Form: 10-Q

Quarterly report pursuant to Section 13 or 15(d)

August 14, 2014

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2014

 

OR

 

o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _____to_____

 

COMMISSION FILE NUMBER 000-21846

 

AETHLON MEDICAL, INC.

 

(Exact name of registrant as specified in its charter)

 

NEVADA   13-3632859
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

8910 UNIVERSITY CENTER LANE, SUITE 660, SAN DIEGO, CA 92122

 

(Address of principal executive offices) (Zip Code)

 

(858) 459-7800

(Registrant's telephone number, including area code)

 

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 (ss.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  S    NO £

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  o Accelerated filer  o

Non-accelerated filer  o

(Do not check if a smaller reporting company)

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

 

As of August 12, 2014, the registrant had outstanding 261,096,690 shares of common stock, $.001 par value.

 

 
 

 

PART I. FINANCIAL INFORMATION 3
     
ITEM 1. FINANCIAL STATEMENTS 3
     
  CONDENSED CONSOLIDATED BALANCE SHEETS AT JUNE 30, 2014 (UNAUDITED) AND MARCH 31, 2014 3
     
  CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTH PERIOD ENDED JUNE 30, 2014 AND 2013 (UNAUDITED) 4
     
  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED JUNE 30, 2014 AND 2013 (UNAUDITED) 5
     
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 7
     
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 27
     
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 31
     
ITEM 4. CONTROLS AND PROCEDURES 31
     
PART II.  OTHER INFORMATION 32
     
ITEM 1. LEGAL PROCEEDINGS 32
     
ITEM 1A. RISK FACTORS 32
     
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 32
     
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 32
     
ITEM 4. MINE SAFETY DISCLOSURES 32
     
ITEM 5. OTHER INFORMATION 32
     
ITEM 6. EXHIBITS 33

 

 

2
 

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

AETHLON MEDICAL, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

 

    June 30,
2014
    March 31,
2014
 
    (Unaudited)        
ASSETS                
Current assets                
Cash   $ 807,330     $ 1,250,279  
Accounts receivable     11,096       95,177  
Deferred financing costs     77,749       83,191  
Prepaid expenses and other current assets     41,855       50,699  
Total current assets     938,030       1,479,346  
                 
Property and equipment, net     77,232       84,279  
Patents and patents pending, net     110,198       112,489  
Deposits     18,988       18,988  
Total assets   $ 1,144,448     $ 1,695,102  
                 
LIABILITIES AND STOCKHOLDERS' DEFICIT                
                 
Current liabilities                
Accounts payable   $ 658,185     $ 517,651  
Due to related parties     818,070       839,070  
Notes payable     390,000       390,000  
Convertible notes payable, current portion     482,655       1,367,655  
Derivative liabilities           10,679,067  
Other current liabilities     1,314,943       1,855,374  
Total current liabilities     3,663,853       15,648,817  
                 
Noncurrent liabilities                
Convertible notes payable, noncurrent portion     1,001,451       776,451  
 Total noncurrent liabilities     1,001,451       776,451  
                 
Total liabilities     4,665,304       16,425,268  
                 
Commitments and Contingencies (Note 13)                
                 
Stockholders' Deficit                
Common stock, par value $0.001 per share; 500,000,000 shares authorized as of June 30, 2014 and March 31, 2014; 253,395,651 and 224,973,980 shares issued and outstanding as of June 30, 2014 and March 31, 2014, respectively     253,394       224,984  
Additional paid-in capital     74,544,327       59,659,137  
Accumulated deficit     (78,488,496 )     (74,832,557 )
Total Aethlon Medical, Inc. stockholders’ deficit before noncontrolling interests     (3,690,775 )     (14,948,436 )
                 
Noncontrolling interests     169,919       218,270  
                 
Total deficit     (3,520,856 )     (14,730,166 )
                 
Total liabilities and deficit   $ 1,144,448     $ 1,695,102  

 

See accompanying notes.

 

3
 

 

AETHLON MEDICAL, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

For the Three Months Ended June 30, 2014 and 2013

(Unaudited)

 

    Three Months
Ended
June 30,
2014
    Three Months
Ended
June 30,
2013
 
REVENUES                
                 
Government contract revenue   $ 51,296     $ 195,596  
                 
OPERATING EXPENSES                
                 
Professional fees     401,613       324,070  
Payroll and related     620,686       458,631  
General and administrative     201,005       196,693  
Total operating expenses     1,223,304       979,394  
OPERATING LOSS     (1,172,008 )     (783,798 )
                 
OTHER EXPENSE (INCOME)                
Gain on change in fair value of derivative liability           (609,125 )
Interest and other debt expenses     78,654       106,096  
Interest income           (60 )
Loss on settlement of notes     2,453,630       22,789  
Total other (income) expense     2,532,284       (480,300 )
NET LOSS BEFORE NONCONTROLLING INTERESTS     (3,704,292 )     (303,498 )
                 
LOSS ATTRIBUTABLE TO NONCONTROLLING INTERESTS     (48,351 )      
                 
NET LOSS ATTRIBUTABLE TO COMMON STOCKHOLDERS   $ (3,655,941 )   $ (303,498 )
                 
BASIC AND DILUTED LOSS PER COMMON SHARE   $ (0.02 )   $ (0.00 )
WEIGHTED AVERAGE NUMBER OF COMMON SHARES  OUTSTANDING –
BASIC AND DILUTED
    227,112,657       176,221,634  

 

See accompanying notes.

 

4
 

 

AETHLON MEDICAL, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Three Months Ended June 30, 2014 and 2013

(Unaudited)

 

    Three Months
Ended
June 30,
2014
    Three Months
Ended
June 30,
2013
 
Cash flows from operating activities:                
Net loss   $ (3,704,292 )   $ (303,498 )
Adjustments to reconcile net loss to net cash used in operating activities:                
Depreciation and amortization     9,338       2,436  
Stock based compensation     170,887       115,788  
Fair market value of common stock, warrants and options issued for services     38,268       21,750  
Change in fair value of derivative liabilities           (609,125 )
Loss on settlement of notes     2,465,630       22,789  
Amortization of debt discount and deferred financing costs     9,942       2,896  
Changes in operating assets and liabilities:                
Accounts receivable     84,081       208,781  
Prepaid expenses and other current assets     8,844       (4,250 )
Accounts payable and other current liabilities     174,553       258,104  
Due to related parties     (21,000 )     62,708  
Net cash used in operating activities     (763,749 )     (221,621 )
                 
Cash flows from financing activities:                
Proceeds from the issuance of common stock     320,800       128,000  
Net cash provided by financing activities     320,800       128,000  
                 
Net decrease in cash     (442,949 )     (93,621 )
                 
Cash at beginning of period     1,250,279       125,274  
                 
Cash at end of period   $ 807,330     $ 31,653  

 

 

See accompanying notes.

 

5
 

 

AETHLON MEDICAL, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

For the Three Months Ended June 30, 2014 and 2013

(Unaudited)

  

    Three Months
Ended
June 30,
2013
    Three Months
Ended
June 30,
2012
 
Supplemental disclosures of cash flow information:                
                 
Cash paid during the period for:                
                 
Interest   $     $ 2,821  
                 
Supplemental disclosures of non-cash investing and financing activities:                
                 
Debt and accrued interest converted to common stock   $ 660,000        
                 
Reclassification of warrant derivative liability into equity   $ 10,679,067     $ 45,081  

 

See accompanying notes.

 

6
 

 

AETHLON MEDICAL, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

June 30, 2014

 

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

 

ORGANIZATION

 

Aethlon Medical, Inc. and subsidiary ("Aethlon", the "Company", "we" or "us") is a medical device company focused on creating innovative devices that address unmet medical needs in cancer, infectious disease and other life-threatening conditions. At the core of our developments is the Aethlon ADAPT™ (Adaptive Dialysis-Like Affinity Platform Technology) system, a medical device platform that converges single or multiple affinity drug agents with advanced plasma membrane technology to create therapeutic filtration devices that selectively remove harmful particles from the entire circulatory system without loss of essential blood components. On June 25, 2013, the United States Food and Drug Administration (FDA) approved an Investigational Device Exemption (IDE) that allows us to initiate human feasibility studies of the Aethlon Hemopurifier® in the United States. Under the feasibility study protocol, we will enroll ten end-stage renal disease patients who are infected with the Hepatitis C virus (HCV) to demonstrate the safety of Hemopurifier therapy. Successful completion of this study will allow us the opportunity to initiate pivotal studies that are required for market clearance to treat HCV and other disease conditions in the United States.

 

Successful outcomes of human trials will also be required by the regulatory agencies of certain foreign countries where we intend to sell this device. Some of our patents may expire before FDA approval or approval in a foreign country, if any, is obtained. However, we believe that certain patent applications and/or other patents issued more recently will help protect the proprietary nature of the Hemopurifier(R) treatment technology.

 

In October 2013, our subsidiary, Exosome Sciences, Inc. (“ESI”), commenced operations with a focus on advancing exosome-based strategies to diagnose and monitor the progression of cancer, infectious disease and other life-threatening conditions. 

 

Our common stock is quoted on the OTCQB marketplace administered by the OTC Markets Group under the symbol "AEMD."

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and applicable sections of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments necessary to make the financial statements not misleading have been included. The condensed consolidated balance sheet as of March 31, 2014 was derived from our audited financial statements. Operating results for the three months ended June 30, 2014 are not necessarily indicative of the results that may be expected for the year ending March 31, 2015. For further information, refer to our Annual Report on Form 10-K for the year ended March 31, 2014, which includes audited financial statements and footnotes as of March 31, 2014 and 2013 and for the years then ended.

 

NOTE 2. LIQUIDITY

 

The accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the ordinary course of business. We have incurred continuing losses from operations and at June 30, 2014 are in default on certain debt agreements, have negative working capital of approximately $2,726,000, and an accumulated deficit of approximately $78,488,000. These factors, among other matters, raise substantial doubt about our ability to continue as a going concern. A significant amount of additional capital will be necessary to advance the development of our products to the point at which they may become commercially viable. We intend to fund operations, working capital and other cash requirements for the fiscal year ending March 31, 2015 through debt and/or equity financing arrangements as well as through revenues and related cash receipts under our government contracts (see Note 12).

 

During the June 2014 quarter, we converted a past due convertible note in the amount of $660,000 and related accrued interest into equity and also restructured and extended a formerly past due convertible note in the amount of $225,000. Those actions allowed us to reclassify our derivative liability in the amount of $10,679,067 into equity.

 

We are currently addressing our liquidity issue by seeking additional investment capital through private placements of common stock and debt and by applying for additional grants issued by government agencies in the United States. We believe that our cash on hand and funds expected to be received from additional private investment will be sufficient to meet our liquidity needs for fiscal 2015. However, no assurance can be given that we will receive any funds in addition to the funds we have received to date.

 

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The successful outcome of future activities cannot be determined at this time and there is no assurance that, if achieved, we will have sufficient funds to execute our intended business plan or generate positive operating results.

 

The consolidated financial statements do not include any adjustments related to this uncertainty and as to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern.

 

NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

The summary of our significant accounting policies presented below is designed to assist the reader in understanding our condensed consolidated financial statements. Such financial statements and related notes are the representations of our management, who are responsible for their integrity and objectivity. These accounting policies conform to GAAP in all material respects, and have been consistently applied in preparing the accompanying condensed consolidated financial statements.

 

PRINCIPLES OF CONSOLIDATION

 

The accompanying condensed consolidated financial statements include the accounts of Aethlon Medical, Inc. and its majority-owned and controlled subsidiary, ESI. All significant intercompany balances and transactions have been eliminated in consolidation. The Company classifies the noncontrolling interests in ESI as part of consolidated net loss in the three months ended June 30, 2014 and includes the accumulated amount of noncontrolling interests as part of stockholders’ equity. During the fiscal year ended March 31, 2014, Aethlon Medical, Inc. reduced its ownership percentage to 80% by ESI’s issuance of 300,000 shares of ESI common stock in exchange for cash of $1,500,000. If a change in ownership of ESI results in loss of control and deconsolidation, any retained ownership interest will be remeasured with the gain or loss reported in our statement of operations.

 

The losses at ESI during the three months ended June 30, 2014 reduced the noncontrolling interests on our consolidated balance sheet by $48,351 from $218,270 at March 31, 2014 to $169,919 at June 30, 2014.

 

USE OF ESTIMATES

 

We prepare our condensed consolidated financial statements in conformity with GAAP, which 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 reported amounts of revenues and expenses during the reporting periods. Significant estimates made by management include, among others, realization of long-lived assets, estimating fair value associated with debt and equity transactions and valuation of deferred tax assets. Actual results could differ from those estimates.

 

CASH AND CASH EQUIVALENTS

 

Accounting standards define "cash and cash equivalents" as any short-term, highly liquid investment that is both readily convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. For the purpose of financial statement presentation, we consider all highly liquid investment instruments with original maturities of three months or less when purchased, or any investment redeemable without penalty or loss of interest to be cash equivalents. As of June 30, 2014 and March 31, 2014, we had no assets that were classified as cash equivalents.

 

CONCENTRATIONS OF CREDIT RISKS

 

Cash is maintained at two financial institutions in checking accounts and related cash management accounts. Accounts at these institutions are secured by the Federal Deposit Insurance Corporation ("FDIC") up to $250,000. Our June 30, 2014 cash balances were approximately $557,000 over such insured amount. We do not believe that the Company is exposed to any significant risk with respect to its cash.

 

All of our accounts receivable at June 30, 2014 and March 31, 2014 and all of our revenue in the three month periods ended June 30, 2014 and 2013 were directly from the U.S. Department of Defense or from a subcontract under Battelle, which is a prime contractor with the U.S. Department of Defense, and as such no allowance for uncollectable accounts receivable is deemed necessary at June 30, 2014 or March 31, 2014.

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The carrying amount of our cash, accounts receivable, accounts payable, and other current liabilities approximate their estimated fair values due to the short-term maturities of those financial instruments. The carrying amount of the notes payable approximates their fair value due to the short maturity of the notes and since the interest rate approximates current market interest rates for similar instruments.

 

8
 

 

Management has concluded that it is not practical to determine the estimated fair value of amounts due to related parties because the transactions cannot be assumed to have been consummated at arm's length, the terms are not deemed to be market terms, there are no quoted values available for these instruments, and an independent valuation would not be practicable due to the lack of data regarding similar instruments, if any, and the associated potential costs.

 

See Note 9 with respect to derivative liabilities.

 

PROPERTY AND EQUIPMENT

 

Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to five years. Repairs and maintenance are charged to expense as incurred while improvements are capitalized. Upon the sale or retirement of property and equipment, the accounts are relieved of the cost and the related accumulated depreciation with any gain or loss included in the consolidated statements of operations.

 

INCOME TAXES

 

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to the difference between the consolidated financial statements and their respective tax basis. Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts reported for income tax purposes, and (b) tax credit carryforwards. We record a valuation allowance for deferred tax assets when, based on our best estimate of taxable income (if any) in the foreseeable future, it is more likely than not that some portion of the deferred tax assets may not be realized.

 

IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS

 

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. If the cost basis of a long-lived asset is greater than the projected future undiscounted net cash flows from such asset, an impairment loss is recognized. We believe no impairment charges were necessary during the three month periods ended June 30, 2014 and 2013.

 

LOSS PER COMMON SHARE

 

Basic loss per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period of computation. Diluted loss per share is computed similar to basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if potential common shares had been issued, if such additional common shares were dilutive. Since we had net losses for all periods presented, basic and diluted loss per share are the same, and additional potential common shares have been excluded as their effect would be antidilutive.

 

As of June 30, 2014 and 2013, a total of 141,225,399 and 138,279,424 potential common shares, consisting of shares underlying outstanding stock options, warrants and convertible notes payable were excluded as their inclusion would be antidilutive.

 

SEGMENTS

 

Historically, we operated in one segment that was based on our development of therapeutic devices. However in the December 2013 quarter, we initiated the operations of ESI to develop diagnostic tests. As a result, we now operate in two segments, Aethlon for therapeutic applications and ESI for diagnostic applications (See Note 14).

 

DEFERRED FINANCING COSTS

 

Costs related to the issuance of debt are capitalized and amortized to interest expense over the life of the related debt using the effective interest method.  We recorded amortization expense related to our deferred offering costs of $9,942 and $863 during the three month periods ended June 30, 2014 and 2013, respectively.

 

REVENUE RECOGNITION

 

DARPA Contract -- With respect to revenue recognition, we entered into a government contract with DARPA and have recognized revenue under such contract. We adopted the Milestone method of revenue recognition for the DARPA contract under ASC 605-28 “Revenue Recognition – Milestone Method” and we believe we meet the requirements under ASC 605-28 for reporting contract revenue under the Milestone Method.

 

9
 

 

In order to account for this contract, we identify the deliverables included within the contract and evaluate which deliverables represent separate units of accounting based on if certain criteria are met, including whether the delivered element has standalone value to the collaborator. The consideration received is allocated among the separate units of accounting, and the applicable revenue recognition criteria are applied to each of the separate units.

 

A milestone is an event having all of the following characteristics:

 

(1) There is substantive uncertainty at the date the arrangement is entered into that the event will be achieved. A vendor’s assessment that it expects to achieve a milestone does not necessarily mean that there is not substantive uncertainty associated with achieving the milestone.

 

(2) The event can only be achieved based in whole or in part on either: (a) the vendor’s performance; or (b) a specific outcome resulting from the vendor’s performance.

 

(3) If achieved, the event would result in additional payments being due to the vendor.

  

A milestone does not include events for which the occurrence is either: (a) contingent solely upon the passage of time; or (b) the result of a counterparty’s performance.

 

The policy for recognizing deliverable consideration contingent upon achievement of a milestone must be applied consistently to similar deliverables.

 

The assessment of whether a milestone is substantive is performed at the inception of the arrangement. The consideration earned from the achievement of a milestone must meet all of the following for the milestone to be considered substantive:

 

(1) The consideration is commensurate with either: (a) the vendor’s performance to achieve the milestone; or (b) the enhancement of the value of the delivered item or items as a result of a specific outcome resulting from the vendor’s performance to achieve the milestone;

 

(2) The consideration relates solely to past performance; and

 

(3) The consideration is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.

 

A milestone is not considered substantive if any portion of the associated milestone consideration relates to the remaining deliverables in the unit of accounting (i.e., it does not relate solely to past performance). To recognize the milestone consideration in its entirety as revenue in the period in which the milestone is achieved, the milestone must be substantive in its entirety. Milestone consideration cannot be bifurcated into substantive and nonsubstantive components. In addition, if a portion of the consideration earned from achieving a milestone may be refunded or adjusted based on future performance, the related milestone is not considered substantive.

 

See Note 12 for the additional disclosure information required under ASC 605-28.

 

Battelle Subcontract -- We entered into a subcontract agreement with Battelle Memorial Institute (“Battelle”) in March 2013. Battelle was chosen by DARPA to be the prime contractor on the systems integration portion of the original DARPA contract and we are one of several subcontractors on that systems integration project. The Battelle subcontract is cost-reimbursable under a time and materials basis. We began generating revenues under the subcontract during the three months ended September 30, 2013.

 

Our revenue under this contract is a function of cost reimbursement plus an overhead mark-up for hours devoted to the project by specific employees (with specific hourly rates for those employees). Battelle engages us as needed. Each payment requires approval by the program manager at Battelle.

 

STOCK-BASED COMPENSATION

 

Employee stock options and rights to purchase shares under stock participation plans are accounted for under the fair value method. Accordingly, share-based compensation is measured when all granting activities have been completed, generally the grant date, based on the fair value of the award. The exercise price of options is generally equal to the market price of the Company's common stock (defined as the closing price as quoted on the OTCBB on the date of grant). Compensation cost recognized by the Company includes (a) compensation cost for all equity incentive awards granted prior to April 1, 2006, but not yet vested, based on the grant-date fair value estimated in accordance with the original provisions of the then current accounting standards, and (b) compensation cost for all equity incentive awards granted subsequent to April 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of subsequent accounting standards. We use a Binomial Lattice option pricing model for estimating fair value of options granted (see Note 10).

 

10
 

 

The following table summarizes share-based compensation expenses relating to shares and options granted and the effect on loss per common share during the years ended June 30, 2014 and 2013:

 

    June 30, 2014     June 30, 2013  
Vesting of Stock Options   $ 170,887     $ 50,387  
Incremental fair value of option Modifications           957  
Vesting Expense Associated with CEO Restricted Stock Grant           64,444  
Total Stock-Based Compensation Expense   $ 170,887     $ 115,788  
                 
Basic and diluted loss per common share   $ (0.00 )   $ (0.00 )

  

We account for transactions involving services provided by third parties where we issue equity instruments as part of the total consideration using the fair value of the consideration received (i.e. the value of the goods or services) or the fair value of the equity instruments issued, whichever is more reliably measurable. In transactions, when the value of the goods and/or services are not readily determinable and (1) the fair value of the equity instruments is more reliably measurable and (2) the counterparty receives equity instruments in full or partial settlement of the transactions, we use the following methodology:

 

a) For transactions where goods have already been delivered or services rendered, the equity instruments are issued on or about the date the performance is complete (and valued on the date of issuance).

 

b) For transactions where the instruments are issued on a fully vested, non-forfeitable basis, the equity instruments are valued on or about the date of the contract.

 

c) For any transactions not meeting the criteria in (a) or (b) above, we re-measure the consideration at each reporting date based on its then current stock value.

 

We review share-based compensation on a quarterly basis for changes to the estimate of expected award forfeitures based on actual forfeiture experience. The effect of adjusting the forfeiture rate for all expense amortization after March 31, 2006 is recognized in the period the forfeiture estimate is changed. The effect of forfeiture adjustments for the three months ended June 30, 2014 was insignificant.

 

PATENTS

 

Patents include both foreign and domestic patents. There were several patents pending at June 30, 2014. We capitalize the cost of patents and patents pending, some of which were acquired, and amortize such costs over the shorter of the remaining legal life or their estimated economic life, upon issuance of the patent. The unamortized costs of patents and patents pending are subject to our review for impairment under our long-lived asset policy above. 

 

STOCK PURCHASE WARRANTS

 

We grant warrants in connection with the issuance of convertible notes payable and the issuance of common stock for cash. When such warrants are classified as equity and issued in connection with debt, we measure the relative estimated fair value of such warrants and record it as a discount from the face amount of the convertible notes payable. Such discounts are amortized to interest expense over the term of the notes using the effective interest method. Warrants issued in connection with common stock for cash, if classified as equity, are considered issued in connection with equity transactions and the warrant fair value is recorded to additional paid-in-capital. Lastly, warrants not meeting equity classification are recorded as derivative instruments.

 

DERIVATIVE INSTRUMENTS

 

We evaluate free-standing derivative instruments (or embedded derivatives) to properly classify such instruments within equity or as liabilities in our financial statements. Our policy is to settle instruments indexed to our common shares on a first-in-first-out basis.

 

The classification of a derivative instrument is reassessed at each reporting date. If the classification changes as a result of events during a reporting period, the instrument is reclassified as of the date of the event that caused the reclassification. There is no limit on the number of times a contract may be reclassified.

 

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Instruments classified as derivative liabilities are remeasured each reporting period (or upon reclassification) and the change in fair value is recorded on our consolidated statement of operations in other (income) expense.

 

BENEFICIAL CONVERSION FEATURE OF CONVERTIBLE NOTES PAYABLE

 

The convertible feature of certain notes payable provides for a rate of conversion that is below market value. Such feature is normally characterized as a "Beneficial Conversion Feature" ("BCF"). We measure the estimated fair value of the BCF in circumstances in which the conversion feature is not required to be separated from the host instrument and accounted for separately, and record that value in the consolidated financial statements as a discount from the face amount of the notes. Such discounts are amortized to interest expense over the term of the notes.

 

REGISTRATION PAYMENT ARRANGEMENTS

 

We account for contingent obligations to make future payments or otherwise transfer consideration under a registration payment arrangement separately from any related financing transaction agreements, and any such contingent obligations are recognized only when it is determined that it is probable we will become obligated for future payments and the amount, or range of amounts, of such future payments can be reasonably estimated.

 

RESEARCH AND DEVELOPMENT EXPENSES

 

Our research and development costs are expensed as incurred. We incurred approximately $347,000 and $338,000 of research and development expenses for the three month periods ended June 30, 2014 and 2013, respectively, which are included in various operating expenses in the accompanying consolidated statements of operations.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

We have not entered into any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our consolidated financial statements.

 

SIGNIFICANT RECENT ACCOUNTING PRONOUNCEMENTS

 

Management is evaluating significant recent accounting pronouncements that are not yet effective for the Company, including the new accounting standard on revenue recognition, ASU 2014-09 (Topic 606), and has not yet concluded whether any such pronouncements will have a significant effect on the Company’s future consolidated financial statements.

 

NOTE 4. NOTES PAYABLE

 

Notes payable consist of the following:

 

    June 30, 2014     March 31, 2014  
    Principal Balance     Accrued Interest     Principal Balance     Accrued Interest  
12% Notes payable, past due   $ 185,000     $ 360,750     $ 185,000     $ 353,813  
10% Note payable, past due     5,000       6,500       5,000       6,375  
Directors’ Note(s)     200,000       19,516       200,000       14,516  
Total   $ 390,000     $ 386,766     $ 390,000     $ 374,704  

 

During the three months ended June 30, 2014, we recorded interest expense of $12,062 related to the contractual interest rates of our notes payable.

 

12% NOTES

 

From August 1999 through May 2005, we entered into various borrowing arrangements for the issuance of notes payable from private placement offerings (the "12% Notes"). On April 21, 2010, a holder of $100,000 of the 12% Notes converted his principal balance and $71,758 of accrued interest into 687,033 shares of common stock at an agreed conversion price of $0.25 per share. At June 30, 2014, the 12% Notes were past due, in default, and bearing interest at the default rate of 15%.

 

10% NOTES

 

At June 30, 2014, one 10% Note in the amount of $5,000, which is past due and in default, remained outstanding and it bears interest at the default rate of 15%.

 

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Management's plans to satisfy the remaining outstanding balance on these 12% and 10% Notes include converting the notes to common stock at market value or repayment with available funds.

 

DIRECTORS’ NOTES

 

In July 2013, we borrowed $400,000 from two of our directors under two 90 day notes for $200,000 each bearing 10% interest (the “Notes”). At the discretion of the holders, if not paid off by October 9, 2013, the noteholders were entitled to (i) convert their principal and accrued interest into shares of common stock at $0.088 per share (the “Conversion Price”) and (ii) receive warrants to purchase common stock equal to 50% of the principal converted under the Notes, with an exercise price of $0.132 per share. Additionally, there was a provision for a penalty interest rate of 12%.

 

That potential conversion price and warrant exercise price were based on the same pricing mechanism that we have used in prior equity unit financings since March 2012 (see Note 6) which are based on 80% of the then current market price of our common stock and with the warrant exercise price based on 120% of the same then current market price. We initially reserved 6,931,818 shares of common stock to support the conversion of the Notes and accrued interest in full as well as the exercise of the warrants in full (should such conversion and/or issuance occur).

 

During the fiscal year ended March 31, 2014, the principal of $200,000 and accrued interest of $9,367 were paid on one of the notes, which extinguished all potential common stock and warrant issuance provisions related to that Note.

 

The holder of the second Note agreed to extend the expiration date of his Note to July 31, 2014 and then subsequent to June 30, 2014, he converted his principal of $200,000 and accrued interest of $20,349 into 2,503,966 shares of our common stock per conversion formula of the note (see Note 15).

 

5. CONVERTIBLE NOTES PAYABLE

 

Convertible Notes Payable consisted of the following at June 30, 2014:

 

    Principal     Unamortized
Discount
    Net
Amount
    Accrued
Interest
 
Convertible Notes Payable – Current Portion:                                
2008 10% Convertible Notes, past due   $ 25,000     $     $ 25,000     $ 20,104  
October & November 2009 10% Convertible Notes     50,000             50,000       27,347  
April 2010 10% Convertible Note     75,000             75,000       33,313  
July and August 2011 10% Convertible Notes, past due     257,655             257,655       99,918  
Law Firm Note     75,000             75,000       8,542  
Total – Convertible Notes Payable – Current Portion     482,655             482,655       189,224  
                                 
Convertible Notes Payable – Non-Current Portion:                                
Amended and Restated Series A 12% Convertible Notes     225,000             225,000       4,500  
September 2010 12% Convertible Notes     317,072             317,072       44,546  
April 2011 12% Convertible Notes     448,448             448,448       25,571  
September 2011 12% Convertible Notes     10,931             10,931       328  
Total – Convertible Notes Payable – Non-Current Portion     1,001,451             776,451       74,945  
Total Convertible Notes Payable   $ 1,484,106     $     $ 1,484,106     $ 264,169  

 

There were no discounts remaining on any of our Convertible Notes Payable as of June 30, 2014.

 

During the three months ended June 30, 2014, we recorded interest expense of $42,456 related to the contractual interest rates of our convertible notes and interest expense of $9,942 related to the amortization of deferred financing costs related to the convertible notes for a total credit of $61,882. The credit related to the conversion and restructuring of the Amended and Restated Series A 12% Convertible Notes (see below).

 

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Convertible Notes Payable consisted of the following at March 31, 2014:

 

    Principal     Unamortized
Discount
    Net
Amount
    Accrued
Interest
 
Convertible Notes Payable – Current Portion:                                
Amended and Restated Series A 12% Convertible Notes, past due   $ 885,000     $     $ 885,000     $ 575,250  
2008 10% Convertible Notes, past due     25,000             25,000       19,167  
October & November 2009 10% Convertible Notes     50,000             50,000       26,097  
April 2010 10% Convertible Note     75,000             75,000       31,438  
July and August 2011 10% Convertible Notes, past due     257,655             257,655       90,256  
Law Firm Note     75,000             75,000       7,604  
Total – Convertible Notes Payable – Current Portion     1,367,655             1,367,655       749,812  
                                 
Convertible Notes Payable – Non-Current Portion:                                
September 2010 12% Convertible Notes     317,072             317,072       35,034  
April 2011 12% Convertible Notes     448,448             448,448       12,117  
September 2011 12% Convertible Notes     10,931             10,931        
Total – Convertible Notes Payable – Non-Current Portion     776,451             776,451       47,151  
Total Convertible Notes Payable   $ 2,144,106     $     $ 2,144,106     $ 796,963  

 

There were no discounts remaining on any of our Convertible Notes Payable as of March 31, 2014.

 

AMENDED AND RESTATED SERIES A 12% CONVERTIBLE NOTES

 

In June 2010, we entered into Amended and Restated Series A 12% Convertible Promissory Notes (the "Amended and Restated Notes") with the holders of certain promissory notes previously issued by us, extending the due date to December 31, 2010 on the aggregate principal balance of $900,000. During the fiscal year ended March 31, 2013, the holders of $15,000 of the Notes converted their principal and related accrued interest into common stock. The balance remaining at March 31, 2014 was $885,000 and was past due.

 

Weiner Note Conversion

 

On June 24, 2014, we entered into an agreement with the Ellen R. Weiner Family Revocable Trust (the “Trust”), a holder of a Series A 12% Convertible Note (the “Note”), which previously was classified as being in default. As per the agreement, the Trust converted past due principal of $660,000 and accrued interest balance of $343,200 into restricted common stock.

 

Additionally, the Trust agreed to waive anti-dilution price protection underlying warrants previously issued to the Trust. On June 26, 2014, three other parties who held similar warrants also agreed to waive their anti-dilution price protection.

 

Under its agreement, the Trust converted the entire $1,003,200 past due principal and interest balance on the Note, which previously was in default, into an aggregate of 23,318,254 restricted shares of our common stock and five-year warrants to acquire up to 6,809,524 shares of our common stock at an exercise price of $.042 per share (which exercise price was the result of certain contractual price adjustments previously made during 2011) and up to 397,222 shares of our common stock at an exercise price of $.108 per share (collectively, the “Conversion Securities”). Based on the fair value of the warrants and shares issued to the Trust for the accrued interest, we recorded a loss on settlement of notes of $1,791,421.

 

In exchange for the Trust’s conversion in full of the Note and accrued interest and for the waivers of anti-dilution price protection in the previously issued warrants, in addition to the Conversion Securities, we issued to the Trust 75,000 restricted shares of common stock as a service fee, changed the exercise price of all of the previously issued warrants to $.042 per share and extended the expiration date of all of the previously issued warrants to July 1, 2018. We valued the 75,000 share service fee at $12,000 based on our closing price on the date of the agreement and recorded that value as interest expense during the June 2014 period.

 

Bird Estate Extension

 

On July 8, 2014, we executed a written restructuring agreement (the “Agreement”) with the Estate of Allan Bird (the “Estate”), a holder of a Series A 12% Convertible Note (the “Note”), which previously was classified as being in default. Since the negotiations for the Agreement were completed in the month of June, we recorded the impact of the Agreement as of June 30, 2014. In the Agreement, the Estate agreed to extend the expiration date of the Note to April 1, 2016, to convert approximately $116,970 of accrued interest to equity, and to waive anti-dilution price protection underlying the Note and warrants previously issued to the Estate.

 

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Under the Agreement, the Estate converted the entire $116,970 past due interest balance on the Note, which previously was in default, into an aggregate of 2,591,846 restricted shares of our common stock. The Estate received five-year warrants to acquire up to 2,321,429 shares of our common stock at an exercise price of $.042 per share (which exercise price was the result of certain contractual price adjustments previously made during 2011). Based on our common stock prices during a period of negotiation with the Estate including during calendar year 2013, the Estate also received five-year warrants to acquire up to 135,417 shares of our common stock at an exercise price of $.108 (collectively known as the “Conversion Securities”). Based on the fair value of the warrants and shares issued to the Estate for the accrued interest, we recorded a loss on settlement of notes of $663,209.

 

In exchange for the Estate’s extension of the Note, conversion of accrued interest and for the waivers of anti-dilution price protection in the previously issued warrants, in addition to the Conversion Securities, we also issued to the Estate 25,000 restricted shares of common stock as an extension fee and extended the expiration date of all of the previously issued warrants to July 1, 2018. We valued the 25,000 share extension fee at $4,500 based on our closing price and recorded that value as a deferred financing cost, which we will amortize over the extended two year life of the note.

 

2008 10% CONVERTIBLE NOTES

 

One 2008 10% Convertible Note in the amount of $25,000 which matured in January 2010 remained outstanding and past due at June 30, 2014. Such note is convertible into our common stock at $0.50 per share. We are recording interest at the default rate of 15%.

 

OCTOBER & NOVEMBER 2009 10% CONVERTIBLE NOTES

 

In October and November 2009, we raised $430,000 from the sale to accredited investors of 10% convertible notes ("October & November 2009 10% Convertible Notes"). The October & November 2009 10% Convertible Notes matured at various dates between April 2011 and May 2011 and are convertible into our common stock at a fixed conversion price of $0.25 per share. The investors also received matching three year warrants to purchase unregistered shares of our common stock at an exercise price of $0.25 per share. We measured the fair value of the warrants and the beneficial conversion feature of the notes and recorded a 100% discount against the principal of the notes. Such discount was fully amortized at March 31, 2014.

 

In July 2012, we issued 461,409 shares of common stock and 230,705 warrants to purchase common stock to the holder of a $25,000 note in this grouping in exchange for the conversion of such note and related accrued interest of $8,000 (for a total of $33,000). The warrants expired in 2012 and are exercisable at $0.107 per share (see Note 6). We recorded a loss on conversion of $45,796.

 

The following table shows the conversions into principal of the October and November 2009 Convertible Notes by fiscal year:

 

Activity in October & November 2009 10% Convertible Notes
Initial principal balance   $ 450,250  
Conversions during the fiscal year ended March 31, 2010     (70,000 )
Conversions during the fiscal year ended March 31, 2011     (175,000 )
Conversions during the fiscal year ended March 31, 2012     (130,250 )
Conversions during the fiscal year ended March 31, 2013     (25,000 )
Conversions during the fiscal year ended March 31, 2014     --  
Conversions during the three months ended June 30, 2014     --  
Balance as of June 30, 2014   $ 50,000  

 

On March 31, 2012, we agreed to extend the expiration date and to change the exercise price of certain warrants of one of the note holders by two years in exchange for the extension of $50,000 of the October & November 2009 10% Convertible Notes and the $75,000 April 2010 10% Convertible Note (see below) by that same two year period. We recorded a charge of $77,265 relating to this modification.

 

In September 2013, we agreed to extend the expiration date of certain warrants of one of the note holders by two years in exchange for the extension of $50,000 of the October & November 2009 10% Convertible Notes and the $75,000 April 2010 10% Convertible Note (see below) by that same two year period. Management assessed the change in the value of the notes and related warrants before and after that extension and determined that the change in value related to the change in terms was not significant.

 

APRIL 2010 10% CONVERTIBLE NOTE

 

In April 2010, we raised $75,000 from the sale to an accredited investor of a 10% convertible note. The convertible note was originally scheduled to mature in October 2011 and is convertible into our common stock at a fixed conversion price of $0.25 per share prior to maturity. The investor also received three year warrants to purchase 300,000 unregistered shares of our common stock at a price of $0.25 per share.

 

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We measured the fair value of the warrants and the beneficial conversion feature of the notes and recorded a 100% discount against the principal of the notes. We amortized this discount using the effective interest method over the term of the note. As of June 30, 2014, there have not been any conversions of the April 2010 10% Convertible Note.

 

On March 31, 2012, we agreed to extend the expiration date and to change the exercise price of certain warrants of the note holder by two years in exchange for his extension of $50,000 of the October & November 2009 10% Convertible Notes and the $75,000 April 2010 10% Convertible Note by that same two year period.

 

In September 2013, we agreed to extend the expiration date of certain warrants of one of the note holders by two years in exchange for the extension of $50,000 of the October & November 2009 10% Convertible Notes and the $75,000 April 2010 10% Convertible Note (see below) by that same two year period. Management assessed the change in the value of the notes and related warrants before and after that extension and determined that the change in value related to the change in terms was not significant.

  

SEPTEMBER 2010 10% CONVERTIBLE NOTES

 

On September 3, 2010, we entered into a Subscription Agreement with three accredited investors (the “Purchasers”) providing for the issuance and sale of convertible promissory notes and corresponding warrants in the aggregate principal amount of $1,430,000. The initial closing under the Subscription Agreement resulted in the issuance and sale of (i) convertible promissory notes in the aggregate principal amount of $743,600, (ii) five-year warrants to purchase an aggregate of 3,718,000 shares of our common stock at an exercise price of $0.31125 per share, and (iii) five-year warrants to purchase an aggregate of 3,718,000 shares of our common stock at an exercise price of $0.43575 per share. The convertible promissory notes bear interest compounded monthly at the annual rate of ten percent (10%) and mature on April 1, 2016 (see below). The aggregate gross cash proceeds were $650,000, the balance of the principal amount representing a due diligence fee and an original issuance discount. The convertible promissory notes are convertible at the option of the holders into shares of our common stock at a price per share equal to eighty percent (80%) of the average of the three lowest closing bid prices of the common stock as reported by Bloomberg L.P. for the principal market on which the common stock trades or is quoted for the ten (10) trading days preceding the proposed conversion date. Subject to adjustment as described in the notes, the conversion price may not be more than $0.30 nor less than $0.20. There are no registration requirements with respect to the shares of common stock underlying the notes or the warrants. 

 

On March 31, 2014, we entered into separate Amendments to Convertible Notes and Warrants (collectively, the “Amendments”) with three accredited investors (collectively, the “Investors”) who own certain convertible promissory notes (collectively, the “Notes”) and warrants (collectively, the “Warrants”) previously issued by us on various dates between December 5, 2007 and September 23, 2011, including the September 2010 Convertible Notes.

 

Prior to the Amendments, the Notes were past maturity and were in default, resulting in the accrual of interest at the applicable default interest rate. The Amendments extended the maturity date of each of the Notes to April 1, 2016, which permits us to classify them as long-term liabilities. As a result of the Amendments, the Notes are no longer in default and the non-default interest rate for all of the Notes was set at 12% per annum, which represents a reduction from the default interest rates of fifteen percent at which interest had been accruing. By entering into the Amendments, we also agreed to increase the currently outstanding principal amount of the Notes by 12% from a total of $693,260 to a total of $776,451.

 

During the period from October 2011 to February 2014, the Investors had converted, at conversion prices between $.0546 and $.07 per share, portions of principal and interest outstanding under the Notes and certain other convertible promissory notes previously issued to them by us. Certain antidilution provisions applicable to such notes should have resulted in such conversions being effected at a conversion price of $.042 per share. Accordingly, pursuant to the Amendments, we issued to the investors an aggregate of 4,507,105 shares of the Company’s Common Stock, which represents the additional shares of Common Stock that would have been issued to the Investors had such conversions been effected at $.042 per share.

 

The Amendments also set the conversion price of the Notes, as well as the exercise price at which shares of our common stock can be purchased under the Warrants, at $.042 per share. By virtue of the Amendments, the expiration dates of the Warrants also were extended from dates between September 3, 2015 and September 23, 2016 to January 1, 2017.

 

The following table shows the activity in the September 2010 10% Convertible Notes by fiscal year:

 

Activity in the September 2010 10% Convertible Notes
Initial principal balance   $ 743,600  
Conversions during the fiscal year ended March 31, 2012     (405,500 )
Conversions during the fiscal year ended March 31, 2013     (30,000 )
Conversions during the fiscal year ended March 31, 2014     (25,000 )
Increase in principal balance due to 12% extension fee     33,972  
Conversions during the three months ended June 30, 2014     --  
Balance as of June 30, 2014   $ 317,072  

  

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APRIL 2011 10% CONVERTIBLE NOTES

 

In April 2011, we entered into a Subscription Agreement with two accredited investors (the “Purchasers”) providing for the issuance and sale of convertible promissory notes and corresponding warrants in the aggregate principal amount of $385,000. The closing under the Subscription Agreement resulted in the issuance and sale by us of (i) convertible promissory notes in the aggregate principal amount of $385,000, (ii) five-year warrants to purchase an aggregate of 4,004,000 shares of our common stock at an exercise price of $0.125 per share, and (iii) five-year warrants to purchase an aggregate of 4,004,000 shares of our common stock at an exercise price of $0.175 per share. The convertible promissory notes bear interest compounded monthly at the annual rate of 10% and mature on April 1, 2016 (see below). The aggregate gross cash proceeds to us were $350,000, the balance of the principal amount representing a due diligence fee and an original issuance discount. The convertible promissory notes are convertible at the option of the holders into shares of our common stock at a price per share equal to eighty percent (80%) of the average of the three lowest closing bid prices of the common stock as reported by Bloomberg L.P. for the principal market on which the common stock trades or is quoted for the ten (10) trading days preceding the proposed conversion date. Subject to adjustment as described in the notes, the conversion price may not be more than $0.20 nor less than $0.10. There are no registration requirements with respect to the shares of common stock underlying the notes or the warrants.

 

In addition, we issued (i) five-year warrants to purchase an aggregate of 812,500 shares of our common stock at an exercise price of $0.125 per share, and (ii) five-year warrants to purchase an aggregate of 812,500 shares of our common stock at an exercise price of $0.175 per share to the Purchasers. These warrants were issued as an antidilution adjustment under certain common stock purchase warrants held by the Purchasers that were acquired from us in September 2010.

 

On March 31, 2014, we entered into separate Amendments to Convertible Notes and Warrants (collectively, the “Amendments”) with three accredited investors (collectively, the “Investors”) who own certain convertible promissory notes (collectively, the “Notes”) and warrants (collectively, the “Warrants”) previously issued by us on various dates between December 5, 2007 and September 23, 2011, including the April 2011 Convertible Notes.

 

Prior to the Amendments, the Notes were past maturity and were in default, resulting in the accrual of interest at the applicable default interest rate. The Amendments extended the maturity date of each of the Notes to April 1, 2016, which permits us to classify them as long-term liabilities. As a result of the Amendments, the Notes are no longer in default and the non-default interest rate for all of the Notes was set at 12% per annum, which represents a reduction from the default interest rates of 15% at which interest had been accruing. By entering into the Amendments, we also agreed to increase the currently outstanding principal amount of the Notes by 12% from a total of $693,260 to a total of $776,451.

 

During the period from October 2011 to February 2014, the Investors had converted, at conversion prices between $.0546 and $.07 per share, portions of principal and interest outstanding under the Notes and certain other convertible promissory notes previously issued to them by us. Certain antidilution provisions applicable to such notes should have resulted in such conversions being effected at a conversion price of $.042 per share. Accordingly, pursuant to the Amendments, we issued to the investors an aggregate of 4,507,105 shares of the Company’s Common Stock, which represents the additional shares of Common Stock that would have been issued to the Investors had such conversions been effected at $.042 per share.

 

The Amendments also set the conversion price of the Notes, as well as the exercise price at which shares of our common stock can be purchased under the Warrants, at $.042 per share. By virtue of the Amendments, the expiration dates of the Warrants also were extended from dates between September 3, 2015 and September 23, 2016 to January 1, 2017.

 

As of June 30, 2014, there have not been any conversions of the April 2011 10% Convertible Notes and the 12% extension fee noted above increased the principal balance by $48,048 to a principal balance of $448,448.

 

JULY & AUGUST 2011 10% CONVERTIBLE NOTES

 

During the three months ended September 30, 2011, we raised $357,656 in 10% convertible notes. Those notes had a fixed conversion price of $0.09 per share and carried an interest rate of 10%. The convertible notes matured in July and August 2012. We also issued those investors five year warrants to purchase 3,973,957 shares of common stock at $0.125 per share.

 

We measured the fair value of the warrants and the beneficial conversion feature of the notes and recorded a $257,926 discount against the principal of the notes. We amortized this discount using the effective interest method over the term of the note.

 

Effective March 31, 2014, the holders of the three notes totaling $100,000 converted all of their principal and accrued interest into 1,438,700 shares of our common stock at the contractual conversion price of $0.09 per share.

 

At June 30, 2014, the remaining outstanding principal balance was $257,655, all of which was in default. We are recording interest at the default interest rate of 15%.

 

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SEPTEMBER 2011 CONVERTIBLE NOTES

 

In September 2011, we issued $253,760 of convertible notes, convertible at $0.07 per share. Such notes originally matured in September 2012.

 

On March 31, 2014, we entered into separate Amendments to Convertible Notes and Warrants (collectively, the “Amendments”) with three accredited investors (collectively, the “Investors”) who own certain convertible promissory notes (collectively, the “Notes”) and warrants (collectively, the “Warrants”) previously issued by us on various dates between December 5, 2007 and September 23, 2011, including the September 2011 Convertible Notes.

 

Prior to the Amendments, the Notes were past maturity and were in default, resulting in the accrual of interest at the applicable default interest rate. The Amendments extended the maturity date of each of the Notes to April 1, 2016, which permits us to classify them as long-term liabilities. As a result of the Amendments, the Notes are no longer in default and the non-default interest rate for all of the Notes was set at 12% per annum, which represents a reduction from the default interest rates of 15% at which interest had been accruing. By entering into the Amendments, we also agreed to increase the currently outstanding principal amount of the Notes by 12%, which in the case of the September 2011 Notes, they increased from $9,760 to $10,931

 

During the period from October 2011 to February 2014, the Investors had converted, at conversion prices between $.0546 and $.07 per share, portions of principal and interest outstanding under the Notes and certain other convertible promissory notes previously issued to them by us. Certain antidilution provisions applicable to such notes should have resulted in such conversions being effected at a conversion price of $.042 per share. Accordingly, pursuant to the Amendments, we issued to the investors an aggregate of 4,507,105 shares of the Company’s Common Stock, which represents the additional shares of Common Stock that would have been issued to the Investors had such conversions been effected at $.042 per share.

 

The Amendments also set the conversion price of the Notes, as well as the exercise price at which shares of our common stock can be purchased under the Warrants, at $.042 per share. By virtue of the Amendments, the expiration dates of the Warrants also were extended to January 1, 2017.

 

The following table shows the conversions into principal of the September 2011 Convertible Notes by fiscal year:

 

Activity in the September 2011 Convertible Notes
Initial principal balance   $ 253,760  
Conversions during the fiscal year ended March 31, 2012     (15,000 )
Conversions during the fiscal year ended March 31, 2013     (60,000 )
Conversions during the fiscal year ended March 31, 2014     (169,000 )
Increase in principal balance due to extension fee     1,171  
Conversions during the three months ended June 30, 2014     --  
Balance as of June 30, 2014   $ 10,931  

 

Subsequent to June 30, 2014, the investor converted out the remaining principal and accrued interest into our common stock (see Note 15). 

 

LAW FIRM NOTE

 

On March 22, 2012, we entered into a Promissory Note with our corporate law firm for the amount of $75,000, which represented the majority of the amount we owed to that firm at that time. The Promissory Note originally had a maturity date of December 31, 2012 and bears interest at 5% per annum. The note is convertible at the option of the holder into shares of our common stock at a 10% discount to the market price of the common stock on the date prior to conversion with a floor price on such conversions of $0.08 per share. The holder subsequently agreed to extend the Maturity Date of the Note first to October 1, 2013, then to September 30, 2013, and now the expiration date of this note is again extended to October 1, 2014. As of June 30, 2014, there have not been any conversions of the Law Firm Note.

 

6. EQUITY TRANSACTIONS 

 

COMMON STOCK AND WARRANTS

 

Aethlon Medical, Inc. Equity Transactions in the Three Months Ended June 30, 2014

 

In the three months ended June 30, 2014, we completed unit subscription agreements with seven accredited investors pursuant to which we issued 2,192,444 shares of our common stock and 1,096,222 warrants to purchase our common stock for net cash proceeds of $320,800. Such warrants have exercise prices ranging from $0.193 to $0.236 per share.

 

18
 

 
As discussed above in Note 5, during the three months ended June 30, 2014, we issued stock to the holder of one of the Series A 12% Convertible Notes 15,714,286 shares of restricted common in exchange for the conversion in full of the $660,000 principal balance of that note, 7,603,968 shares of restricted common stock in exchange for conversion of $343,200 of accrued interest and 75,000 shares of restricted common stock as a restructuring fee. During that period, we also issued the other holder of the Series A 12% Convertible Notes 2,591,846 shares of restricted common stock in exchange for conversion of $116,970 of accrued interest and 25,000 shares of restricted common stock as a restructuring fee.

 

During the three months ended June 30, 2014, we issued 219,127 shares of common stock pursuant to our S-8 registration statement covering our Amended 2010 Stock Plan at an average price of $0.17 per share in payment for legal services, internal controls consulting services and regulatory consulting services collectively valued at $38,268 based on the value of the services provided.

 

7. RELATED PARTY TRANSACTIONS

 

DUE TO RELATED PARTIES

 

Certain of our officers and other related parties have advanced us funds, agreed to defer compensation and/or paid expenses on our behalf to cover working capital deficiencies. These unsecured and non-interest-bearing liabilities have been included as due to related parties in the accompanying consolidated balance sheets.

 

Other related party transactions are disclosed elsewhere in these notes to consolidated financial statements.

 

8. OTHER CURRENT LIABILITIES

 

Other current liabilities were comprised of the following items:

 

    June 30,     March 31,  
    2014     2014  
Accrued interest   $ 645,404     $ 1,165,335  
Accrued legal fees     179,465       179,465  
Accrued liquidated damages     362,800       362,800  
Other accrued liabilities     127,274       147,774  
Total other current liabilities   $ 1,314,943     $ 1,855,374  

 

As of the date of this report, various promissory and convertible notes payable in the aggregate principal amount of $472,656 (as identified in Notes 4 and 5 above) have reached maturity and are past due. We are continually reviewing other financing arrangements to retire all past due notes. At June 30, 2014, we had accrued interest in the amount of $487,273 associated with these defaulted notes in accrued liabilities payable (see Notes 4 and 5).

 

9. FAIR VALUE MEASUREMENTS

 

We follow FASB ASC 820, "FAIR VALUE MEASUREMENTS AND DISCLOSURES" (“ASC 820”) in connection with assets and liabilities measured at fair value on a recurring basis subsequent to initial recognition. The guidance applies to our derivative liabilities. We had no assets or liabilities measured at fair value on a non-recurring basis for any period reported.

 

ASC 820 requires that assets and liabilities carried at fair value will be classified and disclosed in one of the following three categories: We measure the fair value of applicable financial and non-financial assets based on the following fair value hierarchy:

 

Level 1: Quoted market prices in active markets for identical assets or liabilities.

 

Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data.

 

Level 3: Unobservable inputs that are not corroborated by market data.

 

The hierarchy noted above requires us to minimize the use of unobservable inputs and to use observable market data, if available, when determining fair value.

 

The fair value of our recorded derivative liabilities is determined based on unobservable inputs that are not corroborated by market data, which is a Level 3 classification. We record derivative liabilities on our balance sheet at fair value with changes in fair value recorded in our consolidated statements of operations.

 

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At June 30, 2014, we no longer had any derivative liabilities as all of the holders of the financial instruments that had price antidilution protection waived such price antidilution protection. 

 

Our fair value measurements at the March 31, 2014 reporting date are classified based on the valuation technique level noted in the table below:

 

Description   March 31,
2014
    Quoted Prices
in Active Markets for
(Level 1)
    Significant Other Observable
(Level 2)
    Significant
Unobservable
(Level 3)
 
Derivative Liabilities   $ 10,679,067     $     $     $ 10,679,067  
Total Assets   $ 10,679,067     $     $     $ 10,679,067  

 

The following outlines the significant weighted average assumptions used to estimate the fair value information presented, in connection with our warrant and embedded conversion option derivative instruments utilizing the Binomial Lattice option pricing model:

 

  Three Months Ended June 30, 2013
Risk free interest rate 0.04% - 0.75%
Average expected life 0.25 – 3.2 years
Expected volatility 58.0% - 102.8%
Expected dividends None

 

The table below sets forth a summary of changes in the fair value of our Level 3 financial instruments for the three months ended June 30, 2014:   

 

    April 1,
2014
    Recorded New Derivative
Liabilities
    Change in estimated fair value recognized in results of operations     Reclassification
of Derivative
Liability to Paid
in capital
    June 30,
2014
 
                                         
Derivative liabilities   $ 10,679,067     $     $     $ (10,679,067 )   $  

 

The table below sets forth a summary of changes in the fair value of our Level 3 financial instruments for the three months ended June 30, 2013: 

 

    April 1,
2013
    Recorded New Derivative
Liabilities
    Change in estimated fair value recognized in results of operations     Reclassification
of Derivative
Liability to Paid
in capital
    June 30,
2013
 
                                         
Derivative liabilities   $ 3,588,239     $     $ (609,125 )   $ (92,857 )   $ 2,886,257  

 

10. STOCK COMPENSATION 

 

The following tables summarize share-based compensation expenses relating to shares and options granted and the effect on basic and diluted loss per common share during the three months ended June 30, 2014 and 2013:

 

    June 30, 2014     June 30, 2013  
Vesting of stock options   $ 170,887     $ 50,387  
Incremental fair value of option modifications           957  
Vesting expense associated with CEO restricted stock grant           64,444  
Total stock-based compensation expense   $ 170,887     $ 115,788  
                 
Basic and diluted loss per common share   $ (0.00 )   $ (0.00 )

 

All of the stock-based compensation expense recorded during the three months ended June 30, 2014 and 2013, which totaled $170,887 and $115,788, respectively, is included in payroll and related expense in the accompanying condensed consolidated statements of operations.  Stock-based compensation expense recorded during the three months ended June 30, 2014 and 2013 had no impact on basic and diluted loss per common share.

 

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We review share-based compensation on a quarterly basis for changes to the estimate of expected award forfeitures based on actual forfeiture experience. The cumulative effect of adjusting the forfeiture rate for all expense amortization is recognized in the period the forfeiture estimate is changed. The effect of forfeiture adjustments for the three months ended June 30, 2014 was insignificant.

 

On June 6, 2014, our Board of Directors approved the following grants of options to certain officers and directors of the Company:

 

  o To Mr. James A. Joyce, an option to acquire an aggregate of 1,500,000 shares of our common stock at an exercise price of $0.19 per share, the closing price of our common stock on the date of grant. The fair value of this stock option at the date of grant was $246,000.  The option vested as to 500,000 shares on the grant date for a vesting expense of $82,000 and will vest as to an additional 500,000 shares on each of the first two anniversaries of the grant date. Unless earlier exercised or terminated, the option will expire June 6, 2024.

 

  o To Mr. Rodney S. Kenley, an option to acquire an aggregate of 250,000 shares of our common stock at an exercise price of $0.19 per share, the closing price of our common stock on the date of grant. The fair value of this stock option at the date of grant was $41,000.  The option vested as to 83,333 shares on the grant date for a vesting expense of $13,667 and will vest as to an additional 83,333 shares on the first anniversary of the grant date and 83,334 shares on the second anniversary of the grant date. Unless earlier exercised or terminated, the option will expire June 6, 2024.

 

  o

To Mr. James B. Frakes, an option to acquire an aggregate of 250,000 shares of our common stock at an exercise price of $0.19 per share, the closing price of our common stock on the date of grant. The fair value of this stock option at the date of grant was $41,000. The option vested as to 83,333 shares on the grant date for a vesting expense of $13,667 and will vest as to an additional 83,333 shares on the first anniversary of the grant date and 83,334 shares on the second anniversary of the grant date. Unless earlier exercised or terminated, the option will expire June 6, 2024.

 

  o To Dr. Richard H. Tullis, an option to acquire an aggregate of 50,000 shares of our common stock at an exercise price of $0.19 per share, the closing price of our common stock on the date of grant. The fair value of this stock option at the date of grant was $8,200. The option vested as to 16,667 shares on the grant date for a vesting expense of $2,733 and will vest as to an additional 16,667 shares on the first anniversary of the grant date and 16,666 shares on the second anniversary of the grant date. Unless earlier exercised or terminated, the option will expire June 6, 2024.

 

In addition to the above grants to our officers, on June 6, 2014, our Board of Directors also approved the grant of options to five employees to acquire an aggregate of 370,000 shares of our common stock at an exercise price of $0.19 per share, the closing price of our common stock on the date of grant. The aggregate fair value of those stock options at the date of grant was $60,680. Those options vested as to 123,333 shares on the grant date for a vesting expense of $20,227 and will vest as to an additional 123,333 shares on the first anniversary of the grant date and 123,334 shares on the second anniversary of the grant date. Unless earlier exercised or terminated, the option will expire June 6, 2024.

 

Changes to 2012 Board Compensation Program

 

In July 2012, the Board approved a Board Compensation Program (the “2012 Program”), which modified and superseded the 2005 Directors Compensation Program that had been in effect previously. On June 6, 2014, the Board approved certain changes to the 2012 Program. Under the modified 2012 Program, in which only non-employee Directors may participate, a new eligible Director will receive an initial grant of $50,000 worth of options to acquire shares of common stock, with such grant being valued at the exercise price based on the average of the closing bid prices of our common stock for the five trading days preceding the first day of the fiscal year. These options will have a term of ten years and will vest 1/3 upon grant and 1/3 upon each of the first two anniversaries of the date of grant.

 

At the beginning of each fiscal year, each existing Director eligible to participate in the 2012 Program also will receive a grant of $35,000 worth of options valued at the exercise price based on the average of the closing bid prices of the Common Stock for the five trading days preceding the first day of the fiscal year. Such options will vest on the first anniversary of the date of grant. In lieu of per meeting fees, under the 2012 Program eligible Directors will receive an annual Board retainer fee of $30,000. The modified 2012 Program also provides for the following annual retainer fees: Audit Committee Chair - $5,000, Compensation Committee chair - $5,000, Audit Committee member - $4,000, Compensation Committee member - $4,000 and Lead independent director - $15,000.

 

As a result of the modified 2012 Program on June 6, 2014, we issued 184,211 stock options to each of our three outside directors. Those grants vest over the fiscal year ending March 31, 2015 and have an exercise price of $0.19 per share.

 

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All of the foregoing actions - the changes in base salaries, the option grants and the changes to the Directors Compensation Program discussed herein - were approved and recommended by the Company’s Compensation Committee prior to approval by the Board.

 

The following outlines the significant weighted average assumptions used to estimate the fair value information presented, with respect to stock option grants utilizing the Binomial Lattice option pricing models at, and during the three months ended June 30, 2014: 

 

Risk free interest rate 2.6%
Average expected life    10 years
Expected volatility      90.23%
Expected dividends  None

 

The expected volatility was based on the historic volatility. The expected life of options granted was based on the "simplified method" as described in the SEC's guidance due to changes in the vesting terms and contractual life of current option grants compared to our historical grants.

 

In May 2013, we granted to a scientific advisory board member and a scientific consultant a three year option to purchase 125,000 shares of our common stock at a price of $0.11 per share.

 

The following outlines the significant weighted average assumptions used to estimate the fair value information presented, with respect to stock option grants utilizing the Binomial Lattice option pricing models at, and during the three months ended June 30, 2013: 

 

Risk free interest rate 0.38%
Average expected life    3 years
Expected volatility      94.6%
Expected dividends  None

 

The expected volatility was based on the historic volatility. The expected life of options granted was based on the "simplified method" as described in the SEC's guidance due to changes in the vesting terms and contractual life of current option grants compared to our historical grants.

 

Options outstanding that have vested and are expected to vest as of June 30, 2014 are as follows:

 

    Number of Shares     Weighted Average Exercise Price     Weighted Average Remaining Contractual Term in Years  
                   
Vested     23,356,728     $ 0.27       2.34  
Expected to vest     5,749,310     $ 0.14       9.25  
Total     29,106,038                  

 

A summary of stock option activity during the three months ended June 30, 2014 is presented below:

 

    Amount     Range of
Exercise Price
    Weighted Average
Exercise Price
 
Stock options outstanding at March 31, 2014     26,133,407       $0.076 - $0.41     $ 0.25  
Exercised                    
Granted     2,972,632       0.19     $ 0.19  
Cancelled/Expired                    
Stock options outstanding at June 30, 2014     29,106,038       $0.076 - $0.41     $ 0.24  
Stock options exercisable at June 30, 2014     23,356,728       $0.076 - $0.41     $ 0.27  

 

At June 30, 2014, there was approximately $587,576 of unrecognized compensation cost related to share-based payments, which is expected to be recognized over a weighted average period of 4.49 years.

 

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On June 30, 2014, our stock options had a negative intrinsic value since the closing price on that date of $0.18 per share was below the weighted average exercise price of our stock options.

 

11. WARRANTS

 

A summary of warrant activity during the three months ended June 30, 2014 is presented below:

 

    Amount     Range of
Exercise Price
    Weighted Average
Exercise Price
 
Warrants outstanding at March 31, 2014     70,709,475       $0.042 - $0.25     $ 0.13  
Exercised                    
Issued     10,759,815       $0.241 - $0.042     $ 0.06  
Cancelled/Expired                    
Warrants outstanding at June 30, 2014     81,469,290       $0.07 - $0.25     $ 0.10  
Warrants exercisable at June 30, 2014     81,469,290       $0.07 - $0.25     $ 0.10  

 

The following outlines the significant weighted average assumptions used to estimate the fair value information presented, with respect to warrants utilizing the Binomial Lattice option pricing models at, and during the three months ended June 30, 2014:

 

Risk free interest rate 1.53% - 1.70%  
Average expected life    5 years
Expected volatility      95.0% - 95.2%
Expected dividends  None

 

12. DARPA CONTRACT AND RELATED REVENUE RECOGNITION

 

As discussed in Note 1, we entered into a contract with the DARPA on September 30, 2011. Under the DARPA award, we have been engaged to develop a therapeutic device to reduce the incidence of sepsis, a fatal bloodstream infection that often results in the death of combat-injured soldiers. The award from DARPA was a fixed-price contract with potential total payments to us of $6,794,389 over the course of five years. Fixed price contracts require the achievement of multiple, incremental milestones to receive the full award during each year of the contract. Under the terms of the contract, we will perform certain incremental work towards the achievement of specific milestones against which we will invoice the government for fixed payment amounts. 

 

Originally, only the base year (year one contract) was effective for the parties, however, DARPA subsequently exercised the option on the second and third years of the contract. DARPA has the option to enter into the contract for years four and five. The milestones are comprised of planning, engineering and clinical targets, the achievement of which in some cases will require the participation and contribution of third party participants under the contract. There can be no assurance that we alone, or with third party participants, will meet such milestones to the satisfaction of the government and in compliance with the terms of the contract or that we will be paid the full amount of the contract revenues during any year of the contract term. We commenced work under the contract in October 2011. 

 

Due to budget restrictions within the Department of Defense, on February 10, 2014, DARPA reduced the scope of our contract in years three through five of the contract. The reduction in scope focused our research on exosomes, viruses and blood processing instrumentation. This scope reduction will reduce the possible payments under the contract by $858,491 over years three through five. We recently completed a rebudgeting of the expected costs on the remaining years of the DARPA contract based on the reduced milestones and have concluded that the reductions in our costs due to the scaled back level of work will almost entirely offset the anticipated revenue levels based on current assumptions.

 

We did not invoice DARPA for any milestones in the three months ended June 30, 2014 although we did invoice and receive a milestone in July 2014 (see Note 15). 

 

In the three months ended June 30, 2013, we invoiced the US Government for the twelfth milestone under our DARPA contract in the amount of $195,596 and received that payment. The details of that milestone were as follows:

 

Milestone 2.3.2.2 – Formulate initial design based on work from previous phase. Begin to build and test selected instrument design and tubing sets. The milestone payment was $195,596. Management considers this milestone to be substantive as it was not dependent on the passage of time nor was it based solely on another party's efforts. We demonstrated that we were able to build and test selected instrument design and tubing sets. The report was accepted by the contracting officer's representative and the invoice was submitted thereafter.  

 

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13. COMMITMENTS AND CONTINGENCIES

 

LEASE COMMITMENTS

 

We currently rent approximately 2,300 square feet of executive office space at 8910 University Center Lane, Suite 660, San Diego, CA 92122 at the rate of $6,475 per month on a four year lease that expires in September 2014. We also rent approximately 1,700 square feet of laboratory space at 11585 Sorrento Valley Road, Suite 109, San Diego, California 92121 at the rate of $2,917 per month on a two year lease that expires in October 2014.  We are currently searching for new space in the greater San Diego area.

 

Our Exosome Sciences, Inc. subsidiary rents approximately 2,055 square feet of office and laboratory space at 11 Deer Park Drive, South Brunswick, NJ at the rate of $3,425 per month on a one year lease that expires in October 2014. Our current plans are to renew the lease prior to expiration.

 

Rent expense approximated $37,000 and $26,000 for the three month periods ended June 30, 2014 and 2013, respectively. 

 

LEGAL MATTERS

 

From time to time, claims are made against us in the ordinary course of business, which could result in litigation. Claims and associated litigation are subject to inherent uncertainties and unfavorable outcomes could occur, such as monetary damages, fines, penalties or injunctions prohibiting us from selling one or more products or engaging in other activities.

 

The occurrence of an unfavorable outcome in any specific period could have a material adverse effect on our results of operations for that period or future periods. Other than as mentioned here, we are not presently a party to any pending or threatened legal proceedings.

 

14. SEGMENTS

 

We operate our businesses principally through two reportable segments: Aethlon, which represents our therapeutic business activities, and ESI, which represents our diagnostic business activities. Our reportable segments have been determined based on the nature of the potential products being developed. ESI did not have any operations in the three months ended June 30, 2013.

 

Aethlon’s revenue is generated primarily from government contracts to date and ESI does not yet have any revenues. We have not included any allocation of corporate overhead to the ESI segment.

 

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The following tables set forth certain information regarding our segments and other operations that conforms to the consolidated balance sheet and statement of operations presented in this Report:

 

    Three Months Ended June 30,  
    2014     2013  
Revenues:                
Aethlon   $ 51,296     $ 195,596  
ESI            
Total Revenues   $ 51,296     $ 195,596  
                 
Operating Losses:                
Aethlon   $ (930,252 )   $ (783,798 )
ESI     (241,756 )      
Total Operating Loss   $ (1,172,008 )   $ (783,798 )
                 
Net Losses:                
Aethlon   $ (3,462,536 )   $ (303,498 )
ESI     (241,756 )      
Net Loss Before Non-Controlling Interests   $ (3,704,292 )   $ (303,498 )
                 
Cash:                
Aethlon   $ 45,704     $ 31,653  
ESI     761,626        
Total Cash   $ 807,330     $ 31,653  
                 
Total Assets:                
Aethlon   $ 294,662     $ 195,243  
ESI     849,786        
Total Assets   $ 1,144,448     $ 195,243  
                 
Capital Expenditures:                
Aethlon   $     $  
ESI            
Capital Expenditures   $     $  
                 
Depreciation and Amortization:                
Aethlon   $ 4,442     $ 2,436  
ESI     4,896        
Total Depreciation and Amortization   $ 9,338     $ 2,436  
                 
Interest Expense:                
Aethlon   $ (35,626 )   $ 106,096  
ESI            
Total Interest Expense   $ (35,626 )   $ 106,096  

 

15. SUBSEQUENT EVENTS

 

Management has evaluated events subsequent to June 30, 2014 through the date that the accompanying condensed consolidated financial statements were filed with the Securities and Exchange Commission for transactions and other events which may require adjustment of and/or disclosure in such financial statements.

 

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Government Contracts

 

Subsequent to June 30, 2014, we billed and collected $197,362 under our DARPA contract, and under the Battelle subcontract we billed $23,041 and we collected $22,496.

 

Common Stock Issuances

 

Subsequent to June 30, 2014, we issued 276,935 shares of common stock pursuant to our S-8 registration statement covering our Amended 2010 Stock Plan at an average price of $0.14 per share in payment for legal and scientific consulting services valued at $39,170 based on the value of the services provided.

 

Subsequent to June 30, 2014, we issued 309,301 shares of restricted common stock at an average price of $0.24 per share in payment for investor relations consulting services valued at $75,000 based on the value of the services provided.

 

Subsequent to June 30, 2014, we issued 1,937,505 shares of restricted common stock to the holders of three convertible notes in exchange for the partial or full conversion of principal and interest in the aggregate amount of $81,375 at a conversion price of $0.042 per share.

 

On July 24, 2014, we issued an aggregate of 2,503,966 shares of restricted common stock and a seven-year warrant to issue up to 1,251,983 shares of common stock at an exercise price of $0.132 per share to Dr. Chetan Shah, a director. The common stock and warrant were issued to Dr. Shah upon the conversion of an aggregate of $220,349 of unpaid principal and accrued interest due under a 10% Convertible Note previously issued to Dr. Shah by us on July 9, 2013.

 

Subsequent to June 30, 2014, four investors received 2,673,231 shares of restricted common stock through the cash exercise of eight warrants for $259,474 of cash at an average exercise price of approximately $0.10 per share. As an inducement to those investors, we issued them replacement warrants to acquire up to an aggregate of 2,673,231 shares of common stock on the same terms as the warrants they exercised.

 

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

 

The following discussion of our financial condition and results of operations should be read in conjunction with, and is qualified in its entirety by, the condensed consolidated financial statements and notes thereto included in Item 1 in this Quarterly Report on Form 10-Q. This item contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those indicated in such forward-looking statements.

 

FORWARD LOOKING STATEMENTS

 

All statements, other than statements of historical fact, included in this Form 10-Q are, or may be deemed to be, "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended ("the Securities Act"), and Section 21E of the Exchange Act. Such forward-looking statements involve assumptions, known and unknown risks, uncertainties and other factors which may cause the actual results, performance, or achievements of Aethlon Medical, Inc. ("we", "us" or "the Company") to be materially different from any future results, performance, or achievements expressed or implied by such forward-looking statements contained in this Form 10-Q. Such potential risks and uncertainties include, without limitation, completion of our capital-raising activities, FDA approval of our products, other regulations, patent protection of our proprietary technology, product liability exposure, uncertainty of market acceptance, competition, technological change, and other risk factors detailed herein and in other of our filings with the Securities and Exchange Commission. The forward-looking statements are made as of the date of this Form 10-Q, and we assume no obligation to update the forward-looking statements, or to update the reasons actual results could differ from those projected in such forward-looking statements.

 

Overview

 

Aethlon Medical, Inc. ("Aethlon", the "Company", "we" or "us") is a medical device company focused on creating innovative devices that address unmet medical needs in cancer, infectious disease and other life-threatening conditions. At the core of our developments is the Aethlon ADAPT™ (Adaptive Dialysis-Like Affinity Platform Technology) system, a medical device platform that converges single or multiple affinity drug agents with advanced plasma membrane technology to create therapeutic filtration devices that selectively remove harmful particles from the entire circulatory system without loss of essential blood components.

 

In June 2013, the U.S. Food and Drug Administration ("FDA") approved our Investigational Device Exemption ("IDE") application to initiate a ten patient human clinical trial in one location in the United States. Successful outcomes of that human trial as well as at least one follow-on human trial will be required by the FDA in order to commercialize our products in the US. The regulatory agencies of certain foreign countries where we intend to sell this device will also require one or more human clinical trials.

 

Some of our patents may expire before we receive FDA approval to market our products in the United States or we receive approval to market our products in a foreign country. However, we believe that certain patent applications and/or other patents issued more recently will help protect the proprietary nature of the Hemopurifier(R) treatment technology.

 

In October 2013, our subsidiary, Exosome Sciences, Inc. (ESI), commenced operations with a focus on advancing exosome-based strategies to diagnose and monitor the progression of cancer, infectious disease and other life-threatening conditions.

 

Our common stock is quoted on the OTCQB marketplace administered by the OTC Markets Group under the symbol "AEMD."

 

WHERE YOU CAN FIND MORE INFORMATION

 

We are subject to the informational requirements of the Securities Exchange Act and must file reports, proxy statements and other information with the SEC. The reports, information statements and other information we file with the Commission can be inspected and copied at the Commission Public Reference Room, 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at (800) SEC-0330. The Commission also maintains a Web site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants, like us, which file electronically with the Commission. Our headquarters are located at 8910 University Center Lane, Suite 660, San Diego, CA 92122. Our phone number at that address is (858) 459-7800. Our Web site is http://www.aethlonmedical.com.

 

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RESULTS OF OPERATIONS 

 

THREE MONTHS ENDED JUNE 30, 2014 COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2013

 

Revenues

 

We recorded government contract revenue in the three months ended June 30, 2014 and 2013.  This revenue arose from work performed under our government contract with DARPA and our subcontract with Battelle as follows:

 

    Three Months Ended 6/30/14     Three Months Ended 6/30/13     Change in Dollars  
DARPA Contract   $     $ 195,596     $ (195,596 )
Battelle Subcontract     51,296             51,296  
Total Government Contract Revenue   $ 51,296     $ 195,596     $ (144,300 )

 

DARPA Contract

 

We entered into a contract with the DARPA on September 30, 2011. Under the DARPA award, we have been engaged to develop a therapeutic device to reduce the incidence of sepsis, a fatal bloodstream infection that often results in the death of combat-injured soldiers. The award from DARPA was a fixed-price contract with potential total payments to us of $6,794,389 over the course of five years. Fixed price contracts require the achievement of multiple, incremental milestones to receive the full award during each year of the contract. Under the terms of the contract, we will perform certain incremental work towards the achievement of specific milestones against which we will invoice the government for fixed payment amounts.

 

Originally, only the base year (year one contract) was effective for the parties, however, DARPA subsequently exercised the option on the second and third years of the contract. DARPA has the option to enter into the contract for years four and five. The milestones are comprised of planning, engineering and clinical targets, the achievement of which in some cases will require the participation and contribution of third party participants under the contract. There can be no assurance that we alone, or with third party participants, will meet such milestones to the satisfaction of the government and in compliance with the terms of the contract or that we will be paid the full amount of the contract revenues during any year of the contract term. We commenced work under the contract in October 2011.

 

Due to budget restrictions within the Department of Defense, on February 10, 2014, DARPA reduced the scope of our contract in years three through five of the contract. The reduction in scope focused our research on exosomes, viruses and blood processing instrumentation. This scope reduction will reduce the possible payments under the contract by $858,491 over years three through five. We recently completed a rebudgeting of the expected costs on the remaining years of the DARPA contract based on the reduced milestones and have concluded that the reductions in our costs due to the scaled back level of work will almost entirely offset the anticipated revenue levels based on current assumptions.

Revenues

 

During the three months ended June 30, 2014 we did not invoice DARPA for any milestones while in the three months ended June 30, 2013, we did invoice DARPA for a milestone payment in the amount of $195,596.  

 

Operating Expenses

 

Consolidated operating expenses for the three months ended June 30, 2014 were $1,223,304 in comparison with $979,394 for the comparable quarter a year ago.  This increase of $243,910, or 24.9%, was due to increases in payroll and related expenses of $162,055, increases in professional fees of $77,543 and increases in general and administrative expenses of $4,312.

 

The $162,055 increase in payroll and related expenses was primarily due to the ESI payroll of $123,711. Another significant factor was an increase in stock-based compensation of $55,099 due to vesting of stock option grants issued in July 2013 and June 2014. Cash-based compensation at Aethlon actually decreased by $16,755 from the 2013 period.

 

The $77,543 increase in our professional fees was partially due to ESI professional fees of $67,044 and an increase of $60,446 for non-DARPA-related professional fees at Aethlon. Those increases at Aethlon were primarily due to a $20,000 increase in Directors’ fees, a $23,198 increase in fees for contract manufacturing of cartridges and a $19,642 increase in legal fees, largely due to increased patent-related activity. Those increases were offset by a decrease in DARPA-related professional fees of $49,947.

 

The $4,312 increase in general and administrative expenses was primarily due to general and administrative expenses at ESI of $51,001. We also had an increase of $11,974 in our non-DARPA-related general and administrative expenses. Those increases were largely offset by a decrease in our DARPA-related general and administrative expenses of $58,663. 

 

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Other (Income) Expense

 

Other (income) expense consists primarily of losses on extinguishment of debt, the change in the fair value of our derivative liability, other expense and interest expense. Other (income) expense for the three months ended June 30, 2014 was other expense of $2,532,284 in comparison with other income of $480,300 for the comparable quarter a year ago.

 

Loss on Extinguishment of Debt

 

We recorded a loss on extinguishment of debt of $2,453,630 for the three months ended June 30, 2014. This loss arose from payments of accrued interest on our 12% Series A convertible notes that were in the form of units (common stock plus warrants). The loss was calculated based on the fair value of the warrants and shares issued in the unit payments less the accrued interest that was paid. The three months ended June 30, 2013 contained a $22,789 loss on settlement of accrued interest and damages.

 

Change in Fair Value of Derivative Liability

 

We did not record a change in the fair value of derivative liabilities in the three months ended June 30, 2014 since we believe the fair value did not change significantly between March 31, 2014 and the date of subsequent extinguishment of all of our derivative liabilities in June 2014. All of the holders of notes and warrants that had price antidilution protection have waived such protection.

 

For the three months ended June 30, 2013, the change in the estimated fair value of derivative liability was a gain of $609,125.

 

Interest Expense

 

Interest expense was $78,654 for the three months ended June 30, 2014 compared to $106,096 in the corresponding prior period, a decrease of $27,442. The various components of our interest expense are shown in the following table:

 

    Quarter Ended     Quarter Ended        
    6/30/14     6/30/13     Change  
Interest Expense   $ 56,712     $ 103,200     $ (46,488 )
Amortization of Deferred Financing Costs     9,942       863       9,079  
Note Restructuring Expense     12,000             12,000  
Amortization of Note Discounts           2,033       (2,033 )
Total Interest Expense   $ 78,654     $ 106,096     $ (27,442 )

 

As noted in the above table, the most significant factor in the $27,442 decrease in interest expense was the $46,488 decrease in the interest expense that was primarily due to lower levels of notes outstanding in the 2014 period. Other smaller factors in the change in our total interest was an increase in the amortization of deferred financing costs of $9,079 and a note restructuring expense of $12,000 related to the restructuring of the 12% Series A convertible notes, which were partially offset by a reduction in the amortization of note discounts.

 

Net Loss

 

As a result of the increased expenses noted above, our net loss before noncontrolling interests increased from approximately $303,000 to approximately $3,704,000 for the quarters ended June 30, 2014 and 2013, respectively.

 

Basic and diluted loss attributable to common stockholders were ($0.02) for the three month period ended June 30, 2014 compared to ($0.00) for the period ended June 30, 2013.

 

LIQUIDITY AND CAPITAL RESOURCES

 

At June 30, 2014, we had a cash balance of $807,330 and a working capital deficit of $2,725,823. This compares to a cash balance of $1,250,279 and a working capital deficit of $14,169,471 at March 31, 2014. Between July 1, 2014 and August 12, 2014, we raised aggregate proceeds of $259,474 through private equity transactions, and we billed and collected $197,362 under our DARPA contract, and under the Battelle subcontract we billed $23,041 and we collected $22,496. Our cash at June 30, 2014 plus additional funds raised to date subsequent to June 30, 2014 are not sufficient to meet our funding requirements during the next twelve months. Significant additional financing must be obtained in order to provide a sufficient source of operating capital and to allow the Company to continue to operate as a going concern. In addition, we will need to raise capital to complete the recently approved human clinical trial in the U.S.

 

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We do not expect revenue from operations will be sufficient to satisfy our funding requirements in the near term, and accordingly, our ability to continue operations and meet our cash obligations as they become due and payable is expected to depend for at least the next several years on our ability to sell securities, borrow funds or a combination thereof. Future capital requirements will depend upon many factors, including progress with pre-clinical testing and clinical trials, the number and breadth of our clinical programs, the time and costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other proprietary rights, the time and costs involved in obtaining regulatory approvals, competing technological and market developments, as well as our ability to establish collaborative arrangements, effective commercialization, marketing activities and other arrangements. We expect to continue to incur increasing negative cash flows and net losses for the foreseeable future.

 

Should the U.S. Government elect not to exercise the options for years four and through five of our DARPA contract, the effects may be material to us. The loss of revenues from the DARPA contract would have a material impact on our revenues, operating cash flows and liquidity.

 

Cash Flows

 

Cash flows from operating, investing and financing activities, as reflected in the accompanying Condensed Consolidated Statements of Cash Flows, are summarized as follows (in thousands):

 

    (In thousands)
For the three months ended
 
    June 30,
2014
    June 30,
2013
 
Cash (used in) provided by:                
Operating activities   $ (764 )   $ (222 )
Investing activities            
Financing activities     321       128  
Net increase (decrease) in cash   $ (443 )   $ (94 )

 

NET CASH FROM OPERATING ACTIVITIES. We used cash in our operating activities due to our losses from operations. Net cash used in operating activities was approximately $764,000 in the three months ended June 30, 2014 compared to $222,000 in the three months ended June 30, 2013, an increase of $542,000.  The $542,000 increase was primarily due to our increased operating loss.

 

NET CASH FROM INVESTING ACTIVITIES. We did not have any investing activities during either period.

 

NET CASH FROM FINANCING ACTIVITIES. Net cash generated from financing activities increased from approximately $128,000 in the three months ended June 30, 2013 to $321,000 in the three months ended June 30, 2014. The only financing activity in both periods was the issuance of common stock.

 

An increase in working capital during the three months ended June 30, 2014 in the amount of approximately $11,443,000 changed our negative working capital position to approximately ($2,726,000) at June 30, 2014 from a negative working capital of approximately ($14,169,000) at March 31, 2014.  The most significant factors in the increase in working capital noted above were a decrease in derivative liability of approximately $10,679,000 and a reduction in the current portion of our convertible notes payable of approximately $885,000. Those liability reductions were partially offset by the collection of approximately $84,000 in accounts receivable and a decrease of approximately $443,000 in cash.

 

At the date of this filing, we plan to invest significantly into purchases of our raw materials and into our contract manufacturing arrangement subject to successfully raising additional capital.

 

CRITICAL ACCOUNTING POLICIES

 

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company to make a number of estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Such estimates and assumptions affect the reported amounts of expenses during the reporting period. On an ongoing basis, we evaluate estimates and assumptions based upon historical experience and various other factors and circumstances. We believe our estimates and assumptions are reasonable in the circumstances; however, actual results may differ from these estimates under different future conditions.

 

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We believe that the estimates and assumptions that are most important to the portrayal of our financial condition and results of operations, in that they require the most difficult, subjective or complex judgments, form the basis for the accounting policies deemed to be most critical to us. These critical accounting policies relate to revenue recognition, measurement of stock purchase warrants issued with notes payable, beneficial conversion feature of convertible notes payable, impairment of intangible assets and long lived assets, stock compensation, and the classification of warrant obligations, and evaluation of contingencies. We believe estimates and assumptions related to these critical accounting policies are appropriate under the circumstances; however, should future events or occurrences result in unanticipated consequences, there could be a material impact on our future financial condition or results of operations.

 

There have been no changes to our critical accounting policies as disclosed in our Form 10-K for the year ended March 31, 2014.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

We have no obligations required to be disclosed herein as off-balance sheet arrangements.

 

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.

 

ITEM 4. CONTROLS AND PROCEDURES.

 

DISCLOSURE CONTROLS AND PROCEDURES

 

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of a date as of the end of the period covered by this Quarterly Report.

 

Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of such period, our disclosure controls and procedures are not effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are not effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

 

There have been no changes in our internal control over financial reporting during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS.

 

From time to time, claims are made against us in the ordinary course of business, which could result in litigation. Claims and associated litigation are subject to inherent uncertainties and unfavorable outcomes could occur, such as monetary damages, fines, penalties or injunctions prohibiting us from selling one or more products or engaging in other activities.

 

The occurrence of an unfavorable outcome in any specific period could have a material adverse effect on our results of operations for that period or future periods. Other than as set forth here, we are not presently a party to any pending or threatened legal proceedings.

 

ITEM 1A. RISK FACTORS.

 

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.

 

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

 

During the quarter ended June 30, 2014, we issued the following securities which were not registered under the Securities Act of 1933, as amended, and have not been included previously in a Current Report on Form 8-K. We did not employ any form of general solicitation or advertising in connection with the offer and sale of the securities described below. In addition, we believe the purchasers of the securities are "ACCREDITED INVESTORS" for the purpose of Rule 501 of the Securities Act. For these reasons, among others, the offer and sale of the following securities were made in reliance on the exemption from registration provided by Section 4(2) of the Securities Act or Regulation D promulgated by the SEC under the Securities Act:

 

In the three months ended June 30, 2014, we completed unit subscription agreements with seven accredited investors pursuant to which we issued 2,192,444 shares of our common stock and 1,096,222 warrants to purchase our common stock for net cash proceeds of $320,800. Such warrants have exercise prices ranging from $0.193 to $0.236 per share.

 

During the three months ended June 30, 2014, we issued to the holder of one of the Series A 12% Convertible Notes 15,714,286 shares of restricted common stock in exchange for the conversion in full of the $660,000 principal balance of that note, 7,603,968 shares of restricted common stock in exchange for conversion of $343,200 of accrued interest and 75,000 shares of restricted common stock as a restructuring fee. During that period, we also issued the other holder of the Series A 12% Convertible Notes 2,591,846 shares of restricted common stock in exchange for conversion of $116,970 of accrued interest and 25,000 shares of restricted common stock as a restructuring fee.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

 

As of the date of this report, various promissory and convertible notes payable in the aggregate principal amount of $472,656 have reached maturity and are past due. We are continually reviewing other financing arrangements to retire all past due notes. At June 30, 2014, we had accrued interest in the amount of $487,273 associated with these notes payable.

 

ITEM 4. MINE SAFETY DISCLOSURES.

 

We have no disclosure applicable to this item.

 

ITEM 5. OTHER INFORMATION.

 

Not applicable

 

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ITEM 6.  EXHIBITS.

 

(a) Exhibits. The following documents are filed as part of this report:

 

3.1 Articles of Incorporation of Aethlon Medical, Inc., as amended (1)
   
3.2 Bylaws of Aethlon Medical, Inc., as amended (2)
   
4.1 Form of Common Stock Purchase Warrant dated June 24, 2014 (1)
   
4.2 Form of Common Stock Purchase Warrant dated July 8, 2014 (2)
   
4.3 Form of Common Stock Purchase Warrant dated July 24, 2014 (3)
   
10.1 Form of Restructuring Agreement dated June 24, 2014(1)
   
10.2 Form of Restructuring Agreement dated June 24, 2014 (1)
   
10.3 Form of Restructuring Agreement dated July 8, 2014 (2)
   
31.1 Certification of Principal Executive Officer pursuant to Securities Exchange Act rules 13a- 14(a) and 15d-14(a) as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002*
   
31.2 Certification of Principal Financial Officer pursuant to Securities Exchange Act rules 13a- 14(a) and 15d-14(a) as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002*
   
32.1 Certification of Principal Executive Officer pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002*
   
32.2 Certification of Principal Financial Officer pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002*
   
101 Interactive Data Files

 

  101.INS XBRL Instance Document
     
  101.SCH XBRL Schema Document
     
  101.CAL XBRL Calculation Linkbase Document
     
  101.DEF XBRL Definition Linkbase Document
     
  101.LAB XBRL Label Linkbase Document
     
  101.PRE XBRL Presentation Linkbase Document

 

* Filed herewith.

 

  (1) Incorporated by reference to the filing of such exhibit with the Company's Current Report on Form 8-K filed June 30, 2014.

 

  (2) Incorporated by reference to the filing of such exhibit with the Company’s Current Report on Form 8-K filed July 10, 2014.

 

  (3) Incorporated by reference to the filing of such exhibit with the Company’s Current Report on Form 8-K filed July 28, 2014.

 

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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.

 

 

  AETHLON MEDICAL, INC.  
       
Date: August 14, 2014 By: /s/ JAMES B. FRAKES  
    JAMES B. FRAKES  
    CHIEF FINANCIAL OFFICER  
    CHIEF ACCOUNTING OFFICER  
       

 

 

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