our Series A and B Convertible Notes were converted into common
stock which resulted in the non-cash loss of $0.3 million.





Other
income (expense)





Quarter Ended December 31, 2009
                    
                    
                    Quarter Ended December 31, 2008
                    
                    
                    Year-Over-Year ChangeAmount
                    
                    
                    % of net sales
                    
                    
                    Amount
                    
                    
                    % of net sales
                    
                    
                    Amount
                    
                    
                    % of changeInterest
      income
                    
                    $
                    3,000
                    
                    
                    
                    0.0
                    %
                    
                    $
                    7,000
                    
                    
                    
                    0.1
                    %
                    
                    $
                    (4,000
                    )
                    
                    
                    (57.1
                    )%Interest
      expense
                    
                    
                    (4,425,000
                    )
                    
                    
                    (25.0
                    )%
                    
                    
                    (365,000
                    )
                    
                    
                    (7.2
                    )%
                    
                    
                    (4,060,000
                    )
                    
                    
                    1112.3
                    %Gain
      on change in fair market value of compound embedded
    derivative
                    
                    
                    104,000
                    
                    
                    
                    0.6
                    %
                    
                    
                    475,000
                    
                    
                    
                    9.3
                    %
                    
                    
                    (371,000
                    )
                    
                    
                    (78.1
                    )%Gain
      on change in fair market value of warrant liability
                    
                    
                    921,000
                    
                    
                    
                    5.2
                    %
                    
                    
                    1,644,000
                    
                    
                    
                    32.3
                    %
                    
                    
                    (723,000
                    )
                    
                    
                    (44.0
                    )%Other
      expense
                    
                    
                    (132,000
                    )
                    
                    
                    (0.7
                    )%
                    
                    
                    (20,000
                    )
                    
                    
                    (0.4
                    )%
                    
                    
                    (112,000
                    )
                    
                    
                    560.0
                    %Total
      other income (expense)
                    
                    $
                    (3,529,000
                    )
                    
                    
                    (19.9
                    )%
                    
                    $
                    1,741,000
                    
                    
                    
                    34.2
                    %
                    
                    $
                    (5,270,000
                    )
                    
                    
                    (302.7
                    )%





For the
three months ended December 31, 2009, total other expenses were $3.5 million,
representing an increase of $5.3 million or 302.7% compared to total other
income of $1.7 million for the same period of the prior year. Other expenses as
a percentage of net sales for the three months ended December 31, 2009 was a
negative 19.9% compared to a positive 34.2% for the same period in the prior
year. We incurred interest expenses of $4.4 million and $0.4 million in the
three months ended December 31, 2009 and 2008, respectively, primarily related
to amortization on discounted convertible notes and deferred financing cost, and
6% interest charges on Series A and B Convertible Notes. In the three
months ended December 31, 2009, we recorded a gain on change in fair market
value of warranty liability of $0.9 million and a gain on change in fair market
value of compound embedded derivative of $0.1 million compared to a gain on
change in fair market value of warrant liability of $1.6 million and a gain on
change in fair market value of compound embedded derivative of $0.5 million
during the three months ended December 31, 2008. The decrease in the
Company’s stock price is less significant in the three months ended December 31,
2009 than in the three months ended December 31, 2008, which 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 $0.1 million and $20,000 for
the three months ended December 31, 2009 and 2008, respectively, were primarily
related to foreign exchange loss.




Liquidity
and Capital Resources





December31,2009
                
                
                September30,2009
                
                
                ChangeCash
      and cash equivalents
                
                $
                1,633,000
                
                
                $
                1,719,000
                
                
                $
                (86,000
                )





As of
December 31, 2009, we had cash and cash equivalents of $1.6 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.


27





QuarterEndedDecember31,2009
                
                
                2008
                
                
                ChangeNet
      cash provided by (used in):Operating
      activities
                
                $
                138,000
                
                
                $
                2,692,000
                
                
                $
                (2,554,000
                )Investing
      activities
                
                
                (226,000
                )
                
                
                (264,000
                )
                
                
                38,000Effect
      of exchange rate changes on cash and cash equivalents
                
                
                2,000
                
                
                
                9,000
                
                
                
                (7,000
                )Net
      (decrease) increase in cash and cash equivalents
                
                $
                (86,000
                )
                
                $
                2,437,000
                
                
                $
                (2,523,000
                )





Net cash
provided by operating activities were $0.1 million and $2.7 million for the
three months ended December 31, 2009 and 2008, respectively. To present cash
flows from operating activities, net loss for each quarter in the past two years
had to be adjusted for certain significant items. After a positive adjustment of
$3.2 million and a negative adjustment of $1.6 million for the three months
ended December 31, 2009 and 2008, respectively, resulting from the change on 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 net loss is $0.7 million and $5.4 million for the
three months ended December 31, 2009 and 2008 respectively. The decrease of $2.6
million in net cash provided by operating activities from December 31, 2008 to
December 31, 2009 was mainly attributable to the following reasons:





·
            The
      decrease of $4.7 million in the net loss, after the adjustments related to
      the compound derivative liabilities and warrants liabilities, amortization
      of note discount and deferred financing cost, and loss on debt
      extinguishment during the three months ended December 31, 2009 compared to
      the three months ended December 31,
2008;





·
            The
      decrease of $0.7 million in the non-cash charges related to stock-based
      compensation and depreciation of property and equipment;
    and





·
            Unfavorable
      changes in operating assets of $6.5 million primarily resulting from
      higher inventories, accounts receivable and VAT receivables, partially
      offset by higher accounts payable related to favorable vendor payment
      terms, and lower advance payments for raw material purchases. Lower
      advance payments is another change in the industry after the financial
      crisis, which changed the previously required 100% cash advance to secure
      key raw material (wafer) to zero in the current economic
      situation.





Net cash
used in investment activities were $0.2 million and $0.3 million in the three
months ended December 31, 2009 and 2008. The amount of cash used remained
relatively stable as the existing property and equipment are sufficient for the
Company’s needs.





There was
no cash provided by financing activities for the three months ended December 31,
2009 and 2008.





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.





We 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 and $9.1 million in principal amount of Series B Convertible Notes,
which were recorded at carrying amount at $6.8 million and $3.1 million as of
December 31, 2009 and September 30, 2009, respectively. These Notes bear
interest at 6% per annum and are due on March 7, 2010





We only
had $1.6 million in cash and cash equivalents on hand as of December 31, 2009.
On January 7, 2010, we entered into the Conversion Agreement with the holders of
Notes representing at least seventy-five percent of the aggregate principal
amounts outstanding under the Notes to modify the terms of the Notes. Pursuant
to the terms of the Conversion Agreement, the Notes would automatically be
converted into shares of our common stock at a conversion price of $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 (the
“Conversion”) at a conversion price per share of common stock of $0.15 effective
as of January 7, 2010 (the “Conversion Date”).  As of the Conversion
Date, no further payments are owing or payable under the Notes.  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.


28




In
connection with the Conversion, on January 7, 2010, we entered into an Amendment
to the Series A, Series B and Series C Warrants (the “Warrant Amendment”) with
the holders of at least a majority of the common stock underlying each of our
outstanding Series A Warrants, Series B Warrants and Series C Warrants
(collectively the “PIPE Warrants”). The Warrant Amendment reduces the exercise
price for all of the PIPE Warrants from $1.21, $0.90 and $1.00, respectively, to
$0.15, removes certain maximum ownership provisions and removes anti-dilution
provisions for lower-priced security issuances.





On
January 19, 2010, a holder of approximately $1.8 million of the Company’s
formerly outstanding Series B Notes and Series B Warrants exercisable into
approximately 4.6 million shares (hereinafter referred to as the “Holder”) of
the Company’s common stock disputes the effectiveness of the Conversion
Agreement and the Warrant Amendment.  The Company concludes that the
Conversion Agreement and Warrant Amendment were duly authorized, amended and
effective and is currently under discussions with the Holder to resolve this
matter. If this matter is not resolved, the Holder has the right to demand
payment from the Company on March 7, 2010. It is uncertain whether the Company
will be able to satisfy this claim if it comes due. None-withstanding 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.





On
January 15, 2010, the Company incorporated a wholly-owned subsidiary at 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.





Historically,
we have incurred operating losses and cash outflows from operations. As of
December 31, 2009, we had $1.6 million of cash and cash
equivalents.  Since April 2009 significant steps were taken to reach
operational profitability. 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.





We
believe that the successful completion of the debt restructuring, 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.





Off-Balance
Sheet Arrangements




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, a polysilicon
manufacturer based in Dallas, Texas, for $1.0 million in cash. The Company is
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 Company. In connection with the equity purchase
agreement, the Company has 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 the Company
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 December 31, 2009, the
Company has not yet acquired the additional two million shares. Accordingly, as
of December 31, 2009, the two million shares acquired by the Company have been
diluted and constituted approximately 5.5% of 21-Century Silicon’s outstanding
equity.




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.


29





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 fiscal quarter ended December
31, 2009 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.


30




PART
II - OTHER INFORMATION




ITEM
1. LEGAL PROCEEDINGS




None





ITEM
1A. RISK FACTORS




Except as
set forth below, 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




None




ITEM
3. DEFAULTS UPON SENIOR SECURITIES




None




ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS




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, 2008.31.1
              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.


31




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:
      February 12, 2010
              By:
              /s/ Steve YeSteve
      YeChief
      Financial Officer




32